WATCHGUARD TECHNOLOGIES INC - 10-Q Quarterly Report

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

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

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

33,461,744 shares of WatchGuard common stock were outstanding as of April 30, 2004.

WatchGuard Technologies, Inc. (WatchGuard) is a leading provider of Internet security solutions designed to protect small- to medium-sized enterprises, or SMEs, that use the Internet for electronic commerce and secure communications.

The accompanying consolidated unaudited financial statements of WatchGuard, which include the December 31, 2003 balance sheet that was derived from audited consolidated financial statements, have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the unaudited financial statements include all adjustments, consisting of normal recurring accruals, necessary for a fair presentation. Operating results for the three-month period ended March 31, 2004 are not necessarily indicative of the results that may be expected for future quarters or for the year ending December 31, 2004. The financial statements should be read in conjunction with the financial statements and related notes for the year ended December 31, 2003 included in WatchGuard’s annual report on Form 10-K, filed with the Securities and Exchange Commission (SEC) on March 15, 2004.

WatchGuard generates revenues through sales of its Firebox products, including licenses for related software options, subscriptions for its LiveSecurity Service, which includes access to technical support, software updates (if and when available), early-warning vulnerability alerts and expert instruction and training, and sales of ServerLock products. Software license revenues are generated from licensing the rights to use WatchGuard’s products directly to end-users, from sublicense fees from resellers and distributors and from sales of its managed security solution products to Internet service providers and other service providers that utilize WatchGuard’s products to provide managed security services to their customers.

WatchGuard recognizes revenue in accordance with accounting standards for software companies, including Statement of Position (SOP) 97-2, “Software Revenue Recognition,” as amended by SOP 98-9, and related interpretations, including Technical Practice Aids and the SEC Topic 13 “Revenue Recognition” of the codification of the Staff Accounting Bulletins. Topic 13 summarizes certain of the SEC’s views in applying generally accepted accounting principles to revenue recognition in financial statements. WatchGuard believes its current revenue recognition policies and practices are consistent with the current accounting standards.

Revenues from software license agreements are generally recognized upon delivery of software if persuasive evidence of an arrangement exists, collection is probable, the fee is fixed or determinable, and vendor-specific objective evidence of fair value for undelivered elements of the arrangement has been established. Vendor-specific objective evidence of fair value is typically based on the price charged when an element is sold separately or, if an element is not sold separately, on the price established by authorized management, if it is probable that the price, once established, will not change before market introduction. WatchGuard uses the residual method, as defined in SOP 98-9, to allocate revenues to delivered elements once it has established vendor-specific objective evidence of fair value for all undelivered elements. Under the residual method, any discount in the arrangement is allocated to the delivered element.

WatchGuard provides allowances for estimated returns and return rights and pricing protection rights, which are offered to most customers. WatchGuard also provides allowances for promotional rebates offered to its customers. A customer’s return rights are generally limited to the lesser of its on-hand inventory or a percentage of the customer’s purchases for the previous quarter. Pricing protection rights, offered to many of WatchGuard’s customers, are generally limited to 60 to 90 days after notification of a price change. Revenues are reduced by the provision for estimated returns and allowances at the time the sales are made.

The promotional rebates vary by type and term and are earned by customers in accordance with various conditions. WatchGuard accounts for promotional rebates given to customers in accordance with the Emerging Issues Task Force (EITF) Issue No. 01-09, “Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Product,” which requires that sales incentives given to customers or resellers be accounted for as a reduction of revenue unless a vendor receives a benefit that is identifiable and can be reasonably estimated. WatchGuard accrues allowances for rebates to the maximum amount possible unless there are sufficient historical trends which would indicate a lower rate of accrual is appropriate.

Revenues from some distribution arrangements where the distributor has unlimited stock returns and rotation rights are not recognized until the distributors sell the products to their customers.

Revenues from LiveSecurity Service subscriptions are recognized ratably over the term of the subscription, typically 90 days to two years. WatchGuard’s payment terms typically range from 30 to 60 days.

The consolidated financial statements include the accounts of WatchGuard and its wholly owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation.

Basic and diluted net loss per share is calculated using the average number of shares of common stock outstanding. Other common stock equivalents, including stock options, are excluded from the computation because their effect is antidilutive.

WatchGuard’s investments consist of corporate and government debt securities, are considered available-for-sale, and are stated at fair value, with unrealized gains and losses included as a component of stockholders’ equity. During the three-month periods ended March 31, 2003 and March 31, 2004, there were no material realized gains or losses on securities available-for-sale. All such investments mature within two years, with the weighted average life of the investment portfolio being approximately one year. The following table sets forth the components of comprehensive loss (in thousands):

WatchGuard has elected to apply the disclosure-only provisions of Statement of Financial Accounting Standard (SFAS) 123, “Accounting for Stock-Based Compensation,” as amended by SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” Accordingly, WatchGuard accounts for employee stock-based compensation using the intrinsic value method prescribed in Accounting Principle Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Compensation cost for stock options is measured as the excess, if any, of the fair value of WatchGuard’s common stock at the date of grant over the stock option exercise price.

The following pro forma information regarding stock-based compensation has been determined as if WatchGuard had accounted for its employee stock options and its employee stock purchase plan shares under the fair market value method of SFAS 123. The fair value of the employee stock options was estimated at the date of grant, using a minimum value option pricing model through the date of WatchGuard’s initial public offering in July 1999 and using the Black-Scholes pricing model thereafter. The estimated fair value of the options is amortized over their vesting periods using the accelerated method.

WatchGuard’s pro forma information is as follows (in thousands, except per share data):

Certain prior-period items have been reclassified to conform to the current-period presentation.

WatchGuard’s operating lease for its corporate headquarters includes a collateral restriction that requires WatchGuard to maintain an irrevocable standby letter of credit issued to WatchGuard’s landlord and secured by restricted cash. At December 31, 2003 and at March 31, 2004, WatchGuard’s restricted cash balance was $3 million in conjunction with this facilities lease.

WatchGuard’s hardware products carry a one-year warranty from the delivery date that includes factory repair services or replacement products as needed. WatchGuard accrues estimated expenses for warranty obligations at the time that products are shipped based on historical product repair and replacement information. WatchGuard’s liability is affected by the warranty terms provided to WatchGuard by the original equipment manufacturers ranging from 16 to 24 months from the manufacture date. Other factors that affect WatchGuard’s warranty liability include the number of installed units, historical rates of warranty claims and cost per claim. WatchGuard periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary.

WatchGuard’s estimated product warranty liability was $197,000 and $221,000 at December 31, 2003 and at March 31, 2004, respectively.

During 2001 and 2002 WatchGuard implemented two restructuring plans. The costs of those restructuring plans are accounted for under EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity” as they pertain to the restructuring plans initiated in 2001 and 2002.

In July 2002, the Financial Accounting Standards Board (FASB) issued SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities.” This pronouncement nullified EITF Issue No. 94-3, and generally requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred rather than at the date of an entity’s commitment to an exit plan. However, the provisions of SFAS 146 are effective for exit and disposal activities initiated after December 31, 2002, and therefore are not applicable to WatchGuard’s restructuring plans initiated in 2001 and 2002.

At March 31, 2004, the remaining balance of the restructuring liabilities, including short-term and long-term portions, was $5.4 million. No adjustments to the remaining liabilities were required in the three-month period ended March 31, 2004.

In the second quarter of 2001, WatchGuard announced a restructuring plan designed to streamline operations and reduce operating costs. All costs related to this restructuring have been paid or settled, except for accrued amounts related to losses for the lease commitments, net of estimated proceeds from subleases of abandoned facilities, which are expected to be paid through 2010. The accrued liabilities relating to this restructuring at December 31, 2003 and at March 31, 2004 and activity recorded through March 31, 2004 are as follows (in thousands):

In the second quarter of 2002, WatchGuard implemented a restructuring plan primarily designed to eliminate redundancies and excess headcount resulting from the acquisition of RapidStream, Inc. in April of 2002, which included a reduction in workforce, consolidation of excess facilities and elimination of technology-related contracts that are no longer required or part of WatchGuard’s strategy. All costs related to this restructuring have been paid or settled, except for accrued amounts related to losses for the lease commitments, net of estimated proceeds from subleases of abandoned facilities, which are expected to be paid through 2010. The accrued liabilities relating to this restructuring at December 31, 2003 and at March 31, 2004, and activity recorded through March 31, 2004 are as follows (in thousands):

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis provides information that we believe is relevant to an assessment and understanding of WatchGuard’s financial condition and results of operations. The discussion should be read in conjunction with the consolidated financial statements and the notes thereto. References to “we,” “our” and “us” in this quarterly report refer to WatchGuard Technologies, Inc. and our wholly owned subsidiaries.

Our disclosure and analysis in this quarterly report on Form 10-Q contain forward-looking statements, which provide our current expectations or forecasts of future events. Forward-looking statements in this quarterly report include, without limitation:

Words such as “expects,” “believes,” “anticipates” and “intends” and similar words may identify forward-looking statements, but the absence of these words does not necessarily mean that a statement is not forward-looking. Forward-looking statements are subject to known and unknown risks and uncertainties and are based on potentially inaccurate assumptions that could cause actual results to differ materially from those expected or implied by the forward-looking statements. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including the factors described in the section entitled “Important Factors That May Affect Our Business, Our Results of Operations and Our Stock Price” in this quarterly report. Other factors besides those described in this quarterly report could also affect actual results. You should carefully consider the factors described in the section entitled “Important Factors That May Affect Our Business, Our Results of Operations and Our Stock Price” in evaluating our forward-looking statements.

You should not unduly rely on these forward-looking statements, which speak only as of the date of this quarterly report. We undertake no obligation to publicly revise any forward-looking statement to reflect circumstances or events after the date of this quarterly report, or to reflect the occurrence of unanticipated events. You should, however, review the factors and risks we describe in the reports we file from time to time with the Securities and Exchange Commission, or SEC.

WatchGuard is a leading provider of Internet security solutions designed to protect small- to medium-sized enterprises, or SMEs, that use the Internet for e-commerce and secure communications.

Our award-winning products and services include our integrated, expandable Firebox security solutions that offer firewall protection and intrusion prevention technology for access control, virtual private networking for secure communications, content and spam filtering, anti-virus protection and vulnerability assessment services. Our innovative subscription-based LiveSecurity Service provides our customers with access to expert guidance and support so they can protect their data and communications in a continuously changing environment.

Our market spans the SME market, from smaller-sized companies for which ease-of-use is a primary requirement, to medium-sized companies, including those with high-speed connections supporting virtual private networks, or VPNs, between the corporate headquarters and geographically dispersed branch offices, for which performance, scalability and networking features are key requirements. Our security solutions also give enterprises a security management choice. An enterprise can manage its own Internet security with our product offerings or outsource its security management to an Internet service provider, or ISP, or other managed service provider implementing our managed security solutions.

We sell our Internet security solutions indirectly to end-users through a network that includes thousands of distributors and resellers and we have customers located in over 125 countries. We also sell directly and indirectly to a number of service providers that implement our managed security solution.

Since January 2003, we have continued to invest heavily in the development of our products as follows:

On May 10, 2004, we announced the resignation of Michael McConnell as Senior Vice President and Chief Financial Officer effective May 11, 2004. Mr. McConnell will be leaving WatchGuard to pursue other business interests, but will continue with the company through the end of May to assist in the transition. Jim Richman will serve as Interim CFO, effective May 11, 2004. Mr. Richman previously served seven years as CFO of Spacelabs Medical, Inc., a Nasdaq-traded worldwide developer and manufacturer of medical instrumentation and information systems. Mr. Richman played a key role in the merger of Spacelabs Medical and Instrumentarium, Inc., a worldwide medical products manufacturer. At Instrumentarium, Mr. Richman served as Chief Operating Officer for one of the company’s operating division. Mr. Richman began his career in public accounting with KPMG. He holds a B.A. in Accounting from the University of Washington, is a CPA, and is a member of the American Institute of Certified Public Accountants and Financial Executives International.

Our discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in preparing our consolidated financial statements, including those related to:

We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates if our assumptions change or if actual circumstances differ from those in our assumptions.

We believe the following critical accounting policies affect the more significant judgments and estimates used in preparing our consolidated financial statements.

Revenue recognition rules for software companies are very complex. Although we follow very specific and detailed guidelines in measuring revenue, certain judgments affect the application of our revenue policy. The complexity of the revenue recognition rules and estimates inherent in the revenue recognition process makes revenue results difficult to predict, and any shortfall in revenues or delay in recognizing revenues could cause our operating results to vary significantly from quarter to quarter and could result in future operating losses.

Revenues from products are generally recognized upon delivery if persuasive evidence of an arrangement exists, collection is probable, the fee is fixed or determinable, and vendor-specific objective evidence of fair value for undelivered elements of the arrangement has been established. While we generally recognize product revenues upon shipment, revenues from some distribution arrangements where the distributor has unlimited stock returns and rotation rights are not recognized until the distributors sell the products to their customers.

Service revenues primarily include the initial fees for our LiveSecurity Service subscriptions, which have periods ranging from 90 days to one year and are sold as part of our security solutions, and for LiveSecurity Service subscription renewals, which have periods ranging from nine months to two years, from our enterprise customers and end-users. These service fees provide our customers access to our LiveSecurity Service for product updates, security threat responses, general security information and technical support. These service fees also enable our service provider customers access to the LiveSecurity Service and the ability to manage and update a specific number of their customers’ security appliances. Service subscription revenues are recognized ratably on a monthly basis over the subscription period.

When service fees are bundled with the sales of our products in multiple element arrangements, the elements of those arrangements are unbundled using our objective evidence of the fair value of the undelivered elements represented by our customary pricing for each element when sold in separate transactions. Since customers receive the services over a period of time, WatchGuard determines the fair value of the service portion of the arrangement as an undelivered element, based on the renewal price of the service. Changes in the composition of such multiple-element arrangements, our ability to identify the existence of the vendor-specific objective evidence for the elements in the arrangement or our ability to estimate the fair value of elements in the arrangement could materially impact the amount of earned and unearned revenue.

We have established allowances for estimated returns and pricing protection rights. We have also established an allowance for promotional rebates that may be earned by our customers. We estimate these allowances and adjust them periodically based on historical rates of returns and allowances, as well as the expected effect of current promotional programs and new product introductions. We estimate the allowance for promotional rebates based on the maximum amounts potentially available to the customers, unless we have accumulated sufficient historical evidence for individual customers with respect to their realization of rebates. If new or expanded promotional programs are introduced, or new products are announced, additional allowances will be required. Alternatively, if actual promotional rebates fall below maximum exposure levels, we will reduce the allowances and recognize additional revenue.

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Significant judgment is required when we assess the ultimate realization of receivables, including the probability of collection and the creditworthiness of each customer. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances might be required, which could have an adverse effect on our results of operations.

Our inventories are stated at the lower of cost or market, with cost being determined on a first-in, first-out basis. We write our inventories down to estimated market value by providing inventory allowances based on assumptions about future demand and market conditions. The introduction of new products that replace existing products, technological advances, and variation in market trends or customer preferences could, however, significantly affect these estimates and result in additional inventory allowances, which could have an adverse effect on our results of operations.

During 2001 and 2002 we implemented two restructuring plans and recorded significant accruals related to those restructuring plans. These accruals included estimates related to the abandonment of excess facilities. We have later adjusted, as required, the restructuring accruals due to continued poor real estate market conditions in the areas where these excess facilities are located. The actual costs related to the restructuring may differ from our estimate if it takes us longer than expected to find suitable tenants for excess facilities or if there are further changes in the real estate market in those areas where excess facilities are located. Any additional adjustments resulting from these factors could have a material effect on our financial condition and operating results.

We account for our business combinations using the purchase method of accounting prescribed by SFAS 141. We allocate the total consideration paid in an acquisition to the fair value of the acquired company’s identifiable assets and liabilities. The remainder of consideration is allocated to goodwill.

We identify and record separately the intangible assets acquired apart from goodwill based on the specific criteria for separate recognition established in SFAS 141, namely:

We recognize current technology as a separate intangible asset acquired and assign the value to this technology based on the income valuation approach, reflecting the present value of the projected net cash flows expected to be generated from future commercial sales of products incorporating this current technology. WatchGuard capitalizes the acquired technology that has reached the phase of technological feasibility.

Apart from the capitalized current technology, we also identify the value of the research and development efforts spent on the technology that has not yet reached the technological feasibility stage and does not have alternative future uses. We base this value of the in-process research and development on several factors, including the state of the development of each project, the time and cost needed to complete the project, expected income and associated risks related to the viability of the potential changes in future target markets. The value of the in-process research and development is expensed at the time of acquisition pursuant to the provisions of SFAS 2.

Our business acquisitions have resulted in, and future acquisitions typically will result in, the recording of goodwill, which represents the excess of the purchase price over the fair value of identifiable assets acquired and liabilities assumed, including capitalized technology and other definite-lived intangible assets.

Pursuant to SFAS 142, we test purchased goodwill for impairment at least annually. Application of the goodwill impairment test may require judgments, including those inherent in the determination of fair value of the reporting unit in which the goodwill resides and the resulting determination of the implicit value of the goodwill. Significant judgments required to estimate the fair value include estimating future cash flows, determining appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value.

Separable intangible assets that do not have indefinite lives are amortized over their useful lives ranging between three and five years. In accordance with SFAS 144, these assets are also periodically reviewed for the existence of facts and circumstances, both internal and external, which may suggest potential impairment. The determination of whether these intangible assets are impaired involves significant judgments based on short- and long-term projections of future performance. Certain of these forecasts reflect assumptions regarding our ability to continue to develop and ultimately to commercialize the products based on these intangible assets, as well as our projections of future cash flows from these products. Changes in strategy and/or market conditions may result in an impairment charge to our operating expenses, which could have an adverse effect on our results of operations.

The following table provides financial data for the periods indicated as a percentage of total revenues:

We categorize our revenues into three geographic regions: the Americas, Europe/Middle East/Africa, or EMEA, and Asia Pacific, or APAC. Revenue information by geographic region, in dollars and as a percentage of total revenues, was as follows:

The dollar and percentage increase in product revenues for the three months ended March 31, 2004 as compared to the same period of 2003 was primarily due to an increase in unit shipments. The shipments increased in all major product lines, with the biggest increase in the Firebox product line that combines Firebox III and Firebox X products. This increase is primarily related to the introduction of Firebox X products in February 2004. The net increase in shipments for the total Firebox line included a decrease in shipments of Firebox III products, as these products are being replaced by comparable new Firebox X products. The increase in revenues was also attributable to a change in mix towards the higher-priced Firebox product line in relation to the SOHO line.

The introduction of new Firebox X resulted in approximately $1.3 million increase in product revenues of the total Firebox product line for the three months ended March 31, 2004 as compared the same period of 2003. However, this increase was partially offset by the reductions in selling prices and higher discounts for most of our products. The unfavorable pricing changes are the result of sales promotions and aggressive trade-up and competitive trade-in programs that were introduced in the second half of 2003 and continued through the first quarter of 2004 in response to product life-cycle considerations combined with competitive pricing pressure in the mid-tier of our market. In the fourth quarter of 2003, promotional offers were extended on small-business appliances (SOHO) for competitive reasons. These offers were continued in the first quarter of 2004.

From a regional standpoint, in the three months ended March 31, 2004 as compared to the same period of 2003, we experienced a decrease in revenues from our international markets, while revenues for the Americas increased. The decrease in EMEA revenues is related, in part, to the efforts of our channel partners to reduce their inventory levels in an effort to allow for a faster competitive response to changes in the market conditions. The decrease in APAC revenues is attributed primarily to realignment efforts in our APAC business, which began in the first quarter of 2003 and continued through the first quarter of 2004, as we focused on improving the performance of our sales channel and reevaluated our channel customer selection strategy and localized some of our products.

Given these realignment efforts in the APAC region and the continuing economic and geopolitical uncertainty and constrained corporate information technology spending, it is difficult to predict revenue levels in future quarters, which may remain depressed or fluctuate more than they have historically. It is too early to determine if recent signs of gradual improvement in information technology spending by businesses and positive sentiment on the economic outlook in early 2004 will continue and can translate into increased demand for our products.

Our service revenues consist primarily of revenues recognized from initial fees for our LiveSecurity Service subscriptions bundled with a hardware product sale and revenues recognized for subscription renewals sold to the existing customer base.

The decline in service revenues in both absolute dollars and as a percentage of total revenues for the three months ended March 31, 2004 as compared to the same period of 2003 is primarily related to the $600,000 of service revenue in the first quarter of 2003 generated from LiveSecurity services that were provided through certain managed security customers to their end-users in prior periods, but were identified by WatchGuard through a license compliance initiative as being previously unreported. The decline in service revenues is also partially attributable to a reduction of LiveSecurity Service subscription prices in the last quarter of 2003 corresponding to lower prices on related hardware products. Those price reductions were in response to the competitive market environment.

Service revenues recognized from initial service subscription fees are generally related to product shipments in preceding quarters, while revenues recognized from service renewals depend on the existing customer base. A decline in product shipments will result in lower initial LiveSecurity Service subscriptions bundled with the products, while an increase in our installed customer base will increase the number of customers with the opportunity to renew their LiveSecurity Service subscriptions. As a result, it is difficult to predict future service revenue levels.

The provision for estimated sales returns, price protection rights and promotional rebates was $1.7 million, or 7.3% of total revenues before the provision in the first quarter of 2003, and $2.0 million, or 8.6% of total revenues before the provision in the first quarter of 2004. The higher provision in absolute dollars and in percentage of revenue for the three months ended March 31, 2004 as compared to the same period of 2003 corresponds to increased unit shipments in combination with the increase in promotional offerings. We expect to introduce new products and promotional programs through the remainder of 2004, which may affect our reserve for sales returns and allowances.

Gross margins are impacted by various factors, including the volume discount level offered to our customers, the cost of our hardware appliances, including components and labor, the expense associated with provision for inventory reserves, lower of cost or market assessment of inventory carrying value, fixed manufacturing overhead, the mix of product and services sales, which include hardware and software products and service subscriptions, the cost of royalties associated with our products, promotional programs, and the cost of our technical support organization and LiveSecurity Service.

Cost of product revenues includes the cost of manufacturing our security appliances, distribution operations, product packaging, third-party product licensing fees and provisions for inventory reserves and warranty.

The dollar increase in cost of product revenues for the three months ended March 31, 2004 as compared to the same period of 2003 resulted from the following:

The decline in product margins in absolute dollars and as a percentage of product revenues reflects an increase in provision for excess and obsolete inventory, continued competitive pricing in the marketplace for our products, an increase in manufacturing costs primarily in relation to product upgrades and unfavorable changes in product mix towards lower-margin products.

Forecasting future product gross margin is difficult, as our gross margins may be adversely affected in the future by various factors, such as competitive selling pressures, the impact on the existing inventory values when replacement products are introduced and availability of key components. Our margins as a percentage of revenues could also be negatively affected by continued economic uncertainty, which could result in downward pressure on the prices of technology-based products.

Cost of service revenues includes the costs of our technical support organization and costs associated with our LiveSecurity Service.

Cost of service revenues decreased in absolute dollars but increased as a percentage of related revenues for the three months ended March 31, 2004 as compared to the same period of 2003, resulting in a corresponding decrease in service gross margins in both absolute dollars and as a percentage of related revenues. The dollar decrease in service costs is the result of cost savings achieved after transitioning first-level customer support services to a lower cost third-party provider in the fourth quarter of 2003. The decline in dollar and percentage service margin is primarily attributable to $600,000 of service revenue that was recognized in the first quarter of 2003, without significant additional costs, from our license compliance initiative, discussed above in conjunction with service revenues.

We expect service costs to increase in absolute dollars to the extent that our user base expands during the remainder of 2004. Actual service costs and margins could differ materially from those anticipated, which could have an adverse effect on our results of operations.

Sales and marketing expenses include salaries, commissions and employee-related expenses and certain variable marketing expenses, including distributor promotional costs, public relations costs, marketing collateral, trade show and advertising expenses.

The reduction in sales and marketing expenses in absolute dollars and as a percentage of total revenues for the three months ended March 31, 2004 as compared to the same period of 2003 was primarily due to the following:

These larger decreases were partially offset by increases in marketing programs, especially in advertising and promotions, in support of the Firebox X product launch in February 2004, and by increases of internal information technology costs in support of marketing and sales departments due to consolidation of our customer-facing applications and databases and their migration onto more scalable and extensible application platforms.

For the remainder of 2004, we expect our sales and marketing expenses, in absolute dollar terms, to remain comparable to the levels incurred in the first quarter of 2004. Our actual sales and marketing expenses could differ materially from those anticipated, which could have an adverse effect on our results of operations.

Research and development expenses include costs associated with the development of new products, enhancements of existing products, product integration efforts and quality assurance activities. These costs consist primarily of employee salaries and benefits, costs of noncapitalized equipment, software tools, our security appliance prototypes and certification procedures, payments to designers and contractors and depreciation of capital equipment and software.

Research and development expenses decreased in both absolute dollars and as a percentage of revenues for the three months ended March 31, 2004 as compared to the same period of 2003, primarily due to the following:

We intend to continue to fund our research and development efforts in order to meet the changing requirements of our customers, to provide for continued introduction of new products as technology advances and to enhance and expand our

current product offerings. Significant efforts are currently underway aimed at converging software codes associated with our original security features and the software networking technology obtained in the RapidStream acquisition. We expect to continue to invest in key areas aimed at the development of new generations of our products, further extension of our existing product lines and the development of future technologies. We expect the overall cost of research and development for the remainder of 2004 to increase in absolute amounts from the level of the first quarter of 2004. Our actual research and development expenses could differ materially from those anticipated, which could have an adverse effect on our results of operations.

General and administrative expenses include costs of executive, human resource, finance and administrative support functions, provisions for uncollectible accounts, costs of legal and accounting professional services, and director and officer insurance.

General and administrative expenses increased both in absolute dollars and as a percentage of revenues for the three months ended March 31, 2004 as compared to the same period of 2003. The dollar and percentage increase in general and administrative expenses is attributed primarily to the following:

For the remainder of 2004, we anticipate general and administrative expenses, in terms of absolute dollars, to remain comparable to the level incurred in the first quarter of 2004, as we will continue to incur additional expenses in connection with enhanced regulatory and corporate governance requirements. Our actual general and administrative expenses could differ materially from those anticipated, which could have an adverse effect on our results of operations.

Stock-based compensation expenses allocated by functional operating expense category were as follows (in thousands):

Stock-based compensation expenses arise primarily from amortization of previously deferred stock-based compensation over the vesting periods of stock options and restricted stock.

Deferred stock-based compensation is initially recorded as a component of stockholders’ equity in the amount of the excess of the fair value of our common stock on the date of grant over the exercise price of options and also in the amount of the fair value of temporarily restricted common stock that we issued in our April 2002 acquisition of RapidStream.

Amortization of other intangible assets acquired in the three months ended March 31, 2004 consisted of amortization of capitalized technology obtained in our acquisition of RapidStream in 2002. This technology will be amortized in full by March 31, 2007. In the same period of 2003, the amortization additionally included the amortization of capitalized technology related to our acquisition of Qiave in 2000. The Qiave technology was fully amortized by the end of 2003.

We are amortizing the intangible assets on a straight-line basis over useful live of five years. Amortization of other intangible assets acquired was $518,000 in the three months ended March 31, 2003 and $244,000 in the three months ended March 31, 2004. The decrease in amortization of other intangible assets acquired in the first quarter of 2004 as compared to the first quarter of 2003 resulted primarily from the reduction of the amortizable basis of technology obtained in 2002 RapidStream acquisition and the completion of the amortization of technology obtained in 2000 acquisition of Qiave.

In the second half of 2003, it was determined that an impairment existed for the intangible asset associated with the RapidStream “Secured by Check Point” product brand based on the technology obtained in the 2002 acquisition of RapidStream. Our increased focus on the SME market, resulting in a significant reduction in our sales, marketing and development efforts in support of this brand, together with the historically poor performance of this brand, led management to reduce the future sales projections for the brand and later to exit the market segment served by this product. We therefore recorded an impairment charge of $3.5 million in the second half of 2003 for the remaining book value of this intangible asset.

Interest income is generated primarily from our investment of proceeds from the sale of common stock in our initial public offering in 1999 and our follow-on public offering in February 2000. Interest income decreased from $413,000 for the three months ended March 31, 2003 to $274,000 for the three months ended March 31, 2004. The decrease was caused by both a decrease in the average balance invested and a decline in the average rates of return.

Net interest expense primarily represents financing costs incurred due to term discounts taken by our customers. Interest expense remained comparable for both quarters ended March 31, 2003 and March 31, 2004.

Income tax expense of $6,000 in the three months ended March 31, 2003 and $14,000 in the three months ended March 31, 2004 primarily relates to our provision for foreign income taxes associated with our international operations. We have experienced losses since inception, resulting in a net operating loss carry forward position for federal income tax purposes of approximately $197 million as of March 31, 2004. These carryforwards, if not utilized, will begin to expire in 2011, and may be subject to limitations under Section 382 of the Internal Revenue Code of 1986, as amended. In addition, approximately $105 million of the net operating losses generated for federal income tax purposes are not available to reduce income tax expense for financial reporting purposes because the tax effects of tax deductions for employee stock options in excess of the related financial reporting compensation expense are recognized through equity. A valuation allowance has been established to reflect the uncertainty of generating future taxable income necessary to utilize available tax loss carry forwards.

At March 31, 2004, we had $77.8 million in cash, cash equivalents and short-term investments, which were invested primarily in high-quality money market accounts and marketable securities. We believe that the market risk arising from our holdings of these financial instruments is not material. Our working capital at March 31, 2004 was $64.3 million.

Our operating activities resulted in net cash outflows of $1.1 million for the three month ended March 31, 2003 and $2.0 million for the three months ended March 31, 2004. The operating cash outflows during these periods resulted primarily from net losses.

The difference between our net loss and our operating cash outflow is attributable to noncash expenses included in net loss, and changes in the operating assets and liabilities, as presented below (in thousands):

Noncash expenses are associated with the amortization and impairment of other intangible assets acquired, depreciation and amortization of property and equipment, and compensation charges resulting from the issuance of stock options and common stock subject to repurchase by us.

Changes in operating assets and liabilities reflect primarily changes in working capital components of the balance sheet apart from cash and short-term investments, and also changes in long-term deferred revenues and long-term acquisition and restructuring liabilities with larger fluctuations within some of them as described below.

Trade Accounts Receivable, Net increased from $6.7 million at December 31, 2003 to $8.4 million at March 31, 2004, primarily reflecting higher total revenues in the first quarter of 2004 as compared to the fourth quarter of 2003. Days sales outstanding, or DSOs, calculated on a quarterly basis, increased from 31 days at December 31, 2003 to 35 days at March 31, 2004. DSOs are affected by:

Based on our current sales mix, the linearity of revenues in past and future quarters and timing differences arising from the varying payment terms in our customer agreements, we expect our DSOs to generally range from 35 to 45 days in the future. Any change in these factors, however, could negatively affect expected DSO results.

Net Inventories increased from $3.1 million at December 31, 2003 to $3.7 million at March 31, 2004. The increase in inventories is primarily in support of the Firebox X product launch in February 2004.

Total Accrued Restructuring and Acquisition Costs decreased from $6.5 million at December 31, 2003 to $6.0 million at March 31, 2004, due to the ongoing payment of rents on abandoned facilities.

Total Deferred Revenues increased from $16.7 million at December 31, 2002 to $17.3 million at December 31, 2003. The increase of deferred revenues is attributed primarily to the increase in LiveSecutiry subscription renewals on a growing installed customer base.

Cash provided by investing activities was $3.9 million for the three months ended March 31, 2003 and $1.4 million for the three months ended March 31, 2004. In both periods, these activities primarily related to short-term investment of the proceeds received from our public offerings, offset by capital expenditures for property and equipment.

Cash provided by financing activities totaled $751,000 for the three months ended March 31, 2003 and $1.4 million for the three months ended March 31, 2004. Cash provided by financing activities in both periods reflects the exercise of employee stock options and the purchase of common stock through our employee stock purchase plan.

We believe that our existing available cash, cash equivalents and investments will be sufficient to meet our operating expenses, working capital needs and capital expenditure requirements for at least the next 12 months. We may seek additional funding before that time through public or private financings or other arrangements, however, if the underlying assumed levels of spending prove to be inaccurate, or if we choose to pursue acquisitions or investments in complementary business technology.

We lease office space and some computer equipment under operating leases that are not cancelable. Our facilities commitments include a lease for our corporate headquarters in Seattle, Washington, which expires in September 2010. We have the option to extend this lease for an additional five-year term. We also lease a product fulfillment and distribution warehouse in Seattle with a lease term through April 2006. We lease facilities in Aliso Viejo, San Jose and Tustin, California and Waltham, Massachusetts under operating leases that expire between 2004 and 2007, in addition to leases for other sales offices under operating leases or other lease obligations that expire over various terms. Our excess facilities at our corporate headquarters in Seattle, and in Aliso Viejo and San Jose, California, are partially subleased to tenants, with sublease terms that expire between 2004 and 2010. We also have several operating leases for computer equipment. WatchGuard is a party to several noncancelable and nonrefundable agreements to purchase inventory.

Our contractual commitments at March 31, 2004 associated with lease obligations and purchase obligations, net of future minimum rental income from subleases of $1.7 million, are presented below (in thousands). This future rental income from subleases may be adversely affected if the financial condition of our tenants were to deteriorate, resulting in an impairment of their ability to make lease payments.

In addition, we have contractual agreements with some of our distributors to reimburse them for advertising and other marketing activities that they may incur to promote our products, contingent on performance of those activities in the future. At March 31, 2004, the total amount of those agreements was $1.9 million.

IMPORTANT FACTORS THAT MAY AFFECT OUR OPERATING RESULTS, OUR BUSINESS AND OUR STOCK PRICE

In addition to the other information contained in this annual report, you should carefully read and consider the following risk factors. If any of these risks actually occur, our business, financial condition or operating results could be materially adversely affected and the trading price of our common stock could decline.

We have incurred losses in the past and may not achieve or sustain consistent profitability, which could result in a decline in the value of our common stock.

Since inception, we have incurred net losses and experienced negative cash flows from operations in each quarter, except that we had net income and a positive cash flow from operations in the third quarter of 2000 and a positive cash flow from operations in the third quarter of 2001. As of March 31, 2004, we had an accumulated deficit of approximately $132 million. Although our revenues have increased each year since we began operations, the historical percentage growth rate of our revenues may not be sustainable as our revenue base increases, we may not achieve or sustain profitability in future periods or we may not be able to continue to grow our revenues at all. We expect that over time we will have to increase our operating expenses in connection with:

If we are unable to achieve or sustain profitability in future quarters, the trading price of our common stock could decline.

Our operating results fluctuate and could fall below expectations of securities analysts and investors, resulting in a decline in our stock price.

Our quarterly and yearly operating results have varied widely in the past and will probably continue to fluctuate. For this reason, we believe that period-to-period comparisons of our operating results may not be meaningful. In addition, our limited operating history makes predicting our future performance difficult. If our operating results for a future quarter or year fail to meet market expectations, this shortfall could result in a decline in our stock price.

The economic downturn in the U.S. economy has adversely affected the demand for our products and services and may continue to result in decreased revenue and growth rates. While there has been some early signs of improvement in certain geographical areas, we do not know how long this economic downturn will last or whether it will become more severe. To the extent that this downturn continues or grows deeper in the United States or other geographic regions in which we operate, the Internet security industry and demand for our products and services are likely to be adversely affected.

We base our spending levels for product development, sales and marketing and other operating expenses largely on our expected future revenues. Because our expenses are largely fixed for a particular quarter or year, we may be unable to adjust our spending in time to compensate for any unexpected quarterly or annual shortfall in revenues. A failure to so adjust our spending in time also could cause operating results to fall below the expectations of securities analysts and investors, resulting in a decline in our stock price.

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

Our discussion and analysis of financial condition and results of operations in this annual report is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in preparing our consolidated financial statements, including those related to:

We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, as provided in our discussion and analysis of financial condition and results of operations in this annual report, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Examples of such estimates include, but are not limited to, those associated with the costs of our 2001 and 2002 restructuring, impairment analysis of the intangible assets obtained in our 2002 acquisition of RapidStream, as well as goodwill relating to the acquisitions of BeadleNet, Qiave and RapidStream. Although we do not anticipate further significant adjustments to our 2001 and 2002 restructuring in addition to the $1 million charge we recorded in the fourth quarter of 2003, the actual costs related to the restructuring may differ from our estimate if it takes us longer than expected to find suitable tenants for our excess facilities or if there are further changes in the real estate market where excess facilities are located. Actual results may differ from these and other estimates if our assumptions change or if actual circumstances differ from those in our assumptions, which could cause our operating results to fall below the expectations of securities analysts and investors, resulting in a decline in our stock price.

If potential customers do not accept our Firebox products and the related LiveSecurity Service, our business will not succeed.

We currently expect that future revenues will be primarily generated through sales of our Firebox products and the related LiveSecurity Service, including subscription fees, and we cannot succeed if the market does not accept these products and services. Our success depends on our ability and the ability of our distribution network, which includes distributors, VARs and ISPs and other managed service providers, to obtain and retain customers. Some of our Firebox products, particularly our key Firebox X line of products, however, are relatively new and unproven. The Firebox X line of products has only been available since February 2004. The Firebox X line of products, which replace a product line that represented a majority of our revenues, also represent a new approach to providing security to the SME in that they are designed to be expandable both to incorporate additional features and to provide increased performance, and we may be unsuccessful in marketing and selling this type of product. In addition, if sales of our Firebox products do not meet expectations, we may have excess inventory of products or components and such excess inventory would have a negative impact on our operating results.

To receive our LiveSecurity Service, enterprises are required to pay an annual subscription fee, either to us or, if they obtain the LiveSecurity Service through one of our channel customers, to the channel customer. We are not aware of any other Internet security product that allows enterprises to keep their security solution current by receiving software updates and comprehensive security information over the Internet. SMEs may be unwilling to pay a subscription fee to keep their Internet security up to date and to receive Internet security-related information. Because our LiveSecurity Service is an innovative service, we may not be able to accurately predict the rate at which our customers will renew their annual subscriptions. In addition, most businesses implementing security services have traditionally managed their own Internet security rather than using the services of third-party service providers. As a result, our products and services and the outsourcing of Internet security to third parties may not achieve significant market acceptance.

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

The market for Internet security products is intensely competitive and we expect competition to intensify in the future. An increase in competitive pressures in our market or our failure to compete effectively may result in pricing reductions, reduced gross margins and loss of market share. Currently, the primary competitors in our industry include Check Point, Cisco Systems, Inc., Fortinet Inc., Juniper Networks, Inc., Nokia Corporation, SonicWALL, Inc. and Symantec Corporation. Other competitors offering security products include hardware and software vendors such as Lucent Technologies, Inc. and Network Associates, Inc., operating system vendors such as Microsoft Corporation, Novell, Inc. and Sun Microsystems, Inc., and a number of smaller companies. Many of our competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical, marketing and other resources than we do. Our current and potential competitors may establish cooperative relationships among themselves or with third parties that may further enhance their resources. In addition, current or potential competitors may be acquired by third parties with greater available resources, as has happened as a result of Juniper’s acquisition of Netscreen Technologies, Inc. As a result of such acquisitions, our current or potential competitors might be able to adapt more quickly to new technologies and customer needs, devote greater resources to the promotion or sale of their products and services, initiate or withstand substantial price competition, take advantage of acquisition or other opportunities more readily or develop and expand their product and service offerings more quickly. In addition, our competitors may bundle products competitive with ours with other products that they may sell to our current or potential customers. These customers may accept these bundled products rather than separately purchasing our products.

If our third-party channel customers fail to perform, our ability to sell our products and services will be limited.

We sell most of our products and services through our distribution network, and we expect our success to continue to depend in large part on the performance of this network. Our channel customers have the ability to sell products and services that are competitive with ours, to devote more resources to those competitive products or to cease selling our products and services altogether. The loss of one of these channel customers, a reduction in their sales, a reduction in our share of their sales of Internet security products, or a loss or reduction in sales involving one or more other channel customers, particularly if the reduction results in increased sales of competitive products, could harm our business. In addition, we are in the process of reorganizing our channel in the Asia Pacific region and, particularly, Japan. If this reorganization causes disruption, we could experience a loss or reduction in sales involving one or more of our channel customers.

Product returns, retroactive price adjustments and rebates could exceed our allowances, which could adversely affect our operating results.

We provide most of our channel customers with product return rights for stock rotation and price protection rights for their inventories, which they may exercise if we lower our prices for those products. We also provide promotional rebates to some of our channel customers. We may experience significant returns, price adjustments and rebate costs for which we may not have adequate allowances, particularly with the recent introduction of our Firebox X line of products, which replaced the Firebox III line of products. The short life cycles of our products and the difficulty of predicting future sales increase the risk that new product introductions or price reductions by us or our competitors could result in significant product returns or price adjustments. When we introduced the Firebox II, the Firebox III and then later the Firebox X, security appliances, we experienced an increase in returns of previous products and product versions. Provisions for returns and allowances were $4.6 million in 2002 and $7.3 million in 2003 or 5.7% and 8.4% of total revenues before returns and allowances. The provision for returns and allowances was $2.0 million, or 8.6% of total revenues before returns and allowances in the three months ended March 31, 2004. While we review and adjust our provision for returns and allowances in order to properly reflect the potential for promotional rebate costs, increased returns and pricing adjustments associated with the introduction of new products, such as the Firebox X product line, the provision may still be inadequate. An increase in the provision for returns and allowances will result in the reduction of revenues.

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

To succeed, we must continually change and improve our products in response to rapid technological developments and changes in operating systems, Internet access and communications, application and networking software, computer and communications hardware, programming tools, computer language technology and hacker techniques. We may be unable to successfully and timely develop these new products and services or achieve and maintain market acceptance.

The development of new, technologically advanced products and services is a complex and uncertain process that requires great innovation and the ability to anticipate technological and market trends. Because Internet security technology is complex, it can require long development and testing periods.

Releasing new products and services prematurely may result in quality problems, and releasing them late may result in loss of customer confidence and market share. In the past, we have on occasion experienced delays in the scheduled introduction of new and enhanced products and services, and we may experience delays in the future. When we do introduce new or enhanced products and services, we may be unable to successfully manage the transition from the older products and services to minimize disruption in customer ordering patterns, avoid excessive inventories of older products and deliver enough new products and services to meet customer demand.

Because many potential customers do not fully understand or remain unaware of the need for comprehensive Internet security or may perceive it as costly and difficult to implement, our products and services may not achieve market acceptance.

We believe that many potential customers, particularly SMEs, do not fully understand or are not aware of the need for comprehensive Internet security products and services. Historically, only enterprises having substantial resources have developed or purchased comprehensive Internet security solutions. Also, there is a perception that comprehensive Internet security is costly and difficult to implement. We will therefore not succeed unless the market understands the need for comprehensive Internet security and we can convince our potential customers of our ability to provide this security in an integrated, cost-effective and administratively feasible manner. Although we have spent, and will continue to spend, considerable resources educating potential customers about the need for comprehensive Internet security and the benefits of our products and services, our efforts may be unsuccessful.

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

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

We may be unable to adequately expand and adapt our operational systems to accommodate growth or recent changes in how we deliver our products and services to customers, which could harm our ability to deliver our products and services.

Our operational systems have not been tested at the customer volumes that may be required in the future. In addition, our operational systems required for the delivery of products and services through license-key activation have not been tested at the combination of the number product and service offerings and customer volumes that may be required in the future. We may encounter performance difficulties when operating with a substantially greater number of customers or a substantially greater number of products and services offered through license-key activation or a combination of the two. These performance difficulties could harm our ability to deliver our products and services. An inability to add software and hardware or to develop and upgrade existing technology or operational systems to handle increased traffic or increased number of products and services offered through license-key activation may cause unanticipated system disruptions, slower response times and poor customer service, including problems filling customer orders.

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

Because our products and services provide and monitor Internet security and may protect valuable information, we may face claims for product liability, tort or breach of warranty relating to our products and services. Anyone who circumvents our security measures could misappropriate the confidential information or other property of end-users using our products and services or interrupt their operations. If that happens, affected end-users or channel customers may sue us. In addition, we may face liability for breaches caused by faulty installation and implementation of our products by end-users or channel customers. Although we attempt to reduce the risk of losses from claims through contractual warranty disclaimers and liability limitations, these provisions may be unenforceable. Some courts, for example, have found contractual limitations of liability in standard software licenses to be unenforceable because the licensee does not sign the license. Defending a suit, regardless of its merit, could be costly and could divert management attention. Although we currently maintain business liability insurance, this coverage may be inadequate or may be unavailable in the future on acceptable terms, if at all.

A breach of security could harm public perception of our products and services.

We will not succeed unless the marketplace is confident that we provide effective Internet security protection. Even networks protected by our software products may be vulnerable to electronic break-ins and computer viruses. If an actual or perceived breach of Internet security occurs in an end-user’s systems, regardless of whether the breach is attributable to us, the market perception of the efficacy of our products and services could be harmed. This could cause us or our channel customers to lose current and potential customers or cause us to lose potential channel customers. Because the techniques used by computer hackers to access or sabotage networks change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques.

If we are unable to prevent attacks on our internal network system by computer hackers, public perception of our products and services will be harmed.

Because we provide Internet security, we are a significant target of computer hackers. We have experienced attacks by computer hackers in the past and expect attacks to continue. If attacks on our internal network system are successful, public perception of our products and services will be harmed.

We may be unable to deliver our products and services if component manufacturers fail to supply component parts with acceptable quantity, quality and cost.

We obtain the component parts for our hardware from a variety of manufacturers. Companies in the electronics industry regularly experience lower-than-required component allocations, and the industry is subject to frequent component shortfalls. We have experienced such component shortfalls recently with memory and flash component manufacturers providing these components on a limited allocation basis only. Although we have found additional or replacement sources for hardware components in the past, and believe that we could find additional or replacement sources for our hardware components to address future shortfalls, our operations could be disrupted or negatively affected if we have to add or switch to a replacement vendor, if our component supply is interrupted for an extended period or if the costs of the components increase due to shortages. This could result in loss of customer orders and revenue.

We may be unable to deliver our products and services if manufacturers fail to supply finished product with acceptable quantity, quality and cost.

We rely on third party contract manufacturers for the assembly of all of our security appliance hardware platforms and for the design of certain of our security appliance hardware platforms. Although we believe that we could find a replacement source for these finished products, our operations could be disrupted if we have to add or switch to a replacement manufacturer, particularly if we were required to replace or redesign a hardware platform, or if our finished goods supply is interrupted for an extended period. This could result in loss of customer orders and revenue.

We may be unable to adequately protect our operational systems from damage, failure or interruption, which could harm our reputation and our ability to attract and retain customers.

Our operations, customer service, reputation and ability to attract and retain customers depend on the uninterrupted operation of our operational systems. Although we utilize limited off-site backup facilities and take other precautions to prevent damage, failure or interruption of our systems, our precautions may be inadequate. Any damage, failure or interruption of our computer or communications systems could lead to service interruptions, delays, loss of data and inability to accept and fill customer orders and provide customers with our LiveSecurity Service.

We may be unable to deliver our products and services if we cannot continue to license third-party technology that is important for the functionality of our products.

Our success will depend in part on our continued ability to license technology that is important for the functionality of our products. A significant interruption in the supply of a third-party technology, including open source software, could delay our development and sales until we can find, license and integrate equivalent technology. This could damage our brand and result in loss of current and potential customers. Although we believe that we could find other sources for the technology we license, alternative technologies may be unavailable on acceptable terms, if at all. We depend on our third-party licensors to deliver reliable, high-quality products, develop new products on a timely and cost-effective basis and respond to evolving technology and changes in industry standards. We also depend on the continued compatibility of our third-party software with future versions of our products.

Governmental controls over the export or import of encryption technology could cause us to lose sales.

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

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

Despite our efforts to protect our proprietary rights, unauthorized parties may misappropriate or infringe on our trade secrets, copyrights, trademarks, service marks and similar proprietary rights. We face additional risk when conducting business in countries that have poorly developed or inadequately enforced intellectual property laws. While we are unable to determine the extent to which piracy of our software products exists, we expect piracy to be a continuing concern, particularly in international markets and as a result of the growing use of the Internet.

If we fail to obtain and maintain patent protection for our technology, we may be unable to compete effectively. We have eight issued patents and 14 patents pending, but our patent applications may not result in issued patents. Even if we secure a patent, the patent may not provide meaningful protection. In addition, we rely on unpatented proprietary technology. Because this proprietary technology does not have patent protection, we may be unable to meaningfully protect this technology from unauthorized use or misappropriation by a third party. In addition, our competitors may independently develop similar or superior technologies or duplicate any unpatented technologies that we have developed, which could significantly reduce the value of our proprietary technology or threaten our market position.

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

In the future, we may have to resort to litigation to protect our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Any litigation, regardless of its success, would probably be costly and require significant time and attention of our key management and technical personnel. Litigation could also force us to

Although we have not been sued for intellectual property infringement, we may face infringement claims from third parties in the future. The software industry has seen frequent litigation over intellectual property rights, and we expect that participants in the Internet security industry will be increasingly subject to infringement claims as the number of products, services and competitors grows and functionality of products and services overlaps.

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

Our products and services may contain undetected errors or defects, especially when first released. Despite extensive testing, some errors are discovered only after a product has been installed and used by customers. Any errors discovered after commercial release could result in loss of revenues or claims against us or our channel customers.

If we do not retain our key employees, if changes to the management team cause disruption or if new management team members fail to perform, our ability to execute our business strategy will be impaired.

Our future success will depend largely on the efforts and abilities of our senior management and our key development, technical, operations, information systems, customer support and sales and marketing personnel, and on our ability to retain them. These employees are not obligated to continue their employment with us and may leave us at any time. In addition, there have been changes to our management team in the past year, including the addition of a new chief executive officer. If these changes have a negative impact on our operations, our business and operating results could be adversely affected.

If we do not expand our international operations and successfully overcome the risks inherent in international business activities, the growth of our business will be limited.

Our ability to grow will depend in part on the expansion of our international sales and operations, which are expected to continue to account for a significant portion of our revenues. Sales to customers outside of the United States accounted for approximately 58.5% and 54.1% in 2002 and 2003 respectively. Sales to customers outside the United States accounted for 51.0% in the three months ended March 31, 2004. The failure of our channel customers to sell our products internationally would limit our ability to increase our revenues. In addition, our international sales are subject to the risks inherent in international business activities, including

Our international sales currently are U.S. dollar-denominated. As a result, any increase in the value of the U.S. dollar relative to foreign currencies makes our products less competitive in international markets. Because of this, we may be required to denominate our sales in foreign currencies at some point in the future to remain competitive.

In attempting to integrate the business and technology of any future acquisition, we could incur significant costs that may not be outweighed by any benefits of the acquisition.

As part of our business strategy, we may acquire other companies, products or technologies, and these acquisitions may result in substantial costs. The costs of any future acquisitions may include costs for:

Successful integration of the operations, technology, products, customers, suppliers and personnel of any future acquisition could place a significant burden on our management and internal resources. The diversion of the attention of our management and any difficulties encountered in the transition and integration process could disrupt our business and have an adverse effect on our business and operating results.

We may need additional capital and our ability to secure additional funding is uncertain.

We believe that existing cash and cash equivalent balances will be sufficient to meet our capital requirements for at least the next 12 months. Our capital requirements will depend on several factors, however, including

Our existing capital and future revenues may therefore be insufficient to support the expenses of our operations and the expansion of our business. We may therefore need additional equity or debt capital. We may seek additional funding through

Financing, however, may be unavailable to us when needed or on acceptable terms.

The trading price of our common stock could be subject to fluctuations for a number of reasons, including

In recent years, moreover, the stock market in general and the market for Internet-related technology companies in particular have experienced extreme price and volume fluctuations, often unrelated to the operating performance of the affected companies. Our common stock has experienced, and is likely to continue to experience, these fluctuations in price, regardless of our performance.

We do not hold derivative financial instruments or derivative equity securities in our investment portfolio. Our cash equivalents and short-term investments consist of high-quality securities, as specified in our investment policy guidelines. Our policy limits the amount of credit exposure to any one issue or issuer to a maximum of 20% of the total portfolio or $5 million per issuer at the time of purchase, with the exception of U.S. treasury and agency securities and money market funds, which are exempt from this size limitation. Our policy limits all investments to those that mature in two years or less, with the average maturity of our investments equal to one year or less. The securities are subject to interest-rate risk and will decrease in value if interest rates increase. The fair value of our investment portfolio or related income would not be significantly affected by either a 100 basis point increase or decrease in interest rates, due primarily to the short-term nature of the major portion of our investment portfolio, which is summarized in Note 4 to our consolidated financial statements.

All of our sales and the majority of our expenses are currently denominated in U.S. dollars. As a result, we have not experienced significant foreign exchange gains and losses. While we incurred some expenses in foreign currencies during the three months ended March 31, 2004 and expect to continue to do so in the future, we do not anticipate that foreign exchange gains or losses will be material to us. Although we have not engaged in foreign currency hedging to date, we may do so in the future. In addition, we may be required to denominate our sales in foreign currencies at some point in the future to remain competitive.

Evaluation of disclosure controls and procedures. Our chief executive officer and our chief financial officer, after evaluating the effectiveness of our “disclosure controls and procedures” (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this quarterly report, have concluded that, as of that date, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in this report is accumulated and communicated by our management, to allow timely decisions regarding required disclosure.

To our knowledge, there were no significant changes in our internal controls during the first quarter of 2004 that have materially affected, or are reasonably likely to materially affect, our internal controls.

On February 12, 2004, we furnished a current report on Form 8-K to announce its financial results for the fourth quarter and year ended December 30, 2003.

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.


WATCHGUARD TECHNOLOGIES, INC.

By:		/s/ Michael E. McConnell
		Michael E. McConnell
		Senior Vice President, Chief Financial
		Officer and Treasurer
		(Authorized Officer)
		(Principal Financial and Accounting Officer)


	December 31, 2003			March 31, 2004
				(unaudited)
ASSETS

Current assets:
Cash and cash equivalents	$	3,899		$	4,697
Short-term investments		74,890			73,107
Trade accounts receivable, net		6,700			8,359
Inventories, net		3,068			3,650
Prepaid expenses and other current assets		3,924			3,258

Total current assets		92,481			93,071

Property and equipment, net		5,471			5,219

Restricted cash		3,000			3,000

Goodwill		66,605			66,605

Other intangibles, net and other assets		3,562			3,312

Total assets	$	171,119		$	171,207

LIABILITIES AND STOCKHOLDERS’ EQUITY

Current liabilities:
Accounts payable	$	3,676		$	4,175
Accrued expenses and other liabilities		6,819			6,500
Short-term accrued restructuring and acquisition costs		2,271			2,028
Short-term deferred revenues		15,675			16,091

Total current liabilities		28,441			28,794
Long-term accrued restructuring costs		4,268			3,983
Long-term deferred revenues		1,072			1,205

Total liabilities		33,781			33,982

Stockholders’ equity:

Preferred stock, $0.001 par value:
Authorized shares: 10,000,000
No shares issued and outstanding		—			—

Common stock, $0.001 par value:
Authorized shares: 80,000,000
Shares issued and outstanding: 33,091,787 at December 31, 2003 and 33,409,705 at March 31, 2004		33			33

Additional paid-in capital		267,649			269,038

Deferred stock-based compensation		(25	)		(13	)

Accumulated other comprehensive income (loss)		(41	)		60

Accumulated deficit		(130,278	)		(131,893	)

Total stockholders’ equity		137,338			137,225

Total liabilities and stockholders’ equity	$	171,119		$	171,207


	Three Months Ended March 31,
	2003			2004
Revenues:
Product	$	14,579		$	14,994
Service		7,230			6,482

Total revenues		21,809			21,476

Cost of revenues:
Product		4,975			6,397
Service		1,475			1,344

Total cost of revenues		6,450			7,741

Gross margin		15,359			13,735

Operating expenses:
Sales and marketing (1)		8,673			8,395
Research and development (2)		5,219			4,539
General and administrative (3)		1,934			2,252
Stock-based compensation		121			11
Amortization of other intangible assets acquired		518			244

Total operating expenses		16,465			15,441

Operating loss		(1,106	)		(1,706	)

Interest income, net:
Interest income		413			274
Interest expense		(150	)		(169	)

Total interest income, net		263			105

Loss before income taxes		(843	)		(1,601	)

Provision for income taxes		6			14

Net loss	$	(849	)	$	(1,615	)

Basic and diluted net loss per share	$	(0.03	)	$	(0.05	)

Shares used in calculation of basic and diluted net loss per share		32,740			33,250


	Three Months Ended March 31,
	2003			2004
Operating activities:

Net loss	$	(849	)	$	(1,615	)

Adjustments to reconcile net loss to net cash used in operating activities:

Noncash expenses:
Depreciation and amortization of property and equipment		722			723
Amortization of other intangible assets acquired		518			244
Stock-based compensation		121			11

Changes in operating assets and liabilities:
Trade accounts receivable, net		(1,370	)		(1,659	)
Inventories, net		(1,817	)		(582	)
Prepaid expenses and other current assets		500			666
Other assets		138			6
Accounts payable		776			499
Accrued expenses and other liabilities		1,427			(319	)
Accrued restructuring and acquisition costs		(1,590	)		(528	)
Deferred revenues		363			549

Net cash used in operating activities		(1,061	)		(2,005	)

Investing activities:
Purchases of property and equipment		(757	)		(471	)
Proceeds from maturities of marketable securities		42,655			9,115
Purchases of marketable securities		(37,992	)		(7,231	)

Net cash provided by investing activities		3,906			1,413

Financing activities:
Proceeds from stock option exercises and issuances of common stock under the employee stock purchase plan		751			1,390

Net cash provided by financing activities		751			1,390

Net increase in cash and cash equivalents		3,596			798

Cash and cash equivalents at beginning of period		8,890			3,899

Cash and cash equivalents at end of period	$	12,486		$	4,697


	Three Months Ended March 31,
	2003			2004
Net loss	$	(849	)	$	(1,615	)
Unrealized gain (loss) on investments		(10	)		101

Comprehensive loss	$	(859	)	$	(1,514	)


	Three Months Ended March 31,
	2003			2004
Net loss — as reported	$	(849	)	$	(1,615	)
Add: stock-based compensation, as reported		121			11
Deduct: stock-based compensation determined under fair-value-based method		(5,849	)		(2,852	)

Net loss — pro forma	$	(6,577	)	$	(4,456	)

Net loss per share — as reported	$	(0.03	)	$	(0.05	)
Net loss per share — pro forma	$	(0.20	)	$	(0.13	)

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PART I. FINANCIAL INFORMATION		3

ITEM 1.	FINANCIAL STATEMENTS	3

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	10

RESULTS OF OPERATIONS		14

IMPORTANT FACTORS THAT MAY AFFECT OUR OPERATING RESULTS, OUR BUSINESS AND OUR STOCK PRICE		24

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	32

ITEM 4.	CONTROLS AND PROCEDURES	32

PART II. OTHER INFORMATION		33

ITEM 6.	EXHIBITS AND REPORTS ON FORM 8-K	33


	December 31, 2003			March 31, 2004
Trade accounts receivable	$	9,231		$	11,410
Reserve for returns and allowances		(2,283	)		(2,758	)
Allowance for uncollectible accounts		(248	)		(293	)

	$	6,700		$	8,359


	December 31, 2003			March 31, 2004
Finished goods	$	2,638		$	2,743
Components		1,868			2,027

		4,506			4,770
Inventory allowance		(1,438	)		(1,120	)

	$	3,068		$	3,650


	December 31, 2003		March 31, 2004
Accrued payroll-related liabilities	$	2,225	$	2,115
Other accrued liabilities		4,594		4,385

	$	6,819	$	6,500


	December 31, 2003 Accrued Restructuring Balance		Amounts Paid or Charged			March 31, 2004 Accrued Restructuring Balance
Accrued liabilities related to abandoned facilities	$	1,714	$	(130	)	$	1,584


	Three Months Ended March 31,						Percentage Increase (Decrease)
	2003			2004			Percentage Increase (Decrease)
Revenues (in thousands):
Product	$	14,579		$	14,994		2.8	%
Service		7,230			6,482		(10.3	)%

Total	$	21,809		$	21,476		(1.5	)%

Revenues (as % of total revenues):
Product		66.8	%		69.8	%
Service		33.2	%		30.2	%

Total		100.0	%		100.0	%


	Three Months Ended March 31,						Percentage Increase (Decrease)
	2003			2004			Percentage Increase (Decrease)
Cost of revenues (in thousands):

Product	$	4,975		$	6,397		28.6	%

Service		1,475			1,344		(8.9	)%

Total	$	6,450		$	7,741		20.0	%

Cost of revenues (as % of total revenues):

Product		22.8	%		29.8	%

Service		6.8	%		6.2	%

Total		29.6	%		36.0	%

Cost of revenues (as % of related revenue component):

Product (as % of product revenues)		34.1	%		42.7	%

Service (as % of service revenues)		20.4	%		20.7	%

Gross margin (in thousands):

Product	$	9,604		$	8,597		(10.5	)%

Service		5,755			5,138		(10.7	)%

Total	$	15,359		$	13,735		(10.6	)%

Gross margin (as % of related revenue component):

Product (as % of product revenues)		65.9	%		57.3	%

Service (as % of service revenues)		79.6	%		79.3	%

Total (as % of total revenues)		70.4	%		64.0	%


	Three Months Ended March 31,						Percentage Decrease
	2003			2004			Percentage Decrease
Sales and marketing expenses (in thousands)	$	8,673		$	8,395		(3.2	)%
Sales and marketing expenses (as % of total revenues)		39.8	%		39.1	%


	Three Months Ended March 31,						Percentage Increase
	2003			2004			Percentage Increase
General and administrative expenses (in thousands)	$	1,934		$	2,252		16.4	%
General and administrative expenses (as % of total revenues)		8.9	%		10.5	%


	Three Months Ended March 31,				Percentage (Decrease)
	2003		2004		Percentage (Decrease)
Sales and marketing	$	13	$	2	(84.6	)%
Research and development		94		6	(93.6	)%
General and administrative		14		3	(78.6	)%

Total amortization of stock-based compensation	$	121	$	11	(90.9	%)


	Payment due by period
			Before						After
	Total		December 31, 2004		December 31, 2006		December 31, 2008		December 31, 2008
Operating lease obligations	$	19,990	$	3,057	$	5,825	$	5,921	$	5,187
Inventory purchase obligations		4,856		4,856		—		—		—

Total	$	24,846	$	7,913	$	5,825	$	5,921	$	5,187



3.1		Restated Certificate of Incorporation of the registrant (Exhibit 3.1) (A)

3.2		Restated Bylaws of the registrant (Exhibit 3.2) (A)

31.1		Section 302 Certification of Steven N. Moore

31.2		Section 302 Certification of Michael E. McConnell

32.1		Certification of Steven N. Moore pursuant to 18 U.S.C. Section 13.50, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certification of Michael E. McConnell pursuant to 18 U.S.C. Section 13.50, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


Exhibit		Description

3.1		Restated Certificate of Incorporation of the registrant (Exhibit 3.1) (A)

3.2		Restated Bylaws of the registrant (Exhibit 3.2) (A)

31.1		Section 302 Certification of Steven N. Moore

31.2		Section 302 Certification of Michael E. McConnell

32.1		Certification of Steven N. Moore pursuant to 18 U.S.C. Section 13.50, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certification of Michael E. McConnell pursuant to 18 U.S.C. Section 13.50, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002