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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



FORM 10-Q



Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities
Exchange Act of 1934



For the quarterly period ended
September 30, 2005



Commission File Number 000-26819



WATCHGUARD TECHNOLOGIES, INC.

(Exact Name of Registrant as Specified in Its Charter)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 91-1712427                          
|(State or Other Jurisdiction of Incorporation or Organization) |  | (I.R.S. Employer Identification No.)



505 Fifth Ave.
South, Suite 500, Seattle WA 98104-3892

(Address of Principal Executive Offices) (Zip Code)



Registrants telephone number, including area code:
(206) 521-8340



Not Applicable

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



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



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



Indicate by check whether the registrant is a shell company
(as defined in Rule 12b-2 of the Exchange Act). Yes ̈No  x



34,223,818 shares of WatchGuard common stock were outstanding
as of October 31, 2005.



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WATCHGUARD TECHNOLOGIES, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2005



TABLE OF CONTENTS



|                                                                                              |  |   
|--------------------------------------------------------------------------------------------- |  | --
|PART I. FINANCIAL INFORMATION                                                                 |  |   
|                                                                                              | 
|ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS                                                     |  | 3 
|                                                                                              | 
|ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS |  | 13
|                                                                                              | 
|ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            |  | 37
|                                                                                              | 
|ITEM 4. CONTROLS AND PROCEDURES                                                               |  | 37
|                                                                                              | 
|PART II. OTHER INFORMATION                                                                    |  |   
|                                                                                              | 
|ITEM 1. LEGAL PROCEEDINGS                                                                     |  | 38
|                                                                                              | 
|ITEM 6. EXHIBITS                                                                              |  | 39



2



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PART I. FINANCIAL INFORMATION



|ITEM1. | FINANCIAL STATEMENTS
|------ | --------------------



WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)



|                                                                                                                                                      |  |                   |          |   |                    |   |          |  
|----------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | -------- | - | ------------------ | - | -------- | -
|                                                                                                                                                      |  | December 31, 2004 |          |   | September 30, 2005 |  
|                                                                                                                                                      |  |                   |          |   | (unaudited)        |  
|ASSETS                                                                                                                                                |  |                   |          |   |                    |   |          |  
|Current assets:                                                                                                                                       |  |                   |          |   |                    |   |          |  
|Cash and cash equivalents                                                                                                                             |  | $                 | 4,660    |   |                    | $ | 11,724   |  
|Short-term available-for-sale investments                                                                                                             |  |                   | 72,189   |   |                    |   | 64,414   |  
|Trade accounts receivable, net                                                                                                                        |  |                   | 7,305    |   |                    |   | 5,615    |  
|Inventories, net                                                                                                                                      |  |                   | 3,145    |   |                    |   | 3,927    |  
|Prepaid expenses and other current assets                                                                                                             |  |                   | 2,780    |   |                    |   | 2,728    |  
|                                                                                                                                                      |  |                   |          |   |                    |   |          |  
|Total current assets                                                                                                                                  |  |                   | 90,079   |   |                    |   | 88,408   |  
|Property and equipment, net                                                                                                                           |  |                   | 6,303    |   |                    |   | 5,453    |  
|Restricted cash                                                                                                                                       |  |                   | 3,000    |   |                    |   | 3,000    |  
|Goodwill                                                                                                                                              |  |                   | 66,605   |   |                    |   | 66,605   |  
|Other intangibles, net and other assets                                                                                                               |  |                   | 2,494    |   |                    |   | 1,954    |  
|                                                                                                                                                      |  |                   |          |   |                    |   |          |  
|Total assets                                                                                                                                          |  | $                 | 168,481  |   |                    | $ | 165,420  |  
|                                                                                                                                                      |  |                   |          |   |                    |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                  |  |                   |          |   |                    |   |          |  
|Current liabilities:                                                                                                                                  |  |                   |          |   |                    |   |          |  
|Accounts payable                                                                                                                                      |  | $                 | 3,214    |   |                    | $ | 2,538    |  
|Accrued expenses and other liabilities                                                                                                                |  |                   | 7,581    |   |                    |   | 8,810    |  
|Short-term accrued restructuring costs                                                                                                                |  |                   | 1,289    |   |                    |   | 1,170    |  
|Short-term deferred revenues                                                                                                                          |  |                   | 17,402   |   |                    |   | 17,925   |  
|                                                                                                                                                      |  |                   |          |   |                    |   |          |  
|Total current liabilities                                                                                                                             |  |                   | 29,486   |   |                    |   | 30,443   |  
|Long-term deferred rent                                                                                                                               |  |                   | 1,447    |   |                    |   | 1,348    |  
|Long-term accrued restructuring costs                                                                                                                 |  |                   | 3,599    |   |                    |   | 3,012    |  
|Long-term deferred revenues                                                                                                                           |  |                   | 1,818    |   |                    |   | 2,143    |  
|                                                                                                                                                      |  |                   |          |   |                    |   |          |  
|Total liabilities                                                                                                                                     |  |                   | 36,350   |   |                    |   | 36,946   |  
|Stockholders equity:                                                                                                                                 |  |                   |          |   |                    |   |          |  
|Preferred stock, $0.001 par value:                                                                                                                    |  |                   |          |   |                    |   |          |  
|Authorized shares: 10,000,000 (800,000 shares designated Series A Cumulative Preferred Stock at September 30, 2005); no shares issued and
outstanding |  |                   |         |   |                    |   |         |  
|Common stock, $0.001 par value:                                                                                                                       |  |                   |          |   |                    |   |          |  
|Authorized shares: 80,000,000; shares issued and outstanding: 33,677,830 at December 31, 2004 and 34,217,541 at September 30,
2005                    |  |                   | 34       |   |                    |   | 34       |  
|Additional paid-in capital                                                                                                                            |  |                   | 270,282  |   |                    |   | 274,258  |  
|Deferred stock-based compensation                                                                                                                     |  |                   |         |   |                    |   | (653     | )
|Accumulated other comprehensive loss                                                                                                                  |  |                   | (226     | ) |                    |   | (285     | )
|Accumulated deficit                                                                                                                                   |  |                   | (137,959 | ) |                    |   | (144,880 | )
|                                                                                                                                                      |  |                   |          |   |                    |   |          |  
|Total stockholders equity                                                                                                                            |  |                   | 132,131  |   |                    |   | 128,474  |  
|                                                                                                                                                      |  |                   |          |   |                    |   |          |  
|Total liabilities and stockholders equity                                                                                                            |  | $                 | 168,481  |   |                    | $ | 165,420  |  
|                                                                                                                                                      |  |                   |          |   |                    |   |          |  

---

See accompanying
notes.



3



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WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(unaudited)



|                                                                   |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|------------------------------------------------------------------ |  | -------------------------------- | ------ | - | ------------------------------- | - | ------ | ---------- |  | - | ------ | - |  | - | ------ | -
|                                                                   |  | Three Months Ended September 30, |        |   | Nine Months Ended September 30, |  
|                                                                   |  | 2004                             |        |   | 2005                            |   |        | 2004       |  |   | 2005   |  
|                                                                   |  | (restated)                       |        |   |                                 |   |        | (restated) |  |   |        |  
|Revenues:                                                          |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Product                                                            |  | $                                | 13,393 |   |                                 | $ | 11,622 |            |  | $ | 42,494 |   |  | $ | 33,631 |  
|Service                                                            |  |                                  | 7,381  |   |                                 |   | 7,427  |            |  |   | 21,012 |   |  |   | 22,356 |  
|                                                                   |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Total revenues                                                     |  |                                  | 20,774 |   |                                 |   | 19,049 |            |  |   | 63,506 |   |  |   | 55,987 |  
|                                                                   |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Cost of revenues:                                                  |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Product (1)                                                        |  |                                  | 6,379  |   |                                 |   | 4,746  |            |  |   | 19,342 |   |  |   | 14,094 |  
|Service (1)                                                        |  |                                  | 1,390  |   |                                 |   | 1,384  |            |  |   | 4,165  |   |  |   | 4,312  |  
|                                                                   |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Total cost of revenues                                             |  |                                  | 7,769  |   |                                 |   | 6,130  |            |  |   | 23,507 |   |  |   | 18,406 |  
|                                                                   |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Gross margin                                                       |  |                                  | 13,005 |   |                                 |   | 12,919 |            |  |   | 39,999 |   |  |   | 37,581 |  
|                                                                   |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Operating expenses:                                                |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Sales and marketing (1)                                            |  |                                  | 7,740  |   |                                 |   | 6,274  |            |  |   | 24,439 |   |  |   | 21,827 |  
|Research and development (1)                                       |  |                                  | 4,402  |   |                                 |   | 4,626  |            |  |   | 13,659 |   |  |   | 13,890 |  
|General and administrative (1)                                     |  |                                  | 2,056  |   |                                 |   | 3,350  |            |  |   | 6,391  |   |  |   | 9,474  |  
|Amortization of other intangible assets                            |  |                                  | 243    |   |                                 |   | 243    |            |  |   | 730    |   |  |   | 730    |  
|Restructuring charges                                              |  |                                  | 400    |   |                                 |   |       |            |  |   | 400    |   |  |   |       |  
|                                                                   |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Total operating expenses                                           |  |                                  | 14,841 |   |                                 |   | 14,493 |            |  |   | 45,619 |   |  |   | 45,921 |  
|                                                                   |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Operating loss                                                     |  |                                  | (1,836 | ) |                                 |   | (1,574 | )          |  |   | (5,620 | ) |  |   | (8,340 | )
|Interest and other income, net                                     |  |                                  | 310    |   |                                 |   | 573    |            |  |   | 863    |   |  |   | 1,513  |  
|                                                                   |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Loss before income taxes                                           |  |                                  | (1,526 | ) |                                 |   | (1,001 | )          |  |   | (4,757 | ) |  |   | (6,827 | )
|Provision for income taxes                                         |  |                                  | 23     |   |                                 |   | 23     |            |  |   | 66     |   |  |   | 94     |  
|                                                                   |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Net loss                                                           |  | $                                | (1,549 | ) |                                 | $ | (1,024 | )          |  | $ | (4,823 | ) |  | $ | (6,921 | )
|                                                                   |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Basic and diluted net loss per share                               |  | $                                | (0.05  | ) |                                 | $ | (0.03  | )          |  | $ | (0.14  | ) |  | $ | (0.20  | )
|                                                                   |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Shares used in calculation of basic and diluted net loss per share |  |                                  | 33,575 |   |                                 |   | 33,986 |            |  |   | 33,430 |   |  |   | 33,834 |  
|                                                                   |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|(1)    Includes
stock-based compensation as follows:               |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|                                                                   |  |                                  |        |  
|Cost of revenues:                                                  |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Product                                                            |  | $                                |       |   |                                 | $ | 6      |            |  | $ |       |   |  | $ | 16     |  
|Service                                                            |  |                                  |       |   |                                 |   | 26     |            |  |   |       |   |  |   | 78     |  
|Sales and marketing                                                |  |                                  |       |   |                                 |   | 172    |            |  |   | 4      |   |  |   | 424    |  
|Research and development                                           |  |                                  | (1     | ) |                                 |   | 234    |            |  |   | 9      |   |  |   | 649    |  
|General and administrative                                         |  |                                  | 1      |   |                                 |   | 310    |            |  |   | 5      |   |  |   | 548    |  
|                                                                   |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  
|Total                                                              |  | $                                |       |   |                                 | $ | 748    |            |  | $ | 18     |   |  | $ | 1,715  |  
|                                                                   |  |                                  |        |   |                                 |   |        |            |  |   |        |   |  |   |        |  

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See accompanying
notes.



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WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)



|                                                                                                          |  |                                 |         |   |      |   |         |  
|--------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ---- | - | ------- | -
|                                                                                                          |  | Nine Months Ended September 30, |        
|                                                                                                          |  | 2004                            |         |   | 2005 |  
|                                                                                                          |  | (restated)                      |         |   |      |  
|Operating activities:                                                                                     |  |                                 |         |   |      |   |         |  
|Net loss                                                                                                  |  | $                               | (4,823  | ) |      | $ | (6,921  | )
|Adjustments to reconcile net loss to net cash used in operating activities:                               |  |                                 |         |   |      |   |         |  
|Noncash expenses:                                                                                         |  |                                 |         |   |      |   |         |  
|Depreciation and amortization of property and equipment                                                   |  |                                 | 2,104   |   |      |   | 1,945   |  
|Amortization of other intangible assets                                                                   |  |                                 | 730     |   |      |   | 730     |  
|Stock-based compensation                                                                                  |  |                                 | 18      |   |      |   | 1,715   |  
|Changes in operating assets and liabilities:                                                              |  |                                 |         |   |      |   |         |  
|Trade accounts receivable, net                                                                            |  |                                 | (1,452  | ) |      |   | 1,690   |  
|Inventories, net                                                                                          |  |                                 | (111    | ) |      |   | (782    | )
|Prepaid expenses and other current assets                                                                 |  |                                 | 635     |   |      |   | 52      |  
|Other assets                                                                                              |  |                                 | 100     |   |      |   | (190    | )
|Accounts payable                                                                                          |  |                                 | (668    | ) |      |   | (676    | )
|Accrued expenses, other liabilities and deferred rent                                                     |  |                                 | (206    | ) |      |   | 1,130   |  
|Accrued restructuring costs                                                                               |  |                                 | (1,137  | ) |      |   | (706    | )
|Deferred revenues                                                                                         |  |                                 | 1,953   |   |      |   | 848     |  
|                                                                                                          |  |                                 |         |   |      |   |         |  
|Net cash used in operating activities                                                                     |  |                                 | (2,857  | ) |      |   | (1,165  | )
|                                                                                                          |  |                                 |         |   |      |   |         |  
|Investing activities:                                                                                     |  |                                 |         |   |      |   |         |  
|Purchases of property and equipment, net of disposals                                                     |  |                                 | (1,401  | ) |      |   | (1,095  | )
|Proceeds from maturities of marketable securities                                                         |  |                                 | 33,030  |   |      |   | 53,492  |  
|Purchases of marketable securities                                                                        |  |                                 | (32,272 | ) |      |   | (45,776 | )
|                                                                                                          |  |                                 |         |   |      |   |         |  
|Net cash provided by (used in) investing activities                                                       |  |                                 | (643    | ) |      |   | 6,621   |  
|                                                                                                          |  |                                 |         |   |      |   |         |  
|Financing activities:                                                                                     |  |                                 |         |   |      |   |         |  
|Proceeds from stock option exercises and issuances of common stock under the employee stock purchase plan |  |                                 | 2,576   |   |      |   | 1,608   |  
|                                                                                                          |  |                                 |         |   |      |   |         |  
|Net cash provided by financing activities                                                                 |  |                                 | 2,576   |   |      |   | 1,608   |  
|                                                                                                          |  |                                 |         |   |      |   |         |  
|Net increase in cash and cash equivalents                                                                 |  |                                 | (924    | ) |      |   | 7,064   |  
|Cash and cash equivalents at beginning of period                                                          |  |                                 | 3,899   |   |      |   | 4,660   |  
|                                                                                                          |  |                                 |         |   |      |   |         |  
|Cash and cash equivalents at end of period                                                                |  | $                               | 2,975   |   |      | $ | 11,724  |  
|                                                                                                          |  |                                 |         |   |      |   |         |  

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See accompanying
notes.



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



NOTE 1  DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION



Description of Business



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



Interim Financial Information



The accompanying unaudited consolidated financial statements of WatchGuard have been prepared in accordance with accounting principles generally accepted
in the United States 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
months and nine months ended September 30, 2005 are not necessarily indicative of the results that may be expected for future quarters or for the year ending December 31, 2005. The financial statements should be read in conjunction with
the consolidated financial statements and related notes for the year ended December 31, 2004 included in WatchGuards annual report on Form 10-K, filed with the Securities and Exchange Commission (SEC) on March 31, 2005.



Restatement of Prior Period Information



Financial results for the three months and nine months ended
September 30, 2004 have been restated to correct certain accounting errors identified during WatchGuards financial close and audit process for the year ended December 31, 2004. Refer to WatchGuards annual report on Form 10-K
for the year ended December 31, 2004 for a detailed discussion of the restatement.



NOTE 2  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



Principles of Consolidation



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



Revenue Recognition



WatchGuard generates revenues through sales of its Firebox products,
licenses and subscriptions for related software options and services, and 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. 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 WatchGuards 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.



Because each Firebox hardware product contains embedded software, whereby significant software development costs are
incurred in developing the embedded software, and because the Firebox and the embedded software include the right to receive technical support and software updates on a when, and if, available basis, 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 SEC Topic 13, Revenue
Recognition of the codification of the Staff Accounting Bulletins (SAB). Topic 13 summarizes certain of the SECs views in applying generally accepted accounting principles to revenue recognition in financial statements. WatchGuard
believes its revenue recognition policies and practices are consistent with the accounting standards.



Most of WatchGuards Firebox products and certain software products include an initial period of service subscription bundled in the product price.
Because the timing of revenue recognition differs between the product and the service subscription, the related revenues must be allocated to the product and the subscription service. The allocation of revenues is determined by using the residual
method, as defined in SOP 98-9, if vendor-specific objective evidence of fair value for undelivered elements of the arrangement (typically services) has been established. Under the residual method, the amounts allocated to the undelivered elements
(typically services) are equal to their fair value as established by vendor-specific



6



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objective evidence. The residual revenues in the arrangement are then allocated to the delivered elements (typically products). Vendor-specific objective
evidence of fair value is based on the price charged when an element is sold separately or, if an element is not yet sold separately, on the price established by authorized management if it is probable that the price, once established, will not
change before the element is separately introduced into the marketplace. Prior to recognizing any revenues, WatchGuard ensures that there is persuasive evidence of the arrangement, collection is probable, and the fee is fixed or determinable.



Revenues allocated to products, including software license
fees, are recognized upon delivery of the products to the customer (the sell in method). Where the customer is a distributor with unlimited stock returns and rotation rights, product revenues are not recognized until the distributors
sell the products to their customers (the sell through method). Revenues from LiveSecurity Service subscriptions and other services are recognized ratably over the term of the subscription, ranging from 3 to 30 months. WatchGuards
standard payment terms range from 30 to 60 days. WatchGuard offers term discounts to certain of its larger customers.



During the first quarter of 2005, WatchGuard negotiated changes in contractual obligations with certain channel customers in North America, Australia and
New Zealand which provided such customers with unlimited return rights for products sold after the change date. The changes were triggered by the need to offer promotional programs to give WatchGuard the flexibility in the respective markets to be
more competitive, responsive and effective. As a result, WatchGuard converted these customers to a sell through method beginning in the first quarter of 2005. When a channel customer is converted from the sell in method to the sell through method of
revenue recognition, revenue can no longer be recognized when product is sold to the channel customer, because revenue from products in that channel customers inventory was already recognized in prior periods. Therefore, revenue on individual
inventory items sold subsequent to the conversion can only be recognized after the converted channel customer has disposed of its inventory predating the conversion. As of December 31, 2004, the converted customers held inventory for which
WatchGuard had already recognized revenues in the amount of $2.3 million. Substantially all of these inventories were sold through by the converted customers during the first quarter of 2005.



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 based on historical experience.



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.



Goodwill



Pursuant to Statement of Financial Accounting Standards (SFAS) 142, Goodwill and Other Intangible Assets, WatchGuard tests goodwill for
impairment at least annually. WatchGuard has selected October 1 as the date for its annual impairment test. 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. WatchGuard is currently in the process of performing its annual impairment analysis and expects to complete the analysis
before year-end. Should an impairment be identified, the corresponding charge will be recorded in the fourth quarter of 2005, as impairment losses are charged to earnings in the period in which they are identified.



Stock-Based Compensation



Stock-based compensation primarily consists of stock-based charges resulting
from the variable accounting treatment of certain stock options issued to employees. Stock-based compensation also includes, to a lesser extent, costs associated with restricted stock issued to directors and certain key officers as well as stock
options granted to non-employees. Refer to Note 7 to these consolidated financial statements for further discussion of stock compensation programs resulting in variable accounting treatment of stock awards.



7



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##### Table of Contents

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. Accordingly, compensation cost for stock option and restricted stock awards is measured as the excess, if any,
of the quoted market price of WatchGuards common stock at the measurement date (or the balance sheet date, if the measurement date has not yet occurred) over the amount, if any, required to be paid by the employee. Compensation cost is charged
to expense over the vesting period of each respective award using the accelerated method of expense recognition. Measurement date is defined as the grant date for all stock awards other than variable stock options and variable restricted stock
awards. Measurement date for variable stock options and variable restricted stock awards is defined as the date the number of shares and purchase (exercise) price, if any, are both known. Changes in the quoted market price of WatchGuards
common stock are reflected as an adjustment to stock-based compensation expense in the periods in which the changes occur until the date both the number of shares and purchase price, if any, are known.



Stock-based compensation for options granted to non-employees has been
determined in accordance with EITF Issue No. 96-18, Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, and is based on the fair value of the
equity instruments issued. The fair value of options granted to non-employees is periodically measured as the underlying options vest.



In March 2005, the SEC published SAB No. 107, which expresses the view of the SEC staff and provides guidance on a variety of matters associated with
stock-based compensation. Among other things, SAB No. 107 states that stock-based compensation should be classified on the same expense lines as cash compensation. Accordingly, WatchGuard has reclassified its stock-based compensation from prior
periods to conform to the current period presentation of stock-based compensation within the same operating expense line item(s) as cash compensation.



During the three and nine months ended September 30, 2005, WatchGuard issued 376,000 and 494,000 shares, respectively, of its common stock upon the
exercise of stock options and the issuance of shares under its employee stock purchase plan.



Pro Forma Stock-Based Compensation



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 No. 123, Accounting for Stock-Based Compensation. 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):



|                                                                          |  |                                 |        |   |                                |   |        |            |  |   |         |   |  |   |         |  
|------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---------- |  | - | ------- | - |  | - | ------- | -
|                                                                          |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                                                          |  | 2004                            |        |   | 2005                           |   |        | 2004       |  |   | 2005    |  
|                                                                          |  | (restated)                      |        |   |                                |   |        | (restated) |  |   |         |  
|Net loss  as reported                                                    |  | $                               | (1,549 | ) |                                | $ | (1,024 | )          |  | $ | (4,823  | ) |  | $ | (6,921  | )
|Add: stock-based compensation, as reported                                |  |                                 |       |   |                                |   | 748    |            |  |   | 18      |   |  |   | 1,715   |  
|Deduct: stock-based compensation determined under fair-value-based method |  |                                 | (3,368 | ) |                                |   | (1,353 | )          |  |   | (9,646  | ) |  |   | (6,857  | )
|                                                                          |  |                                 |        |   |                                |   |        |            |  |   |         |   |  |   |         |  
|Net loss  pro forma                                                      |  | $                               | (4,917 | ) |                                | $ | (1,629 | )          |  | $ | (14,451 | ) |  | $ | (12,063 | )
|                                                                          |  |                                 |        |   |                                |   |        |            |  |   |         |   |  |   |         |  
|Net loss per share, basic and diluted  as reported                       |  | $                               | (0.05  | ) |                                | $ | (0.03  | )          |  | $ | (0.14   | ) |  | $ | (0.20   | )
|Net loss per share, basic and diluted  pro forma                         |  | $                               | (0.15  | ) |                                | $ | (0.05  | )          |  | $ | (0.43   | ) |  | $ | (0.36   | )



In December 2004, the
Financial Accounting Standards Board issued SFAS No. 123 revised 2004, or SFAS 123(R), Share-Based Payment, which is a revision to SFAS 123. SFAS 123(R) supersedes APB Opinion No. 25. Generally, the approach described in SFAS
123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options and shares issued under an employee stock purchase plan, to be recognized in the
income statement based on their fair values. Pro forma disclosure will no longer be an alternative. SFAS 123(R) allows public companies to transition using either of the two methods described below. Under the modified prospective method, stock
compensation expense is recognized starting from the date of the adoption for all outstanding unvested stock awards, as well as for all awards granted, modified or settled after the date of the adoption. Under the modified retrospective method,
entities would restate prior period financial statements using the amounts previously reflected in pro forma disclosures under SFAS 123 either for all prior periods presented or for prior interim periods of the year of adoption.



8



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In April 2005, the SEC delayed the effective date of SFAS 123(R) such that each company that is not a
small business issuer will be required to adopt SFAS 123(R) no later than the first interim reporting period of the companys first fiscal year beginning on or after June 15, 2005. Upon adoption of SFAS 123(R), in accordance with its
rules, stock options will no longer be subject to variable accounting treatment. Rather, the amount of stock compensation expense will be fixed based on initial estimated fair values of the replacement stock options and amortized over the remaining
vesting periods of these options. Stock compensation expense recognized until adoption of SFAS 123(R) using variable accounting will not be reversed upon adoption. WatchGuard is currently evaluating valuation models and the transition provisions of
this standard. WatchGuard has not yet decided which implementation method it will select or which date it will adopt the provisions of SFAS 123(R). The effect of adoption of SFAS 123(R) cannot be predicted at this time because it will depend on
levels of share-based payments granted in the future.



Net Loss Per Share



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. Shares used in the
calculation of basic and diluted net loss per share for the three and nine months ended September 30, 2005, exclude 42,250 shares of unvested restricted stock.



Comprehensive Loss



WatchGuards investments consist of commercial paper, corporate and government debt securities and auction rate securities. WatchGuards
investment securities are considered available-for-sale, as defined by SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and are stated at fair value, with unrealized gains and losses
included as a component of stockholders equity. During the three months and six months ended September 30, 2004 and September 30, 2005, there were no material realized gains or losses on available-for-sale securities. The following
table sets forth the components of comprehensive loss (in thousands):



|                                      |  |                                 |        |   |                                |   |        |            |  |   |        |   |  |   |        |  
|------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---------- |  | - | ------ | - |  | - | ------ | -
|                                      |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                      |  | 2004                            |        |   | 2005                           |   |        | 2004       |  |   | 2005   |  
|                                      |  | (restated)                      |        |   |                                |   |        | (restated) |  |   |        |  
|Net loss                              |  | $                               | (1,549 | ) |                                | $ | (1,024 | )          |  | $ | (4,823 | ) |  | $ | (6,921 | )
|Unrealized gain (loss) on investments |  |                                 | 120    |   |                                |   | (20    | )          |  |   | (127   | ) |  |   | (59    | )
|                                      |  |                                 |        |   |                                |   |        |            |  |   |        |   |  |   |        |  
|Comprehensive loss                    |  | $                               | (1,429 | ) |                                | $ | (1,044 | )          |  | $ | (4,950 | ) |  | $ | (6,980 | )
|                                      |  |                                 |        |   |                                |   |        |            |  |   |        |   |  |   |        |  



Reclassifications



Certain prior-period
items have been reclassified to conform to the current-period presentation, including the reclassification of (i) customer early pay incentive discounts from interest expense to product revenues, (ii) certain leasehold improvements
previously netted against the related deferred rent liability from accrued expenses and other liabilities to property and equipment, (iii) certain deferred rent liabilities from accrued expenses and other liabilities to long-term deferred rent,
and (iv) stock-based compensation expense from a stand-alone financial statement line item to the same operating expense line items as cash compensation paid to employees, directors or non-employees.



NOTE 3  BALANCE SHEET ACCOUNT DETAIL



Trade Accounts Receivable, Net



Trade accounts receivable, net consisted of the following (in thousands):



|                                   |  |                   |        |   |                    |   |        |  
|---------------------------------- |  | ----------------- | ------ | - | ------------------ | - | ------ | -
|                                   |  | December 31, 2004 |        |   | September 30, 2005 |  
|Trade accounts receivable          |  | $                 | 9,874  |   |                    | $ | 8,360  |  
|Reserve for returns and allowances |  |                   | (2,299 | ) |                    |   | (2,459 | )
|Allowance for doubtful accounts    |  |                   | (270   | ) |                    |   | (286   | )
|                                   |  |                   |        |   |                    |   |        |  
|                                   |  | $                 | 7,305  |   |                    | $ | 5,615  |  
|                                   |  |                   |        |   |                    |   |        |  



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Inventories, Net



Inventories, net consisted of the following (in thousands):



|                    |  |                  |       |   |                   |   |       |  
|------------------- |  | ---------------- | ----- | - | ----------------- | - | ----- | -
|                    |  | December 31,2004 |       |   | September 30,2005 |  
|Finished goods      |  | $                | 2,570 |   |                   | $ | 2,931 |  
|Components          |  |                  | 1,510 |   |                   |   | 1,718 |  
|                    |  |                  |       |   |                   |   |       |  
|                    |  |                  | 4,080 |   |                   |   | 4,649 |  
|Inventory allowance |  |                  | (935  | ) |                   |   | (722  | )
|                    |  |                  |       |   |                   |   |       |  
|                    |  | $                | 3,145 |   |                   | $ | 3,927 |  
|                    |  |                  |       |   |                   |   |       |  



Inventories held by
sell through customers, included as a component of finished goods, were $511,000 and $870,000 at December 31, 2004 and September 30, 2005, respectively.



Accrued Expenses and Other Liabilities



Accrued expenses and other liabilities consisted of the following (in thousands):



|                                     |  |                  |       |                   |   |      
|------------------------------------ |  | ---------------- | ----- | ----------------- | - | -----
|                                     |  | December 31,2004 |       | September 30,2005
|Accrued payroll-related liabilities  |  | $                | 2,811 |                   | $ | 2,064
|Deposits from sell through customers |  |                  | 1,039 |                   |   | 1,903
|Other accrued liabilities            |  |                  | 3,731 |                   |   | 4,843
|                                     |  |                  |       |                   |   |      
|                                     |  | $                | 7,581 |                   | $ | 8,810
|                                     |  |                  |       |                   |   |      



NOTE 4  GUARANTEES



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, 2004 and September 30, 2005,
WatchGuards restricted cash balance was $3.0 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, included as a component of accrued expenses and other
liabilities, was $530,000 and $417,000 at December 31, 2004 and September 30, 2005, respectively. Changes to WatchGuards estimated product warranty liability during the nine months ended September 30, 2005 were as follows (in
thousands):



|                                                        |  |   |      |  
|------------------------------------------------------- |  | - | ---- | -
|Balance at December 31, 2004                            |  | $ | 530  |  
|Additions charged to cost of revenues during the period |  |   | 207  |  
|Settlements made during the period                      |  |   | (320 | )
|                                                        |  |   |      |  
|Balance at September 30, 2005                           |  | $ | 417  |  
|                                                        |  |   |      |  



NOTE 5  BUSINESS
RESTRUCTURINGS



At September 30, 2005,
WatchGuards accrued restructuring charges, including both the short-term and long-term portions, were $4.2 million. Additional charges of $115,000 related to the 2001 restructuring were recorded during the three months ended September 30,
2005, due to the revision of the cost of excess facilities, as the real estate market remains depressed longer than originally expected. These charges were offset by a $115,000 reduction in the 2002 restructuring liability during the third quarter
of 2005, due to the revision of estimated proceeds from the sublease of excess facilities, as previously vacant space was subleased during the period. Refer below for further detail regarding WatchGuards 2001 and 2002 business restructurings.



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2001 Restructuring



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, 2004 and September 30, 2005, and activity recorded through September 30, 2005, are as follows (in thousands):



|                               |  |                   |       |                               |   |      |                    |  |   |      
|------------------------------ |  | ----------------- | ----- | ----------------------------- | - | ---- | ------------------ |  | - | -----
|                               |  | December 31, 2004 |       | Amounts(Paid) or Charged, Net |   |      | September 30, 2005
|Abandoned facilities and other |  | $                 | 1,492 |                               | $ | (137 | )                  |  | $ | 1,355
|                               |  |                   |       |                               |   |      |                    |  |   |      



2002
Restructuring



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., which included a reduction in workforce, consolidation of excess facilities and
elimination of technology-related contracts that were 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, 2004 and September 30, 2005, and activity
recorded through September 30, 2005, are as follows (in thousands):



|                               |  |                   |       |                               |   |      |                    |  |   |      
|------------------------------ |  | ----------------- | ----- | ----------------------------- | - | ---- | ------------------ |  | - | -----
|                               |  | December 31, 2004 |       | Amounts(Paid) or Charged, Net |   |      | September 30, 2005
|Abandoned facilities and other |  | $                 | 3,396 |                               | $ | (569 | )                  |  | $ | 2,827
|                               |  |                   |       |                               |   |      |                    |  |   |      



NOTE 6  CONTINGENCIES



WatchGuard is subject to legal claims and litigation
arising in the ordinary course of business, such as employment or intellectual property claims, including the matters described below. The outcome of any such matters is currently undeterminable and an adverse result in one or more matters could
negatively affect WatchGuards operating results in the period in which it occurs.



Intellectual Property Employment Litigation



On March 23, 2005, WatchGuard filed a complaint in United States District Court for the Northern District of Texas against a terminated former employee, Michael N. Valentine, and his new employer, SonicWALL,
Inc., a direct competitor of WatchGuard. The complaint was filed to prevent the misappropriation of WatchGuards trade secrets and to enjoin the acts of unfair competition by Valentine and SonicWALL. Valentine currently works for SonicWALL as
its Vice President of Channel Sales. Valentine previously worked for WatchGuard in a similar position, as WatchGuards Vice President of America Sales. As Vice President of America Sales, Valentine received trade secret and proprietary
information about WatchGuard products, sales practices and employees. Valentine owed a contractual duty, as well as a common-law fiduciary duty of loyalty, to WatchGuard not to use or disclose that proprietary information, particularly for the
benefit of a competitor. WatchGuard believes that Valentines new employer, SonicWALL, encouraged Valentine to breach his obligations to WatchGuard and has used WatchGuards trade secrets to actively engage in a campaign to induce key
sales employees to leave WatchGuard and breach their contractual obligations to WatchGuard. WatchGuard has asserted causes of action against both Valentine and SonicWALL for misappropriation of trade secrets and unfair competition. Additionally,
WatchGuard has brought causes of action for breach of contract and breach of fiduciary duty against Valentine and a cause of action for tortious interference with existing contracts against SonicWALL. In this complaint, WatchGuard seeks injunctive
relief, compensatory and punitive damages, and costs of suit. In September 2005, Valentine moved the Court for leave to amend his answer to WatchGuards complaint to add counterclaims against WatchGuard for libel, slander and defamation per se.
In November 2005, over WatchGuards objection, the Court granted Valentines motion and Valentine amended his answer to formally include the counterclaims against WatchGuard. WatchGuard believes that Valentines counterclaims are
baseless and intends to vigorously defend against them. WatchGuard may be unsuccessful in obtaining the full remedies that it is seeking in this litigation and, even if successful, the litigation may be costly and time consuming, which could have a
material adverse effect on WatchGuards operating results.



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Class-Action Securities Litigation



On April 8, 2005, a holder of WatchGuard common stock, on behalf of
himself and purportedly on behalf of a class of WatchGuard stockholders, filed an action in the United States District Court for the Western District of Washington (the Court) against WatchGuard and some of its current and former officers, alleging
violations of the federal securities laws arising out of, among other things, its announcement on March 15, 2005 that it was restating some of its financial results for interim periods of 2004. Subsequently, a number of other related purported
class action suits also alleging violations of the federal securities laws were filed by holders of our common stock. The various actions have been consolidated by the Court, and are referred to herein as the Action. On October 3, 2005, a
consolidated amended complaint was filed in the action. Our response to that complaint is currently due on December 2, 2005. In addition, two related shareholder derivative suits against some of our current and former directors and
officers have subsequently been filed in the Superior Court of the State of Washington, King County and in the United States District Court for the Western District of Washington, respectively, which are referred to as the Derivative Actions.
Plaintiffs in the Action and the Derivative Actions seek unspecified compensatory damages. WatchGuard is obligated to indemnify its officers and directors to the extent permitted by applicable law in connection with the Action, and has insurance for
such individuals, to the extent of the limits of the applicable insurance policies and subject to potential reservations of rights. WatchGuard intends to vigorously defend against the Action. WatchGuard is unable, however, to predict the ultimate
outcome of the Action. At this time, WatchGuard has not recorded any liability associated with this litigation as the associated cost and outcome are currently not determinable. There can be no assurance WatchGuard will be successful in defending
against the Action and, if WatchGuard is unsuccessful, it may be subject to significant damages, which could have a material adverse effect on WatchGuards operating results and financial position. Even if WatchGuard is successful, defending
against the Action is likely to be expensive, time consuming and may divert managements attention from other business concerns and harm its business, which could have a material adverse effect on WatchGuards operating results.



NOTE 7  REVISIONS TO STOCK COMPENSATION PLANS



In the second quarter of 2005, WatchGuard implemented several changes to its
existing stock compensation plans. The primary changes consisted of a stock option exchange program, the creation of a program to encourage stock ownership for directors and executive officers, and revisions to the Board of Directors
compensation package to more accurately reflect current industry practices.



Stock Option Exchange Program



In April 2005, WatchGuard offered a voluntary stock option exchange program to its employees (the option exchange offer). In the option exchange offer, holders of eligible options had the opportunity to exchange their
options with exercise prices of $6.00 or more for a lesser number of replacement options having an exercise price equal to the fair market value of WatchGuards common stock on the grant date of the replacement options. The exchange ratio was
90% for options with an exercise price from $6.00 to $8.00 per share, 75% for options with an exercise price from $8.01 to $10.00 per share, and 33.3% for options with an exercise price of $10.01 or more. Eligible options to purchase 3,983,034
shares of WatchGuards common stock were tendered for exchange and cancellation in the option exchange offer, all of which were accepted for cancellation by WatchGuard. On May 18, 2005, WatchGuard cancelled all eligible options tendered
under the option exchange offer, and granted replacement options to purchase 3,064,882 shares of its common stock at an exercise price of $3.435 per share. Upon grant, each replacement option was vested and exercisable to the same degree as the
original option. WatchGuard did not return the net options eliminated as a result of the reduction in the number of options outstanding to the pool of options available to be granted. In addition, WatchGuard eliminated all shares available for grant
pursuant to non-stockholder-approved stock option plans, further reducing the number of shares available for grant under its option plans by 4,279,328 shares. Following the grant and reduction, WatchGuard had a reserve of 4,141,162 shares available
for future grant under its option plans. For financial reporting purposes, WatchGuard is accounting for all replacement stock options, as well as all options that were subject to the exchange program but were retained by employees, using variable
accounting until adoption of SFAS 123(R).



Director and
Officer Stock Ownership Program



In April 2005,
WatchGuard implemented its Director and Section 16 Officer Stock Ownership Program (the Program) to encourage stock ownership for its directors and executive officers. Under the Program, voluntary purchases of WatchGuards capital stock by
its directors or officers will be matched by WatchGuard in the form of a restricted stock grant equal to 50% of the number of shares purchased in the open market, up to a maximum of 5,000 matching restricted shares per participant per year. The
matching restricted shares granted by WatchGuard will vest annually over three years, and any unvested matching restricted stock shares will be forfeited if the shares that were matched are sold. During the second quarter of 2005, WatchGuard issued
a total of 31,000 shares of matching restricted stock to its directors and executive officers under



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the Program. For financial reporting purposes, WatchGuard is accounting for any matching restricted shares granted under the Program using variable
accounting until adoption of SFAS 123(R).



Board of
Director Compensation



The compensation for
non-employee directors has been changed to increase the annual retainer for general board membership, institute annual retainers for committee membership and committee chairs and eliminate per-meeting fees. In addition, non-employee directors will
continue to receive options to purchase shares of WatchGuards capital stock as before and will also receive an annual grant of 2,500 shares of restricted stock which vests over a one year period. For financial reporting purposes, WatchGuard is
recognizing compensation cost associated with the restricted stock grants over the applicable vesting period.



NOTE 8  SHAREHOLDERS RIGHTS AGREEMENT



On May 6, 2005, WatchGuard adopted a rights agreement. The rights will be exercisable only if a person or group acquires 15% or more of WatchGuards outstanding common stock, whether through open market or
private purchases, or if a person or group commences a tender offer for 15% or more of WatchGuards outstanding common stock. In such case, each right would entitle stockholders other than the acquirer to purchase 1/1000 of a share of a newly
created series of preferred stock for payment of the exercise price. If an acquirer were to acquire 15% or more of WatchGuards outstanding common stock, each stockholder other than the acquirer would have the right to purchase a number of
newly issued shares of WatchGuards common stock having a market value equal to two times the exercise price of the rights for payment of the exercise price (i.e. the right to purchase WatchGuards common stock at a 50% discount).
WatchGuards Board of Directors may redeem the rights for a nominal amount ($0.001 per right) prior to the date they become exercisable or before the right to purchase securities of WatchGuard or an acquiring entity at a discount accrues,
subject to extension under certain circumstances. Until the rights issued under the rights agreement become exercisable, the rights will trade automatically with WatchGuards common stock and separate rights certificates will not be issued.



At or prior to WatchGuards 2006 annual meeting of
stockholders (and in no event later than May 5, 2006), WatchGuard will submit to its stockholders who are not affiliated with management or any member of the Board of Directors (Independent Stockholders) the rights agreement for ratification.
Unless the majority of the votes cast by the Independent Stockholders are voted in favor of the continued existence of the rights agreement, the rights agreement and the rights issued pursuant to the rights agreement will terminate immediately after
such meeting.



|ITEM2. | 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 our financial condition and
operating results. The discussion should be read in conjunction with the unaudited 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.



Forward-Looking
Statements



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



| |  |  | information concerning possible or assumed future operating results, trends in financial results and business plans, including those relating to earnings growth and revenue growth;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | statements about our costs and operating expenses relative to our revenues and about the expected composition of our revenues;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



| |  |  | statements about our future capital requirements and the sufficiency of our cash, cash equivalents, investments and available bank borrowings to meet these requirements;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | information about the anticipated timing of new product releases;
| | - |  | -----------------------------------------------------------------



| |  |  | other statements about our plans, objectives, expectations and intentions; and
| | - |  | ------------------------------------------------------------------------------



| |  |  | other statements that are not historical facts.
| | - |  | -----------------------------------------------



Words such as expects, believes, anticipates, intends and will 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



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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 Operating Results 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 Operating Results 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.



Overview



We are a leading provider of network
security solutions designed to protect small- to medium-sized enterprises, or SMEs, that use the Internet for e-commerce and secure communications. We provide SMEs worldwide with integrated and expandable network security solutions employing
multi-layered defenses designed to protect not only against existing threats, but against future threats, in an intelligent way backed by an intuitive user interface and the expert guidance and support of our LiveSecurity Service. With the risk that
threats and attacks will compromise multiple access points in a corporate network, an effective security solution requires more layers of defense than just firewalls for access control and virtual private networks, or VPNs, for secure
communications. A security solution that integrates multiple layers of defense, however, must do so efficiently to preserve performance and remain flexible enough to adapt to future threats and attacks in the evolving security landscape.



Thousands of enterprises worldwide use our award-winning products and
services to meet these requirements. The core of our products and services is our family of integrated, expandable Firebox X security solutions. We offer firewall protection and intrusion prevention technology for access control, virtual private
networking for secure communications, content and spam filtering, gateway and desktop anti-virus protection and vulnerability assessment services. Our Firebox X security solutions allow users to upgrade to any higher model in the particular line
simply by applying a software license key. We also offer our customers a unified management interface that allows even the non-security professional to effectively install, configure and monitor our security products as well as the networking
features required for more complex network installations. In addition, 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 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 other managed service provider implementing our managed security solutions. For the service provider, our technology improves the economics of managed security services through a
scalable delivery platform that enables the service provider to remotely configure and manage thousands of customer sites quickly and easily.



Since January 2004, we have continued to invest heavily in the development of our products as follows:



| |  |  | In February 2004, we introduced our Firebox X line of integrated, expandable security appliances for SMEs, combining firewall, VPN, application layer security, intrusion prevention
functionality, spam blocking, Web filtering and authentication in a single appliance designed to enable customers to upgrade the appliance to any higher model in the same line or to add ports just by applying a software license key.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In August 2004, we extended the Firebox X family of integrated, upgradeable security appliances to address the needs of remote offices, telecommuters and small businesses with the
launch of the Firebox X Edge line, designed to provide commercial-class security at the furthest points of the network at an affordable price point.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In December 2004, we made available the WatchGuard Gateway AntiVirus for email for our Firebox X line of integrated, upgradeable security appliances. This robust signature-based
solution, combined with our existing deep application inspection capability, is designed to provide comprehensive security against email borne threats at an affordable cost.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | In December 2004, we extended the Firebox X Edge line with a wireless version offering secure 802.11g wireless connection, and enhanced the Edge software for wired and wireless to
include WAN / WAN failover and WAN / Modem failover for greater reliability.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In April 2005, we introduced the Firebox X Peak line, our highest-performance line of integrated security appliances, with up to 1 Gbps firewall throughput, high port density and
advanced networking features. In connection with this product introduction, we also launched Fireware Pro, our advanced security and network operating system designed for more complex network environments. Fireware Pro comes bundled with all Firebox
X Peak appliances and is available as an upgrade to Firebox X Core appliances (formerly the Firebox X line).
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In August 2005, we introduced the Firebox SSL Core VPN Gateway with Citrix Secure Access. The Firebox SSL Core VPN Gateway combines Citrix SSL VPN secure access technology, the
Citrix Access Gateway, with WatchGuards Firebox hardware platform to provide a professional-grade access solution for increasingly mobile SME workforces.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Critical Accounting Policies and Estimates



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 financial statements, including those related to:



| |  |  | revenue recognition, including sales returns and allowances and promotional rebates;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | provision for doubtful accounts;
| | - |  | --------------------------------



| |  |  | inventory reserves;
| | - |  | -------------------



| |  |  | restructuring reserves; and
| | - |  | ---------------------------



| |  |  | analysis for impairment of goodwill and other long-lived intangible assets.
| | - |  | ---------------------------------------------------------------------------



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



Revenue recognition rules for software companies are complex. Although we follow 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.



We generate revenues through:



| |  |  | sales of products and service subscriptions indirectly through our distribution network at a discount from list price;
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | sales of products and service subscriptions to our service provider customers at volume pricing rates; and
| | - |  | ----------------------------------------------------------------------------------------------------------



| |  |  | sales of service subscription renewals directly to end-users, generally at the manufacturers suggested retail price.
| | - |  | ---------------------------------------------------------------------------------------------------------------------



Product revenues, net of sales returns, allowances and promotions, include:



| |  |  | sales of our Firebox products, bundling our security appliances and perpetual software licenses as part of our security solution;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



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| |  |  | revenues from license sales of software options, such as user expansion, software management modules and the license portion of subscriptions; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | revenues from sales of our network operations center security suite software license as part of our managed security solution.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



Most of our Firebox products and certain software products include an initial
period of service subscription bundled in the product price. Because the timing of revenue recognition differs between the product and the service subscription, the related revenues must be allocated to the product and the subscription service. The
allocation of revenues is determined by using the residual method, as defined in Statement of Position (SOP) 98-9, an amendment to SOP 97-2, Software Revenue Recognition, if vendor-specific objective evidence of fair value for
undelivered elements of the arrangement (typically services) has been established. Under the residual method, the amounts allocated to the undelivered elements (typically services) are equal to their fair value as established by vendor-specific
objective evidence. The residual revenues in the arrangement are then allocated to the delivered elements (typically products). Vendor-specific objective evidence of fair value is based on the price charged when an element is sold separately or, if
an element is not yet sold separately, on the price established by authorized management if it is probable that the price, once established, will not change before the element is separately introduced into the marketplace. Prior to recognizing any
revenues, we ensure that there is persuasive evidence of the arrangement, collection is probable, and the fee is fixed or determinable. We are required to exercise judgment in deciding how to interpret the evidence of vendor-specific objective
evidence of fair value to determine the allocation of arrangement consideration with respect to a given element, and in determining whether an established price is likely to change prior to separate market introduction. These judgments may
materially affect the timing of our revenue recognition and operating results.



Revenues allocated to products, including software license fees, are generally recognized upon delivery of the products to the customer (the sell in method). Where the customer is a distributor with
unlimited stock returns and rotation rights, product revenues are not recognized until the distributors sell the products to their customers (the sell through method). Revenues from LiveSecurity Service subscriptions and other services
are recognized ratably over the term of the subscription, ranging from 3 to 30 months. Our standard payment terms range from 30 to 60 days. We offer term discounts to certain of our larger customers.



Service revenues primarily include the allocated fees for the initial
LiveSecurity Service and other services subscriptions and for LiveSecurity Service and other services subscription renewals. These service fees provide our customers access to our LiveSecurity Service and other services 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.



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 historic 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.



Provision for Doubtful Accounts



We maintain allowances for doubtful accounts for estimated losses resulting
from the inability of our customers to make required payments. 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 operating results.



Inventory Valuation



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 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



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customer preferences could, however, significantly affect these estimates and result in additional inventory write-downs, which could have an adverse effect
on our operating results.



Restructuring



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 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.



Accounting for Goodwill and Other Long-Lived Intangible Assets



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 Statement of Financial Accounting
Standards (SFAS) 142, Goodwill and Other Intangible Assets, we test goodwill for impairment at least annually. We have selected October 1 as the date for our annual impairment test. 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. We are currently in the process of
performing our annual impairment analysis and expect to complete our analysis before year-end. Should an impairment be identified, the corresponding charge will be recorded in the fourth quarter of 2005, as impairment losses are charged to earnings
in the period in which they are identified.



Separable
intangible assets that do not have indefinite lives are amortized over their useful lives typically ranging between three and five years. In accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, 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 operating results.



Recent Accounting Pronouncement



In December 2004, the Financial Accounting Standards Board issued SFAS 123
revised 2004, or SFAS 123(R), Share-Based Payment, which is a revision to SFAS 123, Accounting for Stock-Based Compensation. SFAS 123(R) supersedes Accounting Principles Board, or APB, Opinion No. 25, Accounting
for Stock Issued to Employees. Generally, the approach described in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options
and shares issued under an employee stock purchase plan, to be recognized in the income statement based on their fair values. Pro forma disclosure will no longer be an alternative. SFAS 123(R) allows public companies to transition using either of
the two methods described below. Under the modified prospective method, stock compensation expense is recognized starting from the date of the adoption for all outstanding unvested stock awards, as well as for all awards granted, modified or settled
after the date of the adoption. Under the modified retrospective method, entities would restate prior period financial statements using the amounts previously reflected in pro forma disclosures under SFAS 123 either for all prior periods presented
or for prior interim periods of the year of adoption.



In April
2005, the SEC delayed the effective date of SFAS 123(R) such that each company that is not a small business issuer will be required to adopt SFAS 123(R) no later than the first interim reporting period of the companys first fiscal year
beginning on or after June 15, 2005. Upon adoption of SFAS 123(R), in accordance with its rules, stock options will no longer be subject to variable accounting treatment. Rather, the amount of stock compensation expense will be fixed based on
initial estimated fair values of the replacement stock options and amortized over the remaining vesting periods of these options. Stock compensation expense recognized until adoption of SFAS 123(R) using variable accounting will not be



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reversed upon adoption. We are currently evaluating valuation models and the transition provisions of this standard. We have not yet decided which
implementation method we will select or which date we will adopt the provisions of SFAS 123(R).



As permitted by SFAS 123, we currently account for share-based payments to employees using APB Opinion No. 25s intrinsic value method and do
not recognize compensation expense for options granted to employees with an exercise price equal to or in excess of the fair value of the underlying common shares at the date of grant unless the options are subject to variable accounting.
Accordingly, the adoption of SFAS 123(R)s fair value method may have a significant effect on our operating results. The effect of adoption of SFAS 123(R) cannot be predicted at this time because it will depend on levels of share-based payments
granted in the future.



Results of Operations



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



|                                        |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|--------------------------------------- |  | -------------------------------- | -- |  | ------------------------------- | -- |  | ----- | -- |  | ----- | --
|                                        |  | Three Months Ended September 30, |    |  | Nine Months Ended September 30, |   
|                                        |  | 2004                             |    |  | 2005                            |    |  | 2004  |    |  | 2005  |   
|Revenues:                               |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Product                                 |  | 64.5                             | %  |  | 61.0                            | %  |  | 66.9  | %  |  | 60.1  | % 
|Service                                 |  | 35.5                             |    |  | 39.0                            |    |  | 33.1  |    |  | 39.9  |   
|                                        |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Total revenues                          |  | 100.0                            |    |  | 100.0                           |    |  | 100.0 |    |  | 100.0 |   
|                                        |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Cost of revenues:                       |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Product                                 |  | 30.7                             |    |  | 24.9                            |    |  | 30.5  |    |  | 25.2  |   
|Service                                 |  | 6.7                              |    |  | 7.3                             |    |  | 6.5   |    |  | 7.7   |   
|                                        |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Total cost of revenues                  |  | 37.4                             |    |  | 32.2                            |    |  | 37.0  |    |  | 32.9  |   
|                                        |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Gross margin                            |  | 62.6                             |    |  | 67.8                            |    |  | 63.0  |    |  | 67.1  |   
|                                        |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Operating expenses:                     |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Sales and marketing                     |  | 37.2                             |    |  | 32.9                            |    |  | 38.5  |    |  | 39.0  |   
|Research and development                |  | 21.2                             |    |  | 24.3                            |    |  | 21.5  |    |  | 24.8  |   
|General and administrative              |  | 9.9                              |    |  | 17.7                            |    |  | 10.1  |    |  | 16.9  |   
|Amortization of other intangible assets |  | 1.2                              |    |  | 1.2                             |    |  | 1.2   |    |  | 1.3   |   
|Restructuring charges                   |  | 1.9                              |    |  |                                |    |  | 0.6   |    |  |      |   
|                                        |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Total operating expenses                |  | 71.4                             |    |  | 76.1                            |    |  | 71.9  |    |  | 82.0  |   
|                                        |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Operating loss                          |  | (8.8                             | )  |  | (8.3                            | )  |  | (8.9  | )  |  | (14.9 | ) 
|Interest and other income, net          |  | 1.4                              |    |  | 3.0                             |    |  | 1.4   |    |  | 2.7   |   
|                                        |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Loss before income taxes                |  | (7.4                             | )  |  | (5.3                            | )  |  | (7.5  | )  |  | (12.2 | ) 
|Provision for income taxes              |  | 0.1                              |    |  | 0.1                             |    |  | 0.1   |    |  | 0.2   |   
|                                        |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Net loss                                |  | (7.5                             | )% |  | (5.4                            | )% |  | (7.6  | )% |  | (12.4 | )%
|                                        |  |                                  |    |  |                                 |    |  |       |    |  |       |   



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Revenues



|                                   |  |                                 |        |   |                           |   |        |                                |      |       |                           |      |   |        |   |  |   |        |   |  |       |   
|---------------------------------- |  | ------------------------------- | ------ | - | ------------------------- | - | ------ | ------------------------------ | ---- | ----- | ------------------------- | ---- | - | ------ | - |  | - | ------ | - |  | ----- | --
|                                   |  | Three Months EndedSeptember 30, |        |   | PercentIncrease(Decrease) |   |        | Nine Months EndedSeptember 30, |      |       | PercentIncrease(Decrease) |     
|                                   |  | 2004                            |        |   | 2005                      |   |        |                                | 2004 |       |                           | 2005 |   |       
|Revenues (in thousands):           |  |                                 |        |   |                           |   |        |                                |      |       |                           |      |   |        |   |  |   |        |   |  |       |   
|Product                            |  | $                               | 13,393 |   |                           | $ | 11,622 |                                |      | (13.2 | )%                        |      | $ | 42,494 |   |  | $ | 33,631 |   |  | (20.9 | )%
|Service                            |  |                                 | 7,381  |   |                           |   | 7,427  |                                |      | 0.6   | %                         |      |   | 21,012 |   |  |   | 22,356 |   |  | 6.4   | % 
|                                   |  |                                 |        |   |                           |   |        |                                |      |       |                           |      |   |        |   |  |   |        |   |  |       |   
|Total                              |  | $                               | 20,774 |   |                           | $ | 19,049 |                                |      | (8.3  | )%                        |      | $ | 63,506 |   |  | $ | 55,987 |   |  | (11.8 | )%
|                                   |  |                                 |        |   |                           |   |        |                                |      |       |                           |      |   |        |   |  |   |        |   |  |       |   
|Revenues (as % of total revenues): |  |                                 |        |   |                           |   |        |                                |      |       |                           |      |   |        |   |  |   |        |   |  |       |   
|Product                            |  |                                 | 64.5   | % |                           |   | 61.0   | %                              |      |       |                           |      |   | 66.9   | % |  |   | 60.1   | % |  |       |   
|Service                            |  |                                 | 35.5   |   |                           |   | 39.0   |                                |      |       |                           |      |   | 33.1   |   |  |   | 39.9   |   |  |       |   
|                                   |  |                                 |        |   |                           |   |        |                                |      |       |                           |      |   |        |   |  |   |        |   |  |       |   
|Total                              |  |                                 | 100.0  | % |                           |   | 100.0  | %                              |      |       |                           |      |   | 100.0  | % |  |   | 100.0  | % |  |       |   
|                                   |  |                                 |        |   |                           |   |        |                                |      |       |                           |      |   |        |   |  |   |        |   |  |       |   



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:



|                                   |  |                                 |        |   |                            |   |        |                                |      |       |                  |      |   |        |   |  |   |        |   |  |       |   
|---------------------------------- |  | ------------------------------- | ------ | - | -------------------------- | - | ------ | ------------------------------ | ---- | ----- | ---------------- | ---- | - | ------ | - |  | - | ------ | - |  | ----- | --
|                                   |  | Three Months EndedSeptember 30, |        |   | Percent Increase(Decrease) |   |        | Nine Months EndedSeptember 30, |      |       | Percent Decrease |     
|                                   |  | 2004                            |        |   | 2005                       |   |        |                                | 2004 |       |                  | 2005 |   |       
|Revenues (in thousands):           |  |                                 |        |   |                            |   |        |                                |      |       |                  |      |   |        |   |  |   |        |   |  |       |   
|Americas                           |  | $                               | 9,956  |   |                            | $ | 9,270  |                                |      | (6.9  | )%               |      | $ | 31,133 |   |  | $ | 25,859 |   |  | (16.9 | )%
|EMEA                               |  |                                 | 8,118  |   |                            |   | 6,861  |                                |      | (15.5 | )%               |      |   | 23,657 |   |  |   | 21,605 |   |  | (8.7  | )%
|APAC                               |  |                                 | 2,700  |   |                            |   | 2,918  |                                |      | 8.1   | %                |      |   | 8,716  |   |  |   | 8,523  |   |  | (2.2  | )%
|                                   |  |                                 |        |   |                            |   |        |                                |      |       |                  |      |   |        |   |  |   |        |   |  |       |   
|Total                              |  | $                               | 20,774 |   |                            | $ | 19,049 |                                |      | (8.3  | )%               |      | $ | 63,506 |   |  | $ | 55,987 |   |  | (11.8 | )%
|                                   |  |                                 |        |   |                            |   |        |                                |      |       |                  |      |   |        |   |  |   |        |   |  |       |   
|Revenues (as % of total revenues): |  |                                 |        |   |                            |   |        |                                |      |       |                  |      |   |        |   |  |   |        |   |  |       |   
|Americas                           |  |                                 | 47.9   | % |                            |   | 48.7   | %                              |      |       |                  |      |   | 49.0   | % |  |   | 46.2   | % |  |       |   
|EMEA                               |  |                                 | 39.1   |   |                            |   | 36.0   |                                |      |       |                  |      |   | 37.3   |   |  |   | 38.6   |   |  |       |   
|APAC                               |  |                                 | 13.0   |   |                            |   | 15.3   |                                |      |       |                  |      |   | 13.7   |   |  |   | 15.2   |   |  |       |   
|                                   |  |                                 |        |   |                            |   |        |                                |      |       |                  |      |   |        |   |  |   |        |   |  |       |   
|Total                              |  |                                 | 100.0  | % |                            |   | 100.0  | %                              |      |       |                  |      |   | 100.0  | % |  |   | 100.0  | % |  |       |   
|                                   |  |                                 |        |   |                            |   |        |                                |      |       |                  |      |   |        |   |  |   |        |   |  |       |   



The dollar and
percentage decrease in product revenues, for both the three and nine months ended September 30, 2005, as compared to the three and nine months ended September 30, 2004, was primarily due to an overall decrease in product shipments. The
decrease in product revenues for the first nine months of 2005 also includes the effects of certain customers that converted from a sell in method to a sell through method of revenue recognition in the first quarter of 2005 as discussed below.



The decrease in product revenues for both the three and nine
months ended September 30, 2005, compared to the corresponding periods of 2004, reflects decreased unit shipments of our Firebox SOHO, Firebox X and Firebox Vclass product lines, partially offset by shipments of our Firebox X Edge, Firebox Peak
and Firebox SSL Core VPN Gateway product lines introduced in August 2004, April 2005 and August 2005, respectively. Reduced shipments of our Firebox SOHO product line are partially attributable to introduction of the Firebox X Edge product line
in August 2004. Lower shipments of our Firebox Vclass product line are primarily due to introduction of the new Firebox X Peak product line in April 2005. The decrease in unit shipments of our Firebox SOHO and Firebox X product lines for the nine
months ended September 30, 2005, compared to the same period in the prior year, also reflects conversion of certain of our customers to the sell through method of revenue recognition in the first quarter of 2005.



The decrease in unit shipments was partially offset by reduced discounts on
our product offerings for both the three and nine months ended September 30, 2005, in comparison to corresponding periods of the prior year. Lower discounts are primarily attributable to certain customers that converted to the sell through
method of revenue recognition in 2005.





We recognize revenue from certain of our channel customers when we sell product to them (the sell in method). Where the customer is a
distributor with unlimited stock returns and rotation rights, product revenues are not recognized until the distributors sell the products to their customers (the sell through method). During the first quarter of 2005, we negotiated
changes in contractual obligations with certain channel customers in North America, Australia and New Zealand, which provided such customers with unlimited return rights. The changes were triggered by the need to offer promotional



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programs to give us the flexibility in the respective markets to be more competitive, responsive and effective. As a result, we converted these customers to
a sell through method beginning in the first quarter of 2005. When a channel customer is converted from the sell in method to the sell through method of revenue recognition, revenue can no longer be recognized when product is sold to the channel
customer, because revenue from products in that channel customers inventory was already recognized in prior periods. Therefore, revenue on individual inventory items sold subsequent to the conversion can only be recognized after the converted
channel customer has disposed of its inventory predating the conversion. As of December 31, 2004, the converted customers held inventory for which we had already recognized revenues in the amount of $2.3 million. Substantially all of these
inventories were sold through by the converted customers during the first quarter of 2005. While the contractual changes and the resulting conversion of these customers from a sell in method to a sell through method of revenue recognition resulted
in a reduction of revenues during the first quarter of 2005, the total effect of this reduction cannot be measured reliably due to a change in customer buying patterns upon conversion to the sell through method.



We are evaluating taking similar measures with customers in other parts of
the world. To the extent that contract changes with additional channel customers require conversion to a sell through method, there will be an adverse effect on revenues for the quarter in which those conversions take place, with the magnitude
depending on the inventory levels with those channel customers at the time of conversion. To recognize revenue on a sell through method from a channel customer, we will need to continue to obtain adequate reporting on inventory levels from that
channel customer to determine how much of our product has been sold to the end customers. If we are unable to obtain such reporting, our ability to recognize revenue from such channel customers could be materially adversely affected.



From a regional standpoint, revenues decreased in both the Americas market
and the international market for the three and nine months ended September 30, 2005, as compared to the corresponding periods in 2004. Revenues from the Americas market decreased at a significantly higher rate than revenues from the
international markets in the first nine months of 2005, compared to the same period in 2004, partially due to the effects of converting the remaining channel customers in North America to a sell through method from a sell in method of revenue
recognition during the first quarter of 2005.



Given the
continuing economic and geopolitical uncertainty and constrained corporate information-technology spending, it is difficult to predict product revenue levels in future quarters, which may decline or fluctuate more than they have historically.



Service revenues consist of revenues recognized from initial
fees for our LiveSecurity Service and other service subscriptions bundled with a hardware or software product sale, and revenues recognized for subscription renewals sold to our existing customer base. The dollar and percentage increase in service
revenues for both the three and nine months ended September 30, 2005, as compared to the same periods of 2004, is primarily due to growth of our installed customer base, resulting in a greater number of LiveSecurity Service renewals, as well as
initial purchases of existing and new subscription-based services.



Service revenues recognized from initial LiveSecurity Service and other service subscription fees are generally related to product and software shipments in preceding quarters, while revenues recognized from service renewals depend on the
existing customer base and the percentage of those customers eligible for renewal that elect to renew their subscriptions. 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, even from declining product shipments, will increase the number of customers with the opportunity to renew their LiveSecurity Service subscriptions. Due to these factors, it is difficult to predict
future service revenue levels.



20



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##### Table of Contents

Cost of Revenues and Gross Margin



|                                                      |      |                                  |        |      |                             |   |        |                                 |  |       |                             |  |   |        |   |  |   |        |   |  |       |   
|----------------------------------------------------- | ---- | -------------------------------- | ------ | ---- | --------------------------- | - | ------ | ------------------------------- |  | ----- | --------------------------- |  | - | ------ | - |  | - | ------ | - |  | ----- | --
|                                                      |      | Three Months Ended September 30, |        |      | Percent Increase (Decrease) |   |        | Nine Months Ended September 30, |  |       | Percent Increase (Decrease) | 
|                                                      | 2004 |                                  |        | 2005 |                             |   |        | 2004                            |  |       | 2005                        |  |  
|Cost of revenues (in thousands):                      |      |                                  |        |      |                             |   |        |                                 |  |       |                             |  |   |        |   |  |   |        |   |  |       |   
|Product                                               |      | $                                | 6,379  |      |                             | $ | 4,746  |                                 |  | (25.6 | )%                          |  | $ | 19,342 |   |  | $ | 14,094 |   |  | (27.1 | )%
|Service                                               |      |                                  | 1,390  |      |                             |   | 1,384  |                                 |  | (0.4  | )%                          |  |   | 4,165  |   |  |   | 4,312  |   |  | 3.5   | % 
|                                                      |      |                                  |        |      |                             |   |        |                                 |  |       |                             |  |   |        |   |  |   |        |   |  |       |   
|Total                                                 |      | $                                | 7,769  |      |                             | $ | 6,130  |                                 |  | (21.1 | )%                          |  | $ | 23,507 |   |  | $ | 18,406 |   |  | (21.7 | )%
|                                                      |      |                                  |        |      |                             |   |        |                                 |  |       |                             |  |   |        |   |  |   |        |   |  |       |   
|Cost of revenues (as % of total revenues):            |      |                                  |        |      |                             |   |        |                                 |  |       |                             |  |   |        |   |  |   |        |   |  |       |   
|Product                                               |      |                                  | 30.7   | %    |                             |   | 24.9   | %                               |  |       |                             |  |   | 30.5   | % |  |   | 25.2   | % |  |       |   
|Service                                               |      |                                  | 6.7    |      |                             |   | 7.3    |                                 |  |       |                             |  |   | 6.5    |   |  |   | 7.7    |   |  |       |   
|                                                      |      |                                  |        |      |                             |   |        |                                 |  |       |                             |  |   |        |   |  |   |        |   |  |       |   
|Total                                                 |      |                                  | 37.4   | %    |                             |   | 32.2   | %                               |  |       |                             |  |   | 37.0   | % |  |   | 32.7   | % |  |       |   
|                                                      |      |                                  |        |      |                             |   |        |                                 |  |       |                             |  |   |        |   |  |   |        |   |  |       |   
|Cost of revenues (as % of related revenue component): |      |                                  |        |      |                             |   |        |                                 |  |       |                             |  |   |        |   |  |   |        |   |  |       |   
|Product (as % of product revenues)                    |      |                                  | 47.6   | %    |                             |   | 40.8   | %                               |  |       |                             |  |   | 45.5   | % |  |   | 41.9   | % |  |       |   
|Service (as % of service revenues)                    |      |                                  | 18.8   | %    |                             |   | 18.6   | %                               |  |       |                             |  |   | 19.8   | % |  |   | 19.3   | % |  |       |   
|                                                      |      |                                  |        |      |                             |  
|Gross margin (in thousands):                          |      |                                  |        |      |                             |   |        |                                 |  |       |                             |  |   |        |   |  |   |        |   |  |       |   
|Product                                               |      | $                                | 7,014  |      |                             | $ | 6,876  |                                 |  | (2.0  | )%                          |  | $ | 23,152 |   |  | $ | 19,537 |   |  | (15.6 | )%
|Service                                               |      |                                  | 5,991  |      |                             |   | 6,043  |                                 |  | 0.9   | %                           |  |   | 16,847 |   |  |   | 18,044 |   |  | 7.1   | % 
|                                                      |      |                                  |        |      |                             |   |        |                                 |  |       |                             |  |   |        |   |  |   |        |   |  |       |   
|Total                                                 |      | $                                | 13,005 |      |                             | $ | 12,919 |                                 |  | (0.6  | )%                          |  | $ | 39,999 |   |  | $ | 37,581 |   |  | (6.0  | )%
|                                                      |      |                                  |        |      |                             |   |        |                                 |  |       |                             |  |   |        |   |  |   |        |   |  |       |   
|Gross margin (as % of related revenue component):     |      |                                  |        |      |                             |   |        |                                 |  |       |                             |  |   |        |   |  |   |        |   |  |       |   
|Product (as % of product revenues)                    |      |                                  | 52.4   | %    |                             |   | 59.2   | %                               |  |       |                             |  |   | 54.5   | % |  |   | 58.1   | % |  |       |   
|Service (as % of service revenues)                    |      |                                  | 81.2   | %    |                             |   | 81.4   | %                               |  |       |                             |  |   | 80.2   | % |  |   | 80.7   | % |  |       |   
|Total (as % of total revenues)                        |      |                                  | 62.6   | %    |                             |   | 67.8   | %                               |  |       |                             |  |   | 63.0   | % |  |   | 67.1   | % |  |       |   



Gross margins are
affected by various factors, including the mix of product and service sales (which include hardware and software products and LiveSecurity Service and other service subscriptions), discount levels offered to our customers, the cost of our hardware
appliances (including components and labor), costs of excess and obsolete inventory, lower of cost or market assessment of inventory carrying value, fixed manufacturing overhead, 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 product
warranty costs.



The decrease in cost of product revenues, in
terms of absolute dollars and as a percentage of product revenues, for both the three and nine months ended September 30, 2005, as compared to the three and nine months ended September 30, 2004, was primarily due to an overall decrease in
product volumes and a reduction in the costs of excess and obsolete inventory caused by product life cycle considerations and new product introductions. The decrease in cost of product revenues during the first nine months of 2005 also reflects
conversion of certain channel customers from the sell in method to the sell through method of revenue recognition as discussed above.



Product gross margins were comparable, in terms of absolute dollars, for the three months ended September 30, 2005, compared to the three months
ended September 30, 2004. Product gross margins decreased in absolute dollars for the nine months ended September 30, 2005, as compared to the nine months ended September 30, 2004, primarily due to an overall decrease in product
volumes.



Product gross margins increased as a percentage of
product revenues for both the three and nine months ended September 30, 2005, as compared to the three and nine months ended September 30, 2004, primarily due to reduced discounts on our product offerings and a reduction in the costs of
our excess and obsolete inventory in 2005.



21



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##### Table of Contents

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



Cost of service
revenue was comparable, in terms of absolute dollars and as a percentage of related revenues, for the three months ended September 30, 2005, as compared to the three months ended September 30, 2004. Cost of service revenues increased, in
absolute dollars, for the nine months ended September 30, 2005, compared to the nine months ended September 30, 2004, largely due to the effect of a partial refund of customer support software received in the first quarter of 2004. Cost of
services revenues was comparable, as a percentage of related revenues, for the nine months ended September 30, 2005, compared to the corresponding period in 2004.



Service gross margins were comparable, in terms of absolute dollars and as a percentage of revenues, for the three months
ended September 30, 2005, compared to the three months ended September 30, 2004. Service gross margins increased in absolute dollars for the nine months ended September 30, 2005, as compared to the corresponding period in 2004,
primarily due to increased service revenues in 2005 as a result of growth of our installed customer base and initial purchases of new subscription-based services, partially offset by a partial refund of customer support software received in the 2004
first quarter as noted above. As a percentage of related revenues, service gross margins were comparable for the nine months ended September 30, 2005, compared to the corresponding period in 2004.



We expect service costs to continue to increase in absolute dollars as our
user base expands. Service costs and margins could differ materially from those anticipated, which could have an adverse effect on our operating results.



Forecasting future gross margins is difficult, as our gross margins could be adversely affected in the future by heightened sales price competition,
increased material costs, key component shortages and excess and obsolete inventory charges. Our margins could also be negatively affected by continued economic uncertainty, which could result in downward pressure on the prices of technology-based
products.



Operating Expenses



Sales and Marketing



|                                                      |      |                                  |       |      |                  |   |       |                                 |  |       |                  |  |   |        |   |  |   |        |   |  |       |   
|----------------------------------------------------- | ---- | -------------------------------- | ----- | ---- | ---------------- | - | ----- | ------------------------------- |  | ----- | ---------------- |  | - | ------ | - |  | - | ------ | - |  | ----- | --
|                                                      |      | Three Months Ended September 30, |       |      | Percent Decrease |   |       | Nine Months Ended September 30, |  |       | Percent Decrease | 
|                                                      | 2004 |                                  |       | 2005 |                  |   |       | 2004                            |  |       | 2005             |  |  
|Sales and marketing expenses (in thousands)           |      | $                                | 7,740 |      |                  | $ | 6,274 |                                 |  | (18.9 | )%               |  | $ | 24,439 |   |  | $ | 21,827 |   |  | (10.7 | )%
|Sales and marketing expenses (as % of total revenues) |      |                                  | 37.2  | %    |                  |   | 32.9  | %                               |  |       |                  |  |   | 38.5   | % |  |   | 39.0   | % |  |       |   



Sales and marketing
expenses include salaries, commissions and employee-related expenses, stock-based compensation and certain discretionary marketing expenses, including distributor promotional costs, public relations costs, marketing collateral, trade shows,
advertising expenses, direct marketing and costs of demonstration units.



Sales and marketing expenses decreased, in terms of absolute dollars, for both the three and nine months ended September 30, 2005, as compared to the three and nine months ended September 30, 2004, primarily
due to the following:



| |  |  | Lower discretionary spending on marketing-related activities, primarily due to a planned reduction in advertising and marketing development fund expenditures in the current year. In
addition, sales and marketing expenses for the nine months ended September 30, 2004 include significant costs incurred in support of the Firebox X product launch.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | A decrease in compensation-related expenses, primarily due to a reduction in sales commissions and incentive compensation directly related to the achievement of corporate
objectives, partially offset by stock-based compensation expenses resulting from the variable accounting treatment of certain stock options issued to employees under the stock option exchange program in May 2005. See Supplemental Information
About Stock-Based Compensation below.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Sales and marketing expenses decreased, as a percentage of revenues, for the three months ended September 30, 2005 as compared to the three months ended September 30, 2004, primarily due to lower spending on marketing-related
activities and employee compensation in the third quarter of 2005 in comparison to the prior year. Sales and marketing expenses increased, as a percentage of revenues, for the nine months ended September 30, 2005, as compared to the nine months
ended



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##### Table of Contents

September 30, 2004, primarily due to a reduction in product revenue during 2005, partially offset by reduced spending on marketing-related activities
and employee compensation in the current year.



Excluding the
effect of stock-based compensation expenses resulting from the variable accounting treatment of certain stock awards, we expect our sales and marketing expenses for the fourth quarter of 2005 will remain comparable to levels incurred in the third
quarter of 2005. Should our revenues improve, we expect sales and marketing expenses to decrease as a percentage of revenues. Our actual sales and marketing expenses could differ materially from those anticipated, which could have an adverse effect
on our operating results.



Research and Development



|                                                           |  |                                  |       |   |                  |   |       |                                 |      |     |                  |      |   |        |   |  |   |        |   |  |     |  
|---------------------------------------------------------- |  | -------------------------------- | ----- | - | ---------------- | - | ----- | ------------------------------- | ---- | --- | ---------------- | ---- | - | ------ | - |  | - | ------ | - |  | --- | -
|                                                           |  | Three Months Ended September 30, |       |   | Percent Increase |   |       | Nine Months Ended September 30, |      |     | Percent Increase |     
|                                                           |  | 2004                             |       |   | 2005             |   |       |                                 | 2004 |     |                  | 2005 |   |       
|Research and development expenses (in thousands)           |  | $                                | 4,402 |   |                  | $ | 4,626 |                                 |      | 5.1 | %                |      | $ | 13,659 |   |  | $ | 13,890 |   |  | 1.7 | %
|Research and development expenses (as % of total revenues) |  |                                  | 21.2  | % |                  |   | 24.3  | %                               |      |     |                  |      |   | 21.5   | % |  |   | 24.8   | % |  |     |  



Research and
development expenses include costs associated with the development of new products, enhancements of existing products, product integration efforts, product certifications and quality assurance activities. These costs consist primarily of employee
salaries and benefits, including stock-based compensation, 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 increased, in
terms of absolute dollars and as a percentage of revenues, for both the three and nine months ended September 30, 2005, as compared to the three and nine months ended September 30, 2004, primarily due to stock-based compensation expenses
resulting from the variable accounting treatment of certain stock options issued to employees under the stock option exchange program in May 2005. See Supplemental Information About Stock-Based Compensation below. The increase in
research and development expenses for the first nine months of 2005 was partially offset by reduced spending on salaries, reflecting a reduction in headcount, and lower depreciation expense in the current year, primarily due to cost containment for
research and development capital expenditures and the expiration of depreciation on earlier purchases.



The increase in research and development expenses as a percentage of revenues, for both the three and nine months ended September 30, 2005 as
compared to the same periods in 2004, also reflects a reduction in product revenue during 2005 for the reasons noted above.



Excluding the effect of stock-based compensation costs resulting from the variable accounting treatment of certain stock awards, we anticipate an increase
in our research and development expenses in the fourth quarter of 2005 in comparison to levels incurred in the third quarter of 2005. We intend to continue to fund our research and development efforts and hire the necessary personnel in order to
attempt 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. Research and development expenses may vary
significantly from quarter to quarter due to inherent uncertainties in the timing of certain development costs. We expect to continue to invest in key areas aimed at the development of new generations of our products, the further extension of our
existing product lines and the development of future technologies. Our actual research and development expenses could differ materially from those anticipated, which could have an adverse effect on our operating results.



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##### Table of Contents

General and Administrative



|                                                             |  |                                  |       |   |                  |   |       |                                 |      |      |                  |      |   |       |   |  |   |       |   |  |      |  
|------------------------------------------------------------ |  | -------------------------------- | ----- | - | ---------------- | - | ----- | ------------------------------- | ---- | ---- | ---------------- | ---- | - | ----- | - |  | - | ----- | - |  | ---- | -
|                                                             |  | Three Months Ended September 30, |       |   | Percent Increase |   |       | Nine Months Ended September 30, |      |      | Percent Increase |     
|                                                             |  | 2004                             |       |   | 2005             |   |       |                                 | 2004 |      |                  | 2005 |   |      
|General and administrative expenses (in thousands)           |  | $                                | 2,056 |   |                  | $ | 3,350 |                                 |      | 62.9 | %                |      | $ | 6,391 |   |  | $ | 9,474 |   |  | 48.2 | %
|General and administrative expenses (as % of total revenues) |  |                                  | 9.9   | % |                  |   | 17.7  | %                               |      |      |                  |      |   | 10.1  | % |  |   | 16.9  | % |  |      |  



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



General and administrative expenses
increased, in terms of absolute dollars and as a percentage of revenues, for both the three and nine months ended September 30, 2005, as compared to the three and nine months ended September 30, 2004. The dollar and percentage increase in
general and administrative expenses is primarily due to the following:



| |  |  | Increased spending on compensation and benefits, primarily costs associated with the addition of senior executives and other management personnel as well as stock-based compensation
expenses resulting from the variable accounting treatment of certain stock options issued to employees under the stock option exchange program in May 2005. See Supplemental Information About Stock-Based Compensation below.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | A substantial increase in accounting fees, primarily due to higher annual audit fees in 2005, incremental audit fees relating to the 2004 year-end audit and costs incurred in
connection with corporate governance requirements pursuant to the Sarbanes-Oxley Act of 2002, particularly in light of the restatement of prior period interim financial results.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Higher legal expenses reflecting costs associated with regulatory compliance, analysis of, and revisions to, our compensation plans, and ongoing litigation.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Increased contract labor and consulting costs, primarily costs related to our sell through revenue automation initiative, human resource projects and stock compensation programs.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The increase in general and administrative
expenses as a percentage of revenues, for both the three and nine months ended September 30, 2005 as compared to same periods in 2004, also reflects a reduction in product revenue in the current year for the reasons noted above.



Excluding the effect of stock-based compensation costs resulting from the
variable accounting treatment of certain stock awards, we expect general and administrative expenses for the fourth quarter of 2005 to remain comparable to levels incurred in the third quarter of 2005. Our actual general and administrative expenses
could differ materially from those anticipated, which could have an adverse effect on our operating results.



Supplemental Information About Stock-Based Compensation



During the second quarter of 2005, we offered a voluntary stock option exchange program to our employees which resulted in variable accounting
treatment for, at the time of the exchange, approximately 3.1 million stock options. We are accounting for all replacement stock options, as well as all options that were subject to the exchange program but were retained by employees, using
variable accounting until adoption of SFAS 123(R). Under variable accounting, cumulative stock compensation expense at any balance sheet date must equal accumulated amortization of the current intrinsic value of the outstanding variable stock awards
over their vesting periods. Upon adoption of SFAS 123(R), in accordance with its rules, the amount of stock compensation expense will be fixed based on initial estimated fair values of the replacement stock options and amortized over the remaining
vesting periods of these options. Stock compensation expense recognized until adoption of SFAS 123(R) using variable accounting will not be reversed upon adoption. Variable accounting treatment may result in unpredictable and potentially significant
charges or credits recorded to stock-based compensation, which will be dependent upon fluctuations in the quoted market prices of our common stock.



24



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##### Table of Contents

In March 2005, the SEC published Staff Accounting Bulletin, or SAB, No. 107, which expresses the
view of the SEC staff and provides guidance on a variety of matters associated with share based payments and stock-based compensation. Among other things, SAB 107 states that stock-based compensation should be classified on the same expense lines as
cash compensation. Accordingly, we have recorded stock-based compensation costs within the same operating expense line items as cash compensation, as presented below (in thousands):



|                           |  |                                  |    |                                 |      |   |      |  |      |    |  |   |      
|-------------------------- |  | -------------------------------- | -- | ------------------------------- | ---- | - | ---- |  | ---- | -- |  | - | -----
|                           |  | Three Months Ended September 30, |    | Nine Months Ended September 30,
|                           |  | 2004                             |    |                                 | 2005 |   | 2004 |  | 2005
|Cost of revenues:          |  |                                  |    |                                 |      |   |      |  |      |    |  |   |      
|Product                    |  | $                                |   |                                 |      | $ | 6    |  | $    |   |  | $ | 16   
|Service                    |  |                                  |   |                                 |      |   | 26   |  |      |   |  |   | 78   
|Sales and marketing        |  |                                  |   |                                 |      |   | 172  |  |      | 4  |  |   | 424  
|Research and development   |  |                                  | (1 | )                               |      |   | 234  |  |      | 9  |  |   | 649  
|General and administrative |  |                                  | 1  |                                 |      |   | 310  |  |      | 5  |  |   | 548  
|                           |  |                                  |    |                                 |      |   |      |  |      |    |  |   |      
|Total                      |  | $                                |   |                                 |      | $ | 748  |  | $    | 18 |  | $ | 1,715
|                           |  |                                  |    |                                 |      |   |      |  |      |    |  |   |      



Amortization of
Other Intangible Assets



Amortization of other intangible
assets consists primarily of amortization of capitalized technology obtained in our acquisition of RapidStream in 2002. This technology is expected to be fully amortized by March 31, 2007. We amortize our intangible assets acquired on a
straight-line basis over an expected useful life of five years.



Amortization of other intangible assets was $243,000 for both the three months ended September 30, 2005 and three months ended September 30, 2004, and was $730,000 for both the nine months ended September 30, 2005 and nine
months ended September 30, 2004.



Restructuring Charges



Restructuring charges of $400,000 for the three and nine
months ended September 30, 2004 were associated with our restructuring plans initiated in 2001 and 2002. Costs incurred in 2004 relate to the revision of our estimates for future costs associated with the sublease of excess facilities in our
corporate headquarters in Seattle, Washington. As the real estate market in downtown Seattle remained depressed, we revised down our earlier estimates of possible sublease rental income for our space that remains vacant.



Additional charges of $115,000 related to the 2001 restructuring were
recorded during the three months ended September 30, 2005, due to the revision of the cost of excess facilities, as the real estate market remains depressed longer than originally expected. These charges were offset by a $115,000 reduction in
the 2002 restructuring liability due to the revision of estimated proceeds from the sublease of excess facilities, as previously vacant space was subleased during the period.



Interest and Other Income, Net



Interest and other income, net, is primarily comprised of interest income generated from our short-term available-for-sale investments. Interest income
was $573,000 for the three months ended September 30, 2005, compared to $310,000 for the nine months ended September 30, 2004, and was $1.5 million for the nine months ended September 30, 2005, compared to $863,000 for the nine months
ended September 30, 2004. The increases in interest and other income, net are primarily due to higher interest rates on invested balances in 2005.



Provision for Income Taxes



Income tax expense was $23,000 for both the three months ended September 30, 2005 and the three months ended September 30, 2004. Income tax
expense was $94,000 for the nine months ended September 30, 2005 compared to $66,000 for the nine months ended September 30, 2004. Income tax expense, in all periods, primarily relates to our provision for foreign income taxes associated
with our international operations.



Liquidity and Capital Resources



At September 30, 2005, we had $76.1 million in cash,
cash equivalents and short-term available-for-sale investments, which were invested primarily in high-quality money market accounts and marketable securities. We believe that the market



25



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##### Table of Contents

risk arising from our holdings of these financial instruments is not material. Our working capital at September 30, 2005 was $58.0 million.



Operating Activities



Our operating activities resulted in net cash outflows of $2.9 million for
the nine months ended September 30, 2004 and $1.2 million for the nine months ended September 30, 2005. Operating cash outflows during these periods resulted primarily from our 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):



|                                            |  |                                |        |   |      |   |        |  
|------------------------------------------- |  | ------------------------------ | ------ | - | ---- | - | ------ | -
|                                            |  | Nine Months EndedSeptember 30, |       
|                                            |  | 2004                           |        |   | 2005 |  
|Net loss                                    |  | $                              | (4,823 | ) |      | $ | (6,921 | )
|Noncash expenses                            |  |                                | 2,852  |   |      |   | 4,390  |  
|Changes in operating assets and liabilities |  |                                | (886   | ) |      |   | 1,366  |  
|                                            |  |                                |        |   |      |   |        |  
|Net cash used in operating activities       |  | $                              | (2,857 | ) |      | $ | (1,165 | )
|                                            |  |                                |        |   |      |   |        |  



Noncash expenses are
associated with the amortization of other intangible assets acquired, depreciation and amortization of property and equipment, and stock-based compensation charges resulting from the issuance of stock options and restricted stock to employees,
directors and consultants.



Changes in operating assets and
liabilities primarily reflect changes in working capital components of the balance sheet, apart from cash and short-term available-for-sale investments, and changes in long-term deferred rent, long-term deferred revenues and long-term restructuring
liabilities. Significant fluctuations within each of these categories are described below.



Trade Accounts Receivable, Net decreased from $7.3 million at December 31, 2004 to $5.6 million at September 30, 2005, primarily due to a reduction in accounts receivable associated with customers
that transitioned to the sell through method of revenue recognition in 2005. Days sales outstanding, or DSOs, calculated on a quarterly basis, was 34 days at December 31, 2004 and 26 days at September 30, 2005. DSOs are affected by:



| |  |  | the payment terms contained in our customer contracts (which may vary geographically);
| | - |  | --------------------------------------------------------------------------------------



| |  |  | term discounts taken by our customers;
| | - |  | --------------------------------------



| |  |  | revenues on product sales for some of our major distributors that are recorded when these distributors have sold the product to their customers;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | risks associated with the uncertain economy; and
| | - |  | ------------------------------------------------



| |  |  | whether revenues in a particular quarter are linear (that is, whether revenues are evenly distributed throughout the quarter or weighted more toward the end of the quarter).
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Inventories,Net increased from
$3.1 million at December 31, 2004 to $3.9 million at September 30, 2005. Higher inventory levels primarily reflect costs associated with an increase in inventories held by customers on the sell through basis during the first nine months of
2005 and inventory purchases in support of future sales requirements.



Accounts Payable decreased from $3.2 million at December 31, 2004 to $2.5 million at September 30, 2005, primarily due to timing of payment of accounts payable.



Accrued Expenses, Other Liabilities and Deferred Rentincreased from $9.0 million at December 31, 2004 to $10.2
million at September 30, 2005, primarily due to an increase in payments by customers on the sell through method in advance of the sell through of underlying inventory, a significant increase in annual audit fees for 2005, substantial legal
expenses in the current year as a result of ongoing litigation, and promotional rebates associated with expanded programs for international markets.



Total Accrued Restructuring Costs decreased from $4.9 million at December 31, 2004 to $4.2 million at September 30, 2005, reflecting the
ongoing payment of rents on abandoned facilities, net of sublease income.



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Total Deferred Revenuesincreased from $19.2 million at December 31, 2004 to $20.1 million at
September 30, 2005. The increase in deferred revenues is primarily due to LiveSecurity Service subscription renewals on a growing installed customer base, partially offset by expirations and non-renewals of existing subscriptions and sales
returns and allowances.



Investing Activities



Cash used in investing activities was $643,000 for
the nine months ended September 30, 2004 and cash provided by investing activities was $6.6 million for the nine months ended September 30, 2005. In both periods, these amounts primarily reflect proceeds from the maturity of our investment
securities net of amounts reinvested, partially offset by capital expenditures for property and equipment.



Financing Activities



Cash provided by financing activities totaled $2.6 million for the nine months ended September 30, 2004 and $1.6 million for the nine months ended
September 30, 2005. 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 short-term
available-for-sale investments will be sufficient to meet our operating expenses, working capital needs and capital expenditure requirements for at least the next 12 months. 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 may seek additional funding before that time through public or private financings or other arrangements.



Contractual Obligations and Contingencies



We lease office space and some computer equipment under operating leases
that are noncancelable. Our facilities commitments include a lease for our corporate headquarters in Seattle, Washington, which expires in September 2010, with an option to extend this lease for an additional five-year term. We lease a product
fulfillment and distribution warehouse in Seattle with a lease term through April 2006. We also lease facilities in San Jose and Tustin, California and Waltham, Massachusetts under operating leases that expire between 2006 and 2011, 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 Waltham, are partially subleased to tenants, with sublease terms
that expire between 2007 and 2010. We also have several operating leases for computer equipment. We are also a party to a noncancelable and nonrefundable agreement to purchase inventory.



Our contractual commitments at September 30, 2005 associated with lease obligations and purchase obligations, net of
future minimum rental income from subleases of $1.9 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.



|                               |  |       |        |                                     |      |                         |      |                         |       |  |   |       |  |   |       |  |   |       |  |   |      
|------------------------------ |  | ----- | ------ | ----------------------------------- | ---- | ----------------------- | ---- | ----------------------- | ----- |  | - | ----- |  | - | ----- |  | - | ----- |  | - | -----
|                               |  | Total |        | Three MonthsEndingDecember 31, 2005 |      | Year Ended December 31, |      | After December 31, 2009
|                               |  |       | 2006   |                                     | 2007 |                         | 2008 |                         | 2009  | 
|Operating lease obligations    |  | $     | 15,199 |                                     | $    | 828                     |      | $                       | 3,112 |  | $ | 3,017 |  | $ | 3,003 |  | $ | 3,081 |  | $ | 2,158
|Inventory purchase obligations |  |       | 3,381  |                                     |      | 3,381                   |      |                         |      |  |   |      |  |   |      |  |   |      |  |   |     
|                               |  |       |        |                                     |      |                         |      |                         |       |  |   |       |  |   |       |  |   |       |  |   |      
|Total                          |  | $     | 18,580 |                                     | $    | 4,209                   |      | $                       | 3,112 |  | $ | 3,017 |  | $ | 3,003 |  | $ | 3,081 |  | $ | 2,158
|                               |  |       |        |                                     |      |                         |      |                         |       |  |   |       |  |   |       |  |   |       |  |   |      



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 September 30,
2005, the total amount of those agreements was $542,000.



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



In addition to the other information contained in this quarterly 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 and the fourth quarter of 2004. As of September 30, 2005, we had an accumulated deficit of approximately
$144.9 million. Although our revenues have increased each year since we began operations, we may not be able to continue to grow our revenue in the future, and even if we do, the historical percentage growth rate of our revenues may not be
sustainable as our revenue base increases. In addition, irrespective of our revenue, we may not achieve or sustain profitability in future periods as a result of our operating expenses. We expect that over time we will have to increase our operating
expenses in connection with:



| |  |  | continuing to develop our technology;
| | - |  | -------------------------------------



| |  |  | expanding into new product markets;
| | - |  | -----------------------------------



| |  |  | expanding into new geographic markets;
| | - |  | --------------------------------------



| |  |  | continuing to drive demand of our products;
| | - |  | -------------------------------------------



| |  |  | hiring additional personnel;
| | - |  | ----------------------------



| |  |  | upgrading our information and internal control systems;
| | - |  | -------------------------------------------------------



| |  |  | pursuing additional strategic acquisitions;
| | - |  | -------------------------------------------



| |  |  | meeting enhanced regulatory and corporate governance requirements; and
| | - |  | ----------------------------------------------------------------------



| |  |  | ongoing litigation.
| | - |  | -------------------



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.



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 reduce our spending in time to compensate for any unexpected
quarterly or annual shortfall in revenues. If this occurs our operating results could fall below the expectations of securities analysts and investors, which could result 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.



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. 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 managements discussion and analysis of financial condition and results of operations in this quarterly 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. Our results may be adversely affected if our



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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.



Significant assumptions and estimates used in preparing our consolidated financial statements include those related to:



| |  |  | revenue recognition, including sales returns and allowances and promotional rebates;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | provision for doubtful accounts;
| | - |  | --------------------------------



| |  |  | inventory reserves;
| | - |  | -------------------



| |  |  | restructuring reserves; and
| | - |  | ---------------------------



| |  |  | analysis of impairment of goodwill and other long-lived intangible assets.
| | - |  | --------------------------------------------------------------------------



Examples of estimates we have made include, but are not limited to, those associated with the costs of excess and obsolete inventory, costs of our 2001
and 2002 restructuring, impairment analysis of the intangible assets obtained in our 2002 acquisition of RapidStream Inc., as well as goodwill relating to the acquisitions of BeadleNet LLC, Qiave Technologies Corporation and RapidStream. The
estimates may prove to be inaccurate. For example, the costs of excess and obsolete inventory may increase above current estimates if our revenues fall below our sales forecasts. We are currently in the process of performing our annual impairment
analysis and expect to complete our analysis before year-end. Should an impairment be identified, the corresponding charge will be recorded in the fourth quarter of 2005. 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 and the $400,000 charge we recorded in the third quarter of 2004, 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.



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



We currently
expect that future revenues will be primarily generated through sales of our Firebox products and related optional products and services, including the LiveSecurity Service, and we cannot succeed if the market does not accept these products and
services. Some of our Firebox products, particularly our key Firebox X family of products and our relatively new Fireware operating system, however, are relatively new and unproven. The Firebox X Peak line of products and the Fireware operating
system has only been available since April 2005, the Firebox X Core line of products has only been available since February 2004 and the Firebox X Edge line of products has only been available since August 2004. In addition, we have only recently
begun to focus on marketing and selling the related optional products and services, and we may be unsuccessful in marketing, selling and delivering these types of options. The Firebox X family of products, which replaces a product line that
represented a majority of our revenues and augments our existing SOHO security products, also represents a new approach to providing security to the SME market in that the products 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 or the upgrades necessary for customers to take advantage of the expandability. If customers purchase less expensive models than
they otherwise would because of the ability to later upgrade the product, but then fail to purchase upgrades, our revenues from those products would be negatively affected. In addition, we may have to continue to increase discounts on the old SOHO
product line to maintain an acceptable level of sales, which could also adversely affect our revenues. 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 effect on our operating results.



To receive
our LiveSecurity Service and other optional services, enterprises are required to pay an annual subscription fee, either to us or, if they obtain the service through one of our channel customers, to the channel customer. SMEs may be unwilling to pay
a subscription fee to keep their Internet security up to date and to receive Internet security-related information or to obtain additional security-related features and services. Because our LiveSecurity Service is an innovative service, and our
other subscription services are new and unproven, 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.



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If we are unable to compete successfully in the highly competitive market for Internet security products and
services for any reason, including because current or potential competitors gain competitive advantage through partnering or acquisition, 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 Systems,
Inc., 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 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. In addition, many of our smaller competitors that specialize in providing protection from a single type of Internet security threat are often able to deliver these
specialized Internet security products to the market more quickly than us. Our current and potential competitors may also 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.



While some of our competitors have traditionally targeted either large-enterprise security needs or consumer security needs, these vendors could adapt
their existing products to make them more attractive to our markets. If these or other of our competitors were to focus their greater financial, technical and marketing resources on our markets, our business could be harmed. In addition, as our
security solutions are adopted by larger enterprises, we expect to see increased competition from our competitors that traditionally target large-enterprise security needs. Increased competition in any of our markets could result in price
reductions, fewer customer orders, reduced gross margins and loss of market share.



We rely on third-party channel customers to generate most of our revenues, and if they 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. To the extent our channel customers are unsuccessful selling our products, or we are unable to partner with and retain a sufficient number of channel
customers in each of the regions in which we sell products, our ability to sell our products and services will be limited. Our channel customers also 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 or more of these channel customers, a reduction in their sales or a reduction in our share of their sales of Internet security
products, particularly if any such changes result in increased sales of competitive products, could harm our business. In addition, we are still 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.



Channel customers often specialize in selling certain types of products or in selling to specific segments of the market. To be successful, we must
therefore have the right channel customers selling our products in the appropriate market segments as well as have a sufficient number of channel partners selling our products. To the extent that we are unable to partner with and retain the right
channel customers to sell our products, or we introduce new products that our channel customers are unable to sell effectively, our ability to sell our products and services will be limited. For example, our Firebox X Peak line of products recently
introduced in April 2005 are targeted at SME customers that are typically larger or more sophisticated in their use of the Internet than those buying our other Firebox X products. If our current channel customers are unable to sell this product line
effectively, of if we are unable to join with and retain channel customers that can sell this product line effectively, our ability to sell this product line and related services may be limited.



The requirement to recognize revenue on a sell through basis for certain third-party
channel customers due to contractual changes could negatively affect our future revenues.



We recognize revenue from certain of our channel customers when we sell product to them (the sell in method). Where the customer is a
distributor with unlimited stock returns and rotation rights, product revenues are not recognized until the distributors sell the products to their customers (the sell through method). During the first quarter of 2005, we negotiated
changes in contractual obligations with certain channel customers in North America, Australia and New Zealand



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which provided such customers with unlimited return rights. The changes were triggered by the need to offer promotional programs to give us the flexibility
in the respective markets to be more competitive, responsive and effective. As a result, we converted these customers to a sell through method beginning in the first quarter of 2005. When a channel customer is converted from the sell in method to
the sell through method of revenue recognition, revenue can no longer be recognized when product is sold to the channel customer, because revenue from products in that channel customers inventory was already recognized in prior periods.
Therefore, revenue on individual inventory items sold subsequent to the conversion can only be recognized after the converted channel customer has disposed of its inventories predating the conversion. As of December 31, 2004, the converted
customers held inventories for which we had already recognized revenues in the amount of $2.3 million. Substantially all of these inventories were sold through by the converted customers during the first quarter of 2005. While the contractual
changes and the resulting conversion of these customers from a sell in method to a sell through method of revenue recognition resulted in a reduction of revenues during the first quarter of 2005, the total effect of this reduction cannot be measured
reliably due to a change in customer buying patterns upon conversion to the sell through method.



If we are successful in achieving our desired results, we will evaluate taking similar measures with customers in other parts of the world. To the extent
additional channel customers are converted, there will be an adverse effect on revenues for the quarter in which those conversions take place, with the magnitude depending on the inventory levels with those channel customer at the time of
conversion. To recognize revenue on a sell through method from a channel customer, we will need to continue to obtain adequate reporting on inventory levels from that channel customer to determine how much of our product has been sold to the end
customers. If we are unable to obtain such reporting, our ability to recognize revenue from such channel customers could be materially adversely affected and our financial results would be harmed.



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.



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 introduction of our Firebox X line of products which replaced our 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 Core and Firebox X Edge security
appliances, we experienced an increase in returns of previous products and product versions. 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 lines, including the recent release of the Firebox X Peak product line and Fireware operating system in the second quarter of 2005, the
provision may still be inadequate. An increase in the provision for returns and allowances will result in the reduction of revenues.



Customer demand, competitive pressure and rapid changes in technology and industry standards could render our products and services unmarketable or obsolete, and we
may be unable to introduce new or improved products and services, or update existing products or services, timely and successfully.



To succeed, we must continually change and improve our products, add new products and services, and provide updates to products and services in response
to changes in customer demand, competitive pressure, 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 computer hacker techniques. We may be unable to successfully and timely develop and introduce these new, improved or updated products and services or achieve and maintain market acceptance for new, improved or
updated products and services we develop and introduce.



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The development and introduction of new, technologically advanced Internet security products and
services, or providing updates to existing products or services, is a complex and uncertain process that requires great innovation, the ability to anticipate technological and market trends, the ability to deliver updates to a large customer base
efficiently and in a timely fashion and the ability to obtain required domestic and foreign governmental and regulatory certifications. Because Internet security technology is complex and often contains encryption technology, it can require long
development, testing and certification periods.



Releasing new
or improved products and services, or updates to products or 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 experienced delays in the
scheduled or expected introduction of new, improved and updated products and services, and in the future we may experience delays, or be unable to introduce an expected new, improved or updated product or service at all. 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. In the past, when we have introduced new or improved products or services, we have experienced issues with the transition, which had an adverse effect on our operating results. These have included, but
were not limited to, issues such as excess inventories of products that were replaced that we had difficulty selling as customer demand for those product decreased, shortages of new product due to manufacturing and delivery issues that prevented us
from delivering enough new product to meet demand and lower-than-expected initial sales of new or improved products as our sales personnel and channels adapted to selling the new or improved products or services.



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, it is possible that we might not be able to find additional or replacement sources for our hardware components to address future shortfalls. Even if we find replacement sources, 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, which 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. If a third-party manufacturer fails to or inadequately performs its obligations, we may be required to find a replacement, possibly on relatively short notice. Moreover, our contract manufacturers may not be
able to react quickly if our forecasts exceed or fall short of our predictions. Even if we are able to find a replacement source for these finished products on a timely basis, 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, which could result in loss of customer orders and revenue.



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 or for delivering new products.



Our success will depend in part on our continued ability to license technology that is important for the functionality of our products and for the
delivery of new products based on third-party technology. A significant interruption in the supply of a third-party technology, including open source software, could delay our development and sales of existing, updated or new products 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.



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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 formulate and 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, finance and accounting,
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 and development teams recently, including the addition of a new chief executive officer and interim chief financial officer in 2004 and a new vice president of North American sales and a new chief financial officer in 2005.
If these changes have a negative effect on our operations, our business and operating results could be adversely affected.



Because many potential customers do not fully understand or remain unaware of the need for comprehensive and up-to-date Internet security, may perceive it as costly
and difficult to implement, or may not understand the components of comprehensive Internet security well enough to effectively compare competitive offerings, 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 and up-to-date Internet security products and services, and also may not fully understand the components of comprehensive Internet security well enough to effectively compare competitive
offerings. Any inability to effectively compare competitive offerings may give companies with greater resources or more recognizable brands a competitive advantage over us. In addition, historically, only enterprises having substantial resources
have developed or purchased comprehensive Internet security solutions and kept such security up to date. 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 and up-to-date 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 and up-to-date Internet security and the benefits of our products and services, our efforts may be unsuccessful.



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 were not originally designed for the combination of the number of product and service offerings and customer volumes that may be required in the
future, and we will have to update and expand our operational systems to accommodate this activity. We may be unable to update and expand our operational systems in a timely fashion or without disruption to our business, and 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 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.



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.



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,



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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 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 and other optional services.



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 in a timely fashion, if at all, 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 patents, trade secrets, copyrights,
trademarks, service marks and similar proprietary rights. For example, our former Vice President of America Sales recently joined our competitor SonicWALL as its Vice President of Channel Sales. We filed a complaint in federal court against this
former employee and SonicWALL to prevent the misappropriation of our trade secrets and to enjoin the acts of unfair competition by this former employee and SonicWALL. We may, however, be unsuccessful in protecting our trade secrets or, even if
successful, any required litigation may be costly and time consuming, which could harm our business. Moreover, 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 12 issued patents and 16 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.



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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:



| |  |  | stop or delay selling, incorporating or using products that incorporate the challenged intellectual property;
| | - |  | -------------------------------------------------------------------------------------------------------------



| |  |  | pay damages;
| | - |  | ------------



| |  |  | enter into licensing or royalty agreements, which may be unavailable on acceptable terms; or
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | redesign products or services that incorporate infringing technology, which may not be technologically or economically feasible.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------



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.



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 56% of our revenues in both
2003 and 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:



| |  |  | cost of customizing products for foreign countries;
| | - |  | ---------------------------------------------------



| |  |  | export and import restrictions, such as those affecting encryption commodities and software, those requiring local content or those regulating the materials or chemicals used in
manufacturing our products as well as their disposal, such as the European Union WEEE/RoHS directives;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | difficulties in acquiring and authenticating customer information;
| | - |  | ------------------------------------------------------------------



| |  |  | reduced protection of intellectual property rights and increased liability exposure; and
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | regional economic and political conditions.
| | - |  | -------------------------------------------



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:



| |  |  | integration of operations, including combining teams and processes in various functional areas;
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | reorganization or closure of operations and facilities;
| | - |  | -------------------------------------------------------



| |  |  | integration of new technology into our products;
| | - |  | ------------------------------------------------



| |  |  | fees and expenses of professionals involved in completing the integration process; and
| | - |  | --------------------------------------------------------------------------------------



| |  |  | potential existing liabilities of any future acquisition target.
| | - |  | ----------------------------------------------------------------



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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 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. Our capital requirements will depend on several factors, however, including:



| |  |  | the rate of market acceptance of our products and services;
| | - |  | -----------------------------------------------------------



| |  |  | our ability to expand our customer base;
| | - |  | ----------------------------------------



| |  |  | the growth of our sales and marketing capabilities; and
| | - |  | -------------------------------------------------------



| |  |  | the cost of any acquisitions we may complete.
| | - |  | ---------------------------------------------



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:



| |  |  | public or private equity financings, which could result in significant dilution to stockholders;
| | - |  | ------------------------------------------------------------------------------------------------



| |  |  | public or private debt financings; and
| | - |  | --------------------------------------



| |  |  | capital lease transactions.
| | - |  | ---------------------------



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



Our stock price is volatile.



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



| |  |  | actual or anticipated variations in quarterly or annual operating results;
| | - |  | --------------------------------------------------------------------------



| |  |  | changes in analysts earnings projections or recommendations;
| | - |  | -------------------------------------------------------------



| |  |  | failure to meet analysts revenue or earnings projections;
| | - |  | ----------------------------------------------------------



| |  |  | inability to successfully implement our business strategy;
| | - |  | ----------------------------------------------------------



| |  |  | changes in business conditions affecting our customers, our competitors and us; and
| | - |  | -----------------------------------------------------------------------------------



| |  |  | changes in accounting standards that adversely affect our revenues and earnings.
| | - |  | --------------------------------------------------------------------------------



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 are the subject of litigation, which may be expensive
and may be time consuming for our management team.



On
April 8, 2005, a holder of our common stock, on behalf of himself and purportedly on behalf of a class of our stockholders, filed an action in the United States District Court for the Western District of Washington, or the Court, against
WatchGuard and some of our current and former officers, alleging violations of the federal securities laws arising out of, among other things, our announcement on March 15, 2005 that we were restating some of our financial results for interim
periods of 2004. Subsequently, a number of other related purported class action suits also alleging violations of the federal securities laws were filed by holders of our common stock. The various actions have been consolidated by the Court, and are
referred to herein as the Action. The Court has not yet finally appointed a lead plaintiff in the Action. Two shareholder derivative suits against some of our current and former directors and officers have subsequently been filed in the Superior
Court of the State of Washington, King County and in the United States District Court for the Western District of Washington, respectively, which are referred to as the Derivative Actions. Plaintiffs in the Action and the Derivative Actions seek
unspecified compensatory damages. We are obligated to indemnify our officers and directors to the extent permitted by



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applicable law in connection with the Action, and have insurance for such individuals, to the extent of the limits of the applicable insurance policies and
subject to potential reservations of rights. We intend to vigorously defend against the Action. We are unable, however, to predict the ultimate outcome of the Action. We cannot assure that we will be successful in defending against the Action and if
we are unsuccessful we may be subject to significant damages which could have a material adverse effect on our operating results and financial position. Even if we are successful, defending against the Action is likely to be expensive, time
consuming and may divert managements attention from other business concerns and harm our business.



In September, 2005, Michael N. Valentine, one of the defendants in a legal action we had commenced to prevent the misappropriation of our trade secrets
and to enjoin the acts of unfair competition by this former employee and SonicWALL, moved the Court for leave to amend his answer to our complaint to add counterclaims for libel, slander and defamation per se against WatchGuard (the
Counterclaims). In November 2005, over our objection, the Court granted Valentines motion and Valentine amended his answer to formally include the Counterclaims. WatchGuard believes the Counterclaims are baseless and intends to vigorously
defend against the Counterclaims. WatchGuard is unable, however, to predict the ultimate outcome of the Counterclaims. At this time, WatchGuard has not recorded any liability associated with the Counterclaims as the associated cost and outcome are
currently not determinable. There can be no assurance WatchGuard will be successful in defending against the Counterclaims and, if WatchGuard is unsuccessful, it may be subject to significant damages, which could have a material adverse effect on
WatchGuards operating results and financial position. Even if WatchGuard is successful, defending against the Counterclaims may be expensive, time consuming and may divert managements attention from other business concerns and harm its
business, which could have a material adverse effect on WatchGuards operating results.



|ITEM3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
|------ | ----------------------------------------------------------



Interest Rate Risk.



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.



Foreign Currency Risk.



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 and nine months ended September 30, 2005 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.



|ITEM4. | CONTROLS AND PROCEDURES
|------ | -----------------------



Evaluation of disclosure controls and procedures. As of the end of the period covered by this quarterly report, we carried out an evaluation,
under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is
defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended, or the Exchange Act), and management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures, which, by their
nature, can provide only reasonable assurance regarding managements control objectives. You should note that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and we cannot
assure you that any design will succeed in achieving its stated goals under all potential future conditions. Based on our evaluation as of that date, including an evaluation of changes in internal controls described in the following paragraph, our
Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC.



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Changes in internal controls. During the third quarter of 2005, we implemented or enhanced certain
control processes which have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Specifically, we implemented new or enhanced controls and processes surrounding our financial statement
close, data collection and accounting for sell through customer transactions, and revenue classification of billing transactions.



PART II. OTHER INFORMATION



|ITEM1. | LEGAL PROCEEDINGS
|------ | -----------------



We are subject to legal claims and litigation arising in the ordinary course of business, such as employment or intellectual property claims, including
the matter described below. The outcome of any such matters is currently undeterminable and an adverse result in one or more matters could negatively affect our operating results in the period in which it occurs.



Intellectual Property Employment Litigation



On March 23, 2005, we filed a complaint in United States District Court
for the Northern District of Texas against a terminated former employee, Michael N. Valentine, and his new employer, SonicWALL, Inc., a direct competitor of ours. The complaint was filed to prevent the misappropriation of our trade secrets and to
enjoin the acts of unfair competition by Valentine and SonicWALL. Valentine currently works for SonicWALL as its Vice President of Channel Sales. Valentine previously worked for us in a similar position, as our Vice President of America Sales. As
Vice President of America Sales, Valentine received trade secret and proprietary information about our products, sales practices and employees. Valentine owed a contractual duty, as well as a common-law fiduciary duty of loyalty, to us not to use or
disclose that proprietary information, particularly for the benefit of a competitor. We believe that Valentines new employer, SonicWALL, encouraged Valentine to breach his obligations to us and has used our trade secrets to actively engage in
a campaign to induce key sales employees to leave us and breach their contractual obligations to us. We have asserted causes of action against both Valentine and SonicWALL for misappropriation of trade secrets and unfair competition. Additionally,
we have brought causes of action for breach of contract and breach of fiduciary duty against Valentine and a cause of action for tortious interference with existing contracts against SonicWALL. In this complaint, we seek injunctive relief,
compensatory and punitive damages, and costs of suit. In September 2005, Valentine moved the Court for leave to amend his answer to our complaint to add counterclaims against us for libel, slander and defamation per se. In November 2005, over our
objection, the Court granted Valentines motion and Valentine amended his answer to formally include the counterclaims against us. We believe that Valentines counterclaims are baseless and intend to vigorously defend against them. We may
be unsuccessful in obtaining the full remedies that we are seeking in this litigation and, even if successful, the litigation may be costly and time consuming, which could have a material adverse effect on our operating results.



Class-Action Securities Litigation



On April 8, 2005, a holder of our common stock, on behalf of himself
and purportedly on behalf of a class of our stockholders, filed an action in the United States District Court for the Western District of Washington against WatchGuard us and some of our current and former officers, alleging violations of the
federal securities laws arising out of, among other things, our announcement on March 15, 2005 that we were restating some of our financial results for interim periods of 2004. Subsequently, a number of other related purported class action
suits also alleging violations of the federal securities laws were filed by holders of our common stock. The various actions have been consolidated by the Court, and are referred to herein as the Action. On October 3, 2005, a consolidated
amended complaint was filed in the action. Our response to that complaint is currently due on December 2, 2005. In addition, two related shareholder derivative suits against some of our current and former directors and officers have
subsequently been filed in the Superior Court of the State of Washington, King County and in the United States District Court for the Western District of Washington, respectively, which are referred to as the Derivative Actions. Plaintiffs in the
Action and the Derivative Actions seek unspecified compensatory damages. We are obligated to indemnify our officers and directors to the extent permitted by applicable law in connection with the Action, and have insurance for such individuals, to
the extent of the limits of the applicable insurance policies and subject to potential reservations of rights. We intend to vigorously defend against the Action. We are unable, however, to predict the ultimate outcome of the Action. We cannot assure
you that we will be successful in defending against the Action and, if we are unsuccessful, we may be subject to significant damages, which could have a material adverse effect on our operating results and financial position. Even if we are
successful, defending against the Action is likely to be expensive, time consuming and may divert managements attention from other business concerns and harm our business.



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|ITEM6. | EXHIBITS
|------ | --------



|(a) | Exhibits
|--- | --------



|     |  |                                                                                                                                            
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------
|     | 
|31.1 |  | Section 302 Certification of Edward J. Borey                                                                                               
|     | 
|31.2 |  | Section 302 Certification of Bradley E. Sparks                                                                                             
|     | 
|32.1 |  | Certification of Edward J. Borey pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  
|     | 
|32.2 |  | Certification of Bradley E. Sparks pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002



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SIGNATURES



Pursuant to the requirements of Section 13 or 15 (d) of the
Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



Date: November 9, 2005



WATCHGUARD TECHNOLOGIES, INC.By:

/s/ Bradley E. SparksBradley E. SparksChief Financial Officer(Authorized Officer)(Principal Financial and Accounting Officer)




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WATCHGUARD TECHNOLOGIES,
INC.

INDEX TO EXHIBITS



|        |  |                                                                                                                                            
|------- |  | -------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  | Description                                                                                                                                
|        | 
|31.1    |  | Section 302 Certification of Edward J. Borey                                                                                               
|        | 
|31.2    |  | Section 302 Certification of Bradley E. Sparks                                                                                             
|        | 
|32.1    |  | Certification of Edward J. Borey pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  
|        | 
|32.2    |  | Certification of Bradley E. Sparks pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002



41