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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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Quarterly Report Pursuant to Section
13 or 15(d)

of the Securities Exchange Act of 1934



|For the quarterly period ended September 30, 2003 |  |  |  | Commission File Number 000-26819
|------------------------------------------------- |  |  |  | --------------------------------



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WATCHGUARD TECHNOLOGIES, INC.

(Exact Name of Registrant as Specified in Its Charter)



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|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.)



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



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



33,077,363 shares of
WatchGuard common stock were outstanding as of November 3, 2003.



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WATCHGUARD TECHNOLOGIES, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2003



TABLE OF CONTENTS



|PART I.
FINANCIAL INFORMATION |  | 3                                                                                                              
|----------------------------- |  | ---------------------------------------------------------------------------------------------------------------
|                              |  |                                                                                                                
|ITEM 1.                       |  | FINANCIAL STATEMENTS                                                                                           
|                              |  |                                                                                                                
|                              |  | -        
Consolidated Balance Sheets as of December 31, 2002 and September 30, 2003                           
|                              |  |                                                                                                                
|                              |  | -        
Consolidated Statements of Operations for the three and nine months ended September 30, 2002 and 2003
|                              |  |                                                                                                                
|                              |  | -        
Consolidated Statements of Cash Flows for the nine months ended September 30, 2002 and 2003          
|                              |  |                                                                                                                
|                              |  | -        
Notes to Consolidated Financial Statements                                                           
|                              |  |                                                                                                                
|ITEM 2.                       |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS                          
|                              |  |                                                                                                                
|ITEM 3.                       |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                     
|                              |  |                                                                                                                
|ITEM 4.                       |  | CONTROLS AND PROCEDURES                                                                                        
|                              | 
|PART II.
OTHER INFORMATION    |  | 39                                                                                                             
|                              |  |                                                                                                                
|ITEM 4.                       |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                            
|                              |  |                                                                                                                
|ITEM 6.                       |  | EXHIBITS AND REPORTS ON FORM 8-K                                                                               



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PART I. FINANCIAL INFORMATION



ITEM 1. FINANCIAL STATEMENTS



WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

(unaudited)



|                                                                                                    |  | December 31, 2002 |          |   | September 30,2003 |  
|--------------------------------------------------------------------------------------------------- |  | ----------------- | -------- | - | ----------------- | -
|ASSETS                                                                                              |  |                   |          |   |                   |  
|                                                                                                    |  |                  
|Current assets:                                                                                     |  |                   |          |   |                   |  
|Cash and cash equivalents                                                                           |  | $                 | 8,890    |   |                   | $
|Short-term investments                                                                              |  |                   | 80,412   |   |                   |  
|Trade accounts receivable, net                                                                      |  |                   | 8,813    |   |                   |  
|Inventories, net                                                                                    |  |                   | 4,442    |   |                   |  
|Prepaid expenses and other                                                                          |  |                   | 4,435    |   |                   |  
|                                                                                                    |  |                   |          |   |                   |  
|Total current assets                                                                                |  |                   | 106,992  |   |                   |  
|Property and equipment, net                                                                         |  |                   | 6,467    |   |                   |  
|Goodwill                                                                                            |  |                   | 66,605   |   |                   |  
|Other intangibles, net and other assets                                                             |  |                   | 9,234    |   |                   |  
|                                                                                                    |  |                   |          |   |                   |  
|Total assets                                                                                        |  | $                 | 189,298  |   |                   | $
|                                                                                                    |  |                   |          |   |                   |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                |  |                   |          |   |                   |  
|                                                                                                    |  |                  
|Current liabilities:                                                                                |  |                   |          |   |                   |  
|Accounts payable                                                                                    |  | $                 | 4,905    |   |                   | $
|Accrued expenses and other liabilities                                                              |  |                   | 5,143    |   |                   |  
|Accrued restructuring and acquisition costs                                                         |  |                   | 9,035    |   |                   |  
|Deferred revenues                                                                                   |  |                   | 18,451   |   |                   |  
|                                                                                                    |  |                   |          |   |                   |  
|Total current liabilities                                                                           |  |                   | 37,534   |   |                   |  
|                                                                                                    |  |                  
|Stockholders equity:                                                                               |  |                   |          |   |                   |  
|                                                                                                    |  |                  
|Preferred stock, $0.001 par value:                                                                  |  |                   |          |   |                   |  
|Authorized shares: 10,000,000                                                                       |  |                   |          |   |                   |  
|No shares issued and outstanding                                                                    |  |                   |         |   |                   |  
|Common stock, $0.001 par value:                                                                     |  |                   |          |   |                   |  
|Authorized shares: 80,000,000                                                                       |  |                   |          |   |                   |  
|Shares issued and outstanding: 32,655,404 at December 31, 2002 and 32,991,869 at September 30, 2003 |  |                   | 33       |   |                   |  
|Additional paid-in capital                                                                          |  |                   | 265,932  |   |                   |  
|Deferred stock-based compensation                                                                   |  |                   | (254     | ) |                   |  
|Accumulated other comprehensive income (loss)                                                       |  |                   | 229      |   |                   |  
|Accumulated deficit                                                                                 |  |                   | (114,176 | ) |                   |  
|                                                                                                    |  |                   |          |   |                   |  
|Total stockholders equity                                                                          |  |                   | 151,764  |   |                   |  
|                                                                                                    |  |                   |          |   |                   |  
|Total liabilities and stockholders equity                                                          |  | $                 | 189,298  |   |                   | $
|                                                                                                    |  |                   |          |   |                   |  



See accompanying notes.



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WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(unaudited)



|                                                                                    |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|----------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | -
|                                                                                    |  | 2002                            |        |   | 2003                           |  
|Revenues:                                                                           |  |                                 |        |   |                                |  
|Product                                                                             |  | $                               | 14,224 |   |                                | $
|Service                                                                             |  |                                 | 5,851  |   |                                |  
|                                                                                    |  |                                 |        |   |                                |  
|Total revenues                                                                      |  |                                 | 20,075 |   |                                |  
|                                                                                    |  |                                 |        |  
|Cost of revenues:                                                                   |  |                                 |        |   |                                |  
|Product                                                                             |  |                                 | 5,332  |   |                                |  
|Service                                                                             |  |                                 | 1,509  |   |                                |  
|                                                                                    |  |                                 |        |   |                                |  
|Total cost of revenues                                                              |  |                                 | 6,841  |   |                                |  
|                                                                                    |  |                                 |        |   |                                |  
|Gross margin                                                                        |  |                                 | 13,234 |   |                                |  
|                                                                                    |  |                                 |        |  
|Operating expenses:                                                                 |  |                                 |        |   |                                |  
|Sales and marketing                                                                 |  |                                 | 8,859  |   |                                |  
|Research and development                                                            |  |                                 | 5,306  |   |                                |  
|General and administrative                                                          |  |                                 | 1,786  |   |                                |  
|Stock-based compensation (1)                                                        |  |                                 | 288    |   |                                |  
|Amortization of other intangible assets acquired                                    |  |                                 | 1,219  |   |                                |  
|Impairment of other intangible assets acquired                                      |  |                                 |       |   |                                |  
|Acquired in-process technology                                                      |  |                                 |       |   |                                |  
|Restructuring charges                                                               |  |                                 |       |   |                                |  
|                                                                                    |  |                                 |        |   |                                |  
|Total operating expenses                                                            |  |                                 | 17,458 |   |                                |  
|                                                                                    |  |                                 |        |   |                                |  
|Operating loss                                                                      |  |                                 | (4,224 | ) |                                |  
|                                                                                    |  |                                 |        |  
|Interest income, net                                                                |  |                                 | 636    |   |                                |  
|                                                                                    |  |                                 |        |   |                                |  
|Loss before income taxes                                                            |  |                                 | (3,588 | ) |                                |  
|                                                                                    |  |                                 |        |  
|Provision for income taxes                                                          |  |                                 |       |   |                                |  
|                                                                                    |  |                                 |        |   |                                |  
|Net loss                                                                            |  | $                               | (3,588 | ) |                                | $
|                                                                                    |  |                                 |        |   |                                |  
|Basic and diluted net loss per share                                                |  | $                               | (0.11  | ) |                                | $
|                                                                                    |  |                                 |        |   |                                |  
|Shares used in calculation of basic and diluted net loss per share                  |  |                                 | 32,341 |   |                                |  
|                                                                                    |  |                                 |        |   |                                |  
|                                                                                    |  |                                 |        |   |                                |  
|(1)    Stock-based compensation charges relate to the following expense
categories: |  |                                 |        |  
|                                                                                    |  |                                 |        |  
|Sales and marketing                                                                 |  | $                               | 15     |   |                                | $
|Research and development                                                            |  |                                 | 244    |   |                                |  
|General and administrative                                                          |  |                                 | 29     |   |                                |  
|                                                                                    |  |                                 |        |   |                                |  
|Total                                                                               |  | $                               | 288    |   |                                | $
|                                                                                    |  |                                 |        |   |                                |  



See accompanying notes.



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WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)



|                                                                                                                         |  | Nine Months EndedSeptember 30, |        
|------------------------------------------------------------------------------------------------------------------------ |  | ------------------------------ | -------
|                                                                                                                         |  | 2002                           |        
|OPERATING ACTIVITIES:                                                                                                    |  |                                |        
|Net loss                                                                                                                 |  | $                              | (19,925
|Adjustments to reconcile net loss to net cash used in operating activities:                                              |  |                                |        
|Noncash expenses:                                                                                                        |  |                                |        
|Depreciation and amortization of property and equipment                                                                  |  |                                | 2,078  
|Amortization of other intangible assets acquired                                                                         |  |                                | 3,163  
|Impairment of other intangible assets acquired                                                                           |  |                                |       
|Amortization of stock-based compensation                                                                                 |  |                                | 1,302  
|Acquired in-process technology                                                                                           |  |                                | 1,179  
|Changes in operating assets and liabilities:                                                                             |  |                                |        
|Trade accounts receivable, net                                                                                           |  |                                | (2,063 
|Inventories, net                                                                                                         |  |                                | 391    
|Prepaid expenses and other                                                                                               |  |                                | (341   
|Other intangibles, net and other assets                                                                                  |  |                                | (28    
|Accounts payable                                                                                                         |  |                                | 2,735  
|Accrued expenses and other liabilities                                                                                   |  |                                | 858    
|Accrued restructuring and acquisition costs                                                                              |  |                                | 2,933  
|Deferred revenues                                                                                                        |  |                                | 2,101  
|                                                                                                                         |  |                                |        
|NET CASH USED IN OPERATING ACTIVITIES                                                                                    |  |                                | (5,617 
|                                                                                                                         |  |                               
|INVESTING ACTIVITIES:                                                                                                    |  |                                |        
|Purchases of property and equipment                                                                                      |  |                                | (888   
|Proceeds from maturity of marketable securities                                                                          |  |                                | 62,890 
|Proceeds from sale of marketable securities                                                                              |  |                                | 33,373 
|Purchases of marketable securities                                                                                       |  |                                | (77,142
|Net cash paid in connection with the acquisition of RapidStream                                                          |  |                                | (16,793
|                                                                                                                         |  |                                |        
|NET CASH PROVIDED BY INVESTING ACTIVITIES                                                                                |  |                                | 1,440  
|                                                                                                                         |  |                               
|FINANCING ACTIVITIES:                                                                                                    |  |                                |        
|Proceeds from the exercise of common stock options and the sale of common stock through the employee stock purchase
plan |  |                                | 1,004  
|                                                                                                                         |  |                                |        
|NET CASH PROVIDED BY FINANCING ACTIVITIES                                                                                |  |                                | 1,004  
|                                                                                                                         |  |                                |        
|NET DECREASE IN CASH AND CASH EQUIVALENTS                                                                                |  |                                | (3,173 
|                                                                                                                         |  |                               
|CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                                                                         |  |                                | 13,958 
|                                                                                                                         |  |                                |        
|CASH AND CASH EQUIVALENTS AT END OF PERIOD                                                                               |  | $                              | 10,785 
|                                                                                                                         |  |                                |        



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 enterprises that use the Internet for
electronic commerce and secure communications.



Interim
Financial Information



The accompanying
consolidated unaudited financial statements of WatchGuard, which include the December 31, 2002 balance sheet that was derived from audited consolidated financial statements, have been prepared in accordance with generally accepted accounting
principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for
complete financial statements. In the opinion of management, the unaudited financial statements include all adjustments, consisting of normal recurring accruals, necessary for a fair presentation. Operating results for the three-month and nine-month
periods ended September 30, 2003 are not necessarily indicative of the results that may be expected for future quarters or for the year ending December 31, 2003. The financial statements should be read in conjunction with the financial statements
and related notes for the year ended December 31, 2002 included in WatchGuards annual report on Form 10-K, filed with the Securities and Exchange Commission (SEC) on March 26, 2003.



NOTE 2  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



Revenue Recognition



WatchGuard generates revenues through sales of its Firebox and RapidStream Secured by Check Point products, including licenses for related
software options, subscriptions for its LiveSecurity Service, which includes access to technical support, software updates (if and when available), threat responses, expert editorials, support flashes, virus alerts and interactive training, and
sales of ServerLock products. Software license revenues are generated from licensing the rights to use WatchGuards products directly to end-users, from sublicense fees from resellers and distributors and from sales of its managed security
solution products to Internet service providers and other service providers that utilize WatchGuards products to provide managed security services to their customers.



WatchGuard recognizes revenue in accordance with accounting standards for software companies, including Statement of
Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-9, and related interpretations, including Technical Practice Aids. In December 1999, the SEC issued Staff Accounting Bulletin (SAB) 101, Revenue Recognition in
Financial Statements. SAB 101 summarizes certain of the SECs views in applying generally accepted accounting principles to revenue recognition in financial statements. WatchGuard believes its current revenue recognition policies and
practices are consistent with the current accounting standards.



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



WatchGuard provides allowances for estimated returns, 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.



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



The promotional rebates vary by type and term and are earned by customers in accordance with various
conditions. WatchGuard accounts for promotional rebates given to customers in accordance with the Emerging Issues Task Force (EITF) Issue 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 the maximum
amount possible unless historical trends indicate a lower rate of accrual is adequate.



Revenues from some distribution arrangements are not recognized until the distributors sell the products to their customers, including those who have unlimited stock return and rotation rights. Revenues from
LiveSecurity Service subscriptions are recognized ratably over the term of the subscription, typically 90 days to two years. WatchGuards payment terms typically range from 30 to 60 days.



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.



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.



Comprehensive Loss



WatchGuards investments consist of corporate and government debt securities, are considered available-for-sale, and are stated at fair value, with
unrealized gains and losses included as a component of stockholders equity. All such investments mature within two years, with the weighted average life of the investment portfolio being approximately one year. At September 30, 2003 and at
December 31, 2002, short-term investments were restricted by a $3.0 million unconditional letter of credit issued to WatchGuards landlord in conjunction with a facilities lease. During the three- and nine-month periods ended September 30, 2002
and September 30, 2003, there were no material realized gains or losses on securities available-for-sale. The following table sets forth the components of comprehensive loss (in thousands):



|                                      |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | -
|                                      |  | 2002                            |        |   | 2003                           |  
|Net loss                              |  | $                               | (3,588 | ) |                                | $
|                                      |  |                                 |        |  
|Unrealized gain (loss) on investments |  |                                 | 83     |   |                                |  
|                                      |  |                                 |        |   |                                |  
|Comprehensive loss                    |  | $                               | (3,505 | ) |                                | $
|                                      |  |                                 |        |   |                                |  



Recent
Accounting Pronouncements



At the November 21, 2002
meeting, the EITF of the Financial Accounting Standards Board (FASB) reached a consensus on EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables, which addresses revenue recognition for arrangements that may involve the
delivery or performance of multiple products, services and/or rights to use assets. The final consensus is applicable to agreements entered into in fiscal periods beginning after June 15, 2003, with early adoption permitted. To the extent that an
arrangement is within the scope of other existing higher-level authoritative literature that provides guidance regarding whether or how to separate multiple-deliverable arrangements into separate units of accounting, such as SOP 97-2, the
arrangement should be accounted for in accordance with that literature. There was no material impact on WatchGuardss consolidated financial position or results of operation from the adoption of the provisions of EITF Issue 00-21.



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



In May 2003, Statement of Financial Accounting Standards (SFAS) 150, Accounting for Certain
Instruments with Characteristics of Both Liabilities and Equity was issued. The standard establishes how an issuer classifies and measures certain freestanding financial instruments with characteristics of liabilities and equity and requires
that such instruments be classified as liabilities. The standard is effective for financial instruments entered into or modified after May 31, 2003 and is otherwise effective at the beginning of the first interim period beginning after June 15,
2003. Adoption of the standard had no material impact on WatchGuards consolidated financial position or results of operations.



Reclassifications



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



NOTE 3  BALANCE SHEET ACCOUNT DETAIL



Trade Accounts Receivable, Net



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



|                                     |  | December 31, 2002 |        |   | September 30, 2003 |  
|------------------------------------ |  | ----------------- | ------ | - | ------------------ | -
|Trade accounts receivable            |  | $                 | 11,144 |   |                    | $
|Reserve for returns and allowances   |  |                   | (1,845 | ) |                    |  
|Allowance for uncollectible accounts |  |                   | (486   | ) |                    |  
|                                     |  |                   |        |   |                    |  
|                                     |  | $                 | 8,813  |   |                    | $
|                                     |  |                   |        |   |                    |  



Inventories, Net



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



|                   |  | December 31, 2002 |       |   | September 30, 2003 |  
|------------------ |  | ----------------- | ----- | - | ------------------ | -
|Finished goods     |  | $                 | 3,811 |   |                    | $
|Components         |  |                   | 1,256 |   |                    |  
|                   |  |                   |       |   |                    |  
|                   |  |                   | 5,067 |   |                    |  
|Inventory reserves |  |                   | (625  | ) |                    |  
|                   |  |                   |       |   |                    |  
|                   |  | $                 | 4,442 |   |                    | $
|                   |  |                   |       |   |                    |  



Accrued Expenses
and Other Liabilities



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



|                                    |  | December 31, 2002 |       | September 30, 2003
|----------------------------------- |  | ----------------- | ----- | ------------------
|Accrued payroll-related liabilities |  | $                 | 2,226 |                   
|Other accrued liabilities           |  |                   | 2,917 |                   
|                                    |  |                   |       |                   
|                                    |  | $                 | 5,143 |                   
|                                    |  |                   |       |                   



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



Accrued Restructuring and Acquisition Costs



Accrued restructuring and acquisition costs consisted of the following (in
thousands):



|                            |  | December 31, 2002 |       | September 30, 2003
|--------------------------- |  | ----------------- | ----- | ------------------
|Accrued acquisition costs   |  | $                 | 1,628 |                   
|Accrued restructuring costs |  |                   | 7,407 |                   
|                            |  |                   |       |                   
|                            |  | $                 | 9,035 |                   
|                            |  |                   |       |                   



NOTE 4  BUSINESS
RESTRUCTURINGS



During 2001 and 2002, WatchGuard recorded
restructuring charges of $3.7 million and $8.1 million, respectively. At September 30, 2003, the remaining balance of the restructuring liabilities was $5.1 million. No adjustments to the remaining liabilities were required in the nine-month period
ended September 30, 2003.



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 certain liabilities related to abandoned facilities which are as follows (in thousands):



|                                                    |  | December 31, 2002 Accrued RestructuringBalance |       | Amounts Paidor Charged |   |      | September 30, 2003 Accrued Restructuring Balance
|--------------------------------------------------- |  | ---------------------------------------------- | ----- | ---------------------- | - | ---- | ------------------------------------------------
|Accrued liabilities related to abandoned facilities |  | $                                              | 2,035 |                        | $ | (485 | )                                               
|                                                    |  |                                                |       |                        |   |      |                                                 



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 are no longer required or part of WatchGuards strategy. As a result of this restructuring, WatchGuard recorded a $6.7 million restructuring charge in 2002.



As part of this reorganization, WatchGuard implemented a workforce reduction
of 36 employees, which represented approximately 10% of WatchGuards post-acquisition employee base and included employees from all of WatchGuards functional areas. All such employees were terminated prior to June 30, 2002. Other costs
associated with the reorganization consisted of contract terminations and the consolidation of excess facilities. Costs that related to ongoing operations were not included as restructuring charges. Restructuring charges for severance and
termination benefits were paid by December 31, 2002, while accrued amounts relating to losses for the lease buyout or sublease of abandoned facilities of approximately $3.6 million at September 30, 2003 are expected to be realized through 2010.
Contract termination costs were paid during the quarter ended March 31, 2003.



The accrued liability relating to this restructuring as of December 31, 2002 and activity recorded through September 30, 2003 is as follows (in thousands):



|                                                              |  | December 31, 2002Accrued Restructuring Balance |       | Amounts Paid or Charged |   |        | September 30, 2003Accrued Restructuring Balance
|------------------------------------------------------------- |  | ---------------------------------------------- | ----- | ----------------------- | - | ------ | -----------------------------------------------
|Costs related to cancellation of technology-related contracts |  | $                                              | 580   |                         | $ | (580   | )                                              
|Abandoned facilities and other                                |  |                                                | 4,792 |                         |   | (1,225 | )                                              
|                                                              |  |                                                |       |                         |   |        |                                                
|Total                                                         |  | $                                              | 5,372 |                         | $ | (1,805 | )                                              
|                                                              |  |                                                |       |                         |   |        |                                                



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



NOTE 5  STOCK-BASED COMPENSATION



WatchGuard accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principle Board
(APB) Opinion 25 Accounting for Stock Issued to Employees, and related interpretations. Compensation cost for stock options is measured as the excess, if any, of the fair value of WatchGuards common stock at the date of grant over
the stock option exercise price.



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



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



|                                                                          |  | Three Months Ended September 30, |         |   | Nine Months Ended September 30, |  
|------------------------------------------------------------------------- |  | -------------------------------- | ------- | - | ------------------------------- | -
|                                                                          |  | 2002                             |         |   | 2003                            |  
|Net loss  as reported                                                    |  | $                                | (3,588  | ) |                                 | $
|                                                                          |  |                                  |         |  
|Add: stock-based compensation, as reported                                |  |                                  | 288     |   |                                 |  
|Deduct: stock-based compensation determined under fair-value-based method |  |                                  | (7,959  | ) |                                 |  
|                                                                          |  |                                  |         |   |                                 |  
|Net loss  pro forma                                                      |  | $                                | (11,259 | ) |                                 | $
|                                                                          |  |                                  |         |   |                                 |  
|Net loss per share  as reported                                          |  | $                                | (0.11   | ) |                                 | $
|Net loss per share  pro forma                                            |  | $                                | (0.35   | ) |                                 | $



NOTE 6  IMPAIRMENT OF
INTANGIBLE ASSETS ACQUIRED



In accordance with SFAS 144
Accounting for the Impairment or Disposal of Long-Lived Assets, the carrying value of intangible assets is reviewed on a regular basis for the existence of facts or circumstances, both internal and external, that may suggest impairment.
During the third quarter of 2003, it was determined that an impairment existed for the intangible asset associated with the RapidStream Secured by Check Point product brand based on the technology obtained in the 2002 acquisition of
RapidStream. WatchGuards increased focus on its core market of small- to medium-size enterprises, resulting in a significant reduction in our sales, marketing and development efforts in support of this brand, together with the historically
poor performance of the RapidStream Secured by Check Point brand, led management to reduce future sales projections for the brand. The revised undiscounted expected future cash flows resulting from the reduced future sales projections
were determined to be insufficient to recover the carrying value of the related capitalized technology. WatchGuard therefore recorded an impairment charge of $3.3 million during the quarter ended September 30, 2003, based on the difference between
the carrying value of the intangible assets and its estimated fair value using a discounted cash flow approach. At September 30, 2003, there is a remaining net book value of $268,000 for the intangible asset related to underlying technology for the
RapidStream Secured by Check Point product brand.



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|ITEM 2. |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------- |  | -------------------------------------------------------------------------------------



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



Forward-Looking Statements



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



| |  | 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 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 those requirements;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



| |  | other information that is not historical facts.
| | - | -----------------------------------------------



Words such as believes, anticipates and intends may identify forward-looking statements, but the absence of these
words does not necessarily mean that a statement is not forward-looking. Forward-looking statements are subject to known and unknown risks and uncertainties and are based on potentially inaccurate assumptions that could cause actual results to
differ materially from those expected or implied by the forward-looking statements. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including the factors described below under the
heading Important Factors That May Affect Our Operating Results, Our Business 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 those factors 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.



Overview



WatchGuard is a leading provider of Internet security solutions designed to protect enterprises that use the Internet for electronic commerce and secure
communications. Our mission is to provide enterprises worldwide with stronger Internet security solutions by offering integrated, multi-layered defenses and tools that protect against known and future threats in a smart way by including simplified
implementation and management and proactive security with our LiveSecurity Service.



Our award-winning products and services include our high-performance Firebox and RapidStream firewall and VPN appliances for access control, secure communications and (with certain of our Firebox products)
network-based intrusion protection capabilities, and our ServerLock technology and anti-virus solution for content and application security for servers and desktops with host-based intrusion protection capabilities. Our innovative subscription-based
LiveSecurity Service delivers threat responses, software updates, expert editorials, support flashes and virus alerts, which enables our customers, with minimal effort, to protect their data and communications in a continuously changing environment.



Our core market spans the small- to medium-sized enterprise,
or SME, market, ranging from smaller sized companies for whom ease-of-use is a key requirement, to larger sized companies, including those with high-speed connections supporting virtual private networks, or VPNs, between the corporate headquarters
and geographically dispersed branch offices, where performance, scalability and networking features are key requirements.



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



Since January 2002, we have continued to invest heavily in the development of our products as follows:



| |  | In the second quarter of 2002, we acquired RapidStream, Inc., a privately held provider of high-performance, ASIC (application-specific integrated circuit)-based firewall and VPN
appliances, and introduced high-performance Firebox Vclass firewall and VPN appliances, based on the technology RapidStream had developed.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In August 2002, we introduced our new Firebox SOHO 6, Firebox SOHO 6tc, and Firebox SOHO 6tc50 user models.
| | - | ------------------------------------------------------------------------------------------------------------



| |  | In March 2003, we introduced the Firebox S6 and Firebox S-6-VPN firewall and VPN network security appliances for small businesses, remote offices and telecommuters, fully localized
for the Japanese market.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In March 2003, we introduced the Firebox V60L, an addition to our line of Firebox Vclass security appliances, based on WatchGuards intelligent ASIC architecture. The new
product is designed to provide mid-size enterprises with firewall/VPN performance and scalability superior to other solutions in the same price range.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In March 2003, we introduced the Firebox 500, an addition to our Firebox III family of sophisticated, easy-to-manage security solutions for SMEs. The new product is a hardened
firewall appliance for small businesses requiring perimeter security, mobile user VPN support and Web content control.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In March 2003, we introduced the Firebox V200, which extends our line of high-performance Firebox Vclass security solutions based on WatchGuards intelligent ASIC architecture.
The new product is designed to eliminate the need for multiple appliances in environments requiring multi-gigabit throughput, providing a cost-effective, easy-to-implement solution for distributed enterprises and service providers.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In June 2003, we introduced the SOHO 6 Wireless product line, designed to provide a complete, robust wireless and scalable wired security solution in a single firewall/VPN appliance
for small businesses, remote offices and telecommuters.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In September 2003, we introduced AuditScan network vulnerability assessment service, as an option to WatchGuard customers available through the LiveSecurity service subscription
beginning in the fourth quarter of 2003. AuditScan service has been developed in partnership with Qualys, Inc., a leading Web Service Provider of network security audits and vulnerability management, and is designed to enable organizations to
perform independent network security audits quickly, easily and cost effectively.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Critical Accounting Policies



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;
| | - | ------------------------------------------------------------



| |  | the provision for bad debt;
| | - | ---------------------------



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



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



| |  | the allocation of purchase price in business combinations to intangible assets; and
| | - | -----------------------------------------------------------------------------------



| |  | analysis of impairment of goodwill and 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.



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



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 directly and, from time to time, indirectly, through our distributors to our service provider customers at volume pricing rates; and
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | sales of service subscription renewals directly to end-users.
| | - | -------------------------------------------------------------



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



| |  | sales of our security appliances and the perpetual software license fees for our Firebox products that are bundled with the sale of our security appliances as part of our security
solutions;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



| |  | hardware sales of our RapidStream Secured by Check Point line of high-performance security appliances; and
| | - | ------------------------------------------------------------------------------------------------------------



| |  | sales of our ServerLock products and anti-virus solutions for server content, application and desktop security.
| | - | ---------------------------------------------------------------------------------------------------------------



Revenues from products are generally recognized upon delivery if persuasive
evidence of an arrangement exists, collection is probable, the fee is fixed or determinable, and vendor-specific objective evidence of fair value for undelivered elements of the arrangement has been established. While we generally recognize product
revenues upon shipment, revenues on product sales for some of our major distributors are recorded when these distributors have sold the product to their customers.



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



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



We have established
allowances for estimated returns, return rights and pricing protection rights. We have also established an allowance for promotional rebates that may be earned by our customers. We estimate these reserves 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
may be required. Alternatively, if actual promotional rebates fall below maximum exposure levels, we may reduce the allowances and recognize additional revenue.



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Bad Debts



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



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



Restructuring



In 2001 and 2002, we recorded significant accruals related to our restructuring plans. These accruals included estimates related to the abandonment of
excess facilities. We have 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.



Business Combinations Purchase Price Allocation



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



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



| |  | the asset arises from contractual or other legal rights or
| | - | ----------------------------------------------------------



| |  | the asset is capable of being separated from the acquired entity and sold, transferred, licensed, rented or exchanged.
| | - | ----------------------------------------------------------------------------------------------------------------------



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



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



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



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



Results of
Operations for the Three and Nine Month Periods Ended September 30, 2002 and 2003



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



|                                                 |  | Three MonthsEnded September 30, |    |  | Nine MonthsEnded September 30, |   
|------------------------------------------------ |  | ------------------------------- | -- |  | ------------------------------ | --
|                                                 |  | 2002                            |    |  | 2003                           |   
|Revenues:                                        |  |                                 |    |  |                                |   
|Product                                          |  | 70.9                            | %  |  | 64.8                           | % 
|Service                                          |  | 29.1                            |    |  | 35.2                           |   
|                                                 |  |                                 |    |  |                                |   
|Total revenues                                   |  | 100.0                           |    |  | 100.0                          |   
|                                                 |  |                                 |    | 
|Cost of revenues:                                |  |                                 |    |  |                                |   
|Product                                          |  | 26.6                            |    |  | 31.4                           |   
|Service                                          |  | 7.5                             |    |  | 9.2                            |   
|                                                 |  |                                 |    |  |                                |   
|Total cost of revenues                           |  | 34.1                            |    |  | 40.6                           |   
|                                                 |  |                                 |    |  |                                |   
|Gross margin                                     |  | 65.9                            |    |  | 59.4                           |   
|                                                 |  |                                 |    | 
|Operating expenses:                              |  |                                 |    |  |                                |   
|Sales and marketing                              |  | 44.1                            |    |  | 39.2                           |   
|Research and development                         |  | 26.4                            |    |  | 28.7                           |   
|General and administrative                       |  | 8.9                             |    |  | 10.4                           |   
|Stock-based compensation                         |  | 1.4                             |    |  | 0.1                            |   
|Amortization of other intangible assets acquired |  | 6.1                             |    |  | 3.0                            |   
|Impairment of other intangible assets acquired   |  |                                |    |  | 17.7                           |   
|Acquired in-process technology                   |  |                                |    |  |                               |   
|Restructuring charges                            |  |                                |    |  |                               |   
|                                                 |  |                                 |    |  |                                |   
|Total operating expenses                         |  | 86.9                            |    |  | 99.1                           |   
|                                                 |  |                                 |    |  |                                |   
|Operating loss                                   |  | (21.0                           | )  |  | (39.7                          | ) 
|                                                 |  |                                 |    | 
|Interest income, net                             |  | 3.2                             |    |  | 0.7                            |   
|                                                 |  |                                 |    |  |                                |   
|Loss before income taxes                         |  | (17.8                           | )  |  | (39.0                          | ) 
|                                                 |  |                                 |    | 
|Provision for income taxes                       |  |                                |    |  | 0.1                            |   
|                                                 |  |                                 |    |  |                                |   
|Net loss                                         |  | (17.8                           | )% |  | (39.1                          | )%
|                                                 |  |                                 |    |  |                                |   



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Revenues



|                                   |  | Three Months EndedSeptember 30, |        |   | PercentIncrease(Decrease) |   |        | Nine Months EndedSeptember 30, |      |     | Percent Increase |     
|---------------------------------- |  | ------------------------------- | ------ | - | ------------------------- | - | ------ | ------------------------------ | ---- | --- | ---------------- | ----
|                                   |  | 2002                            |        |   | 2003                      |   |        |                                | 2002 |     |                  | 2003
|Revenues (in thousands):           |  |                                 |        |   |                           |   |        |                                |      |     |                  |     
|Product                            |  | $                               | 14,224 |   |                           | $ | 12,048 |                                |      | (15 | )%               |     
|Service                            |  |                                 | 5,851  |   |                           |   | 6,554  |                                |      | 12  | %                |     
|                                   |  |                                 |        |   |                           |   |        |                                |      |     |                  |     
|Total                              |  | $                               | 20,075 |   |                           | $ | 18,602 |                                |      | (7  | )%               |     
|                                   |  |                                 |        |   |                           |   |        |                                |      |     |                  |     
|Revenues (as % of total revenues): |  |                                 |        |   |                           |   |        |                                |      |     |                  |     
|Product                            |  |                                 | 71     | % |                           |   | 65     | %                              |      |     |                  |     
|Service                            |  |                                 | 29     | % |                           |   | 35     | %                              |      |     |                  |     
|                                   |  |                                 |        |   |                           |   |        |                                |      |     |                  |     
|Total                              |  |                                 | 100    | % |                           |   | 100    | %                              |      |     |                  |     
|                                   |  |                                 |        |   |                           |   |        |                                |      |     |                  |     



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 (dollars in thousands):



|          |  | Three Months EndedSeptember 30, |        |   | PercentIncrease(Decrease) |   |        | Nine Months EndedSeptember 30, |      |     | PercentIncrease(Decrease) |     
|--------- |  | ------------------------------- | ------ | - | ------------------------- | - | ------ | ------------------------------ | ---- | --- | ------------------------- | ----
|          |  | 2002                            |        |   | 2003                      |   |        |                                | 2002 |     |                           | 2003
|Revenues: |  |                                 |        |   |                           |   |        |                                |      |     |                           |     
|Americas  |  | $                               | 9,100  |   |                           | $ | 9,818  |                                |      | 8   | %                         |     
|EMEA      |  |                                 | 7,027  |   |                           |   | 6,394  |                                |      | (9  | )%                        |     
|APAC      |  |                                 | 3,948  |   |                           |   | 2,390  |                                |      | (39 | )%                        |     
|          |  |                                 |        |   |                           |   |        |                                |      |     |                           |     
|Total     |  | $                               | 20,075 |   |                           | $ | 18,602 |                                |      | (7  | )%                        |     
|          |  |                                 |        |   |                           |   |        |                                |      |     |                           |     
|Revenues: |  |                                 |        |   |                           |   |        |                                |      |     |                           |     
|Americas  |  |                                 | 45     | % |                           |   | 53     | %                              |      |     |                           |     
|EMEA      |  |                                 | 35     | % |                           |   | 34     | %                              |      |     |                           |     
|APAC      |  |                                 | 20     | % |                           |   | 13     | %                              |      |     |                           |     
|          |  |                                 |        |   |                           |   |        |                                |      |     |                           |     
|Total     |  |                                 | 100    | % |                           |   | 100    | %                              |      |     |                           |     
|          |  |                                 |        |   |                           |   |        |                                |      |     |                           |     



Revenue information
for customers representing more than 10% of total revenues, in dollars and as a percentage of total revenues, was as follows (dollars in thousands):



|             |  | Three MonthsEnded September 30, |       |   | PercentIncrease |   |       | Nine MonthsEndedSeptember 30, |      |    | PercentIncrease |     
|------------ |  | ------------------------------- | ----- | - | --------------- | - | ----- | ----------------------------- | ---- | -- | --------------- | ----
|             |  | 2002                            |       |   | 2003            |   |       |                               | 2002 |    |                 | 2003
|Revenues:    |  |                                 |       |   |                 |   |       |                               |      |    |                 |     
|Tech Data    |  | $                               | 2,347 |   |                 | $ | 4,080 |                               |      | 74 | %               |     
|Ingram Micro |  |                                 | 2,419 |   |                 |   | 4,165 |                               |      | 72 | %               |     
|             |  |                                 |       |   |                 |  
|Revenues:    |  |                                 |       |   |                 |   |       |                               |      |    |                 |     
|Tech Data    |  |                                 | 12    | % |                 |   | 22    | %                             |      |    |                 |     
|Ingram Micro |  |                                 | 12    | % |                 |   | 22    | %                             |      |    |                 |     



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##### Table of Contents

The dollar decrease in product revenues for the three-month period ended September 30, 2003 as compared
to the same period of 2002 was primarily due to lower average selling prices and a slight decrease in unit shipments. Specifically, the factors that contributed to the decline in product revenues were as follows:



| |  |  | overall reduction in inventory by our channel partners;
| | - |  | -------------------------------------------------------



| |  |  | decrease in average selling prices primarily from sales promotions;
| | - |  | -------------------------------------------------------------------



| |  |  | extension of aggressive trade-up and competitive trade-in programs relating to Firebox III line;
| | - |  | ------------------------------------------------------------------------------------------------



| |  |  | decrease in unit shipments of Firebox Vclass product line;
| | - |  | ----------------------------------------------------------



| |  |  | shift in product mix towards lower priced Firebox SOHO products; and
| | - |  | --------------------------------------------------------------------



| |  |  | introduction of new lower priced product models within Firebox Vclass and Firebox III product lines in the first quarter of 2003.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



The dollar increase in product revenues for the nine-month period ended
September 30, 2003 as compared to the same period of 2002 was primarily due to an increase in unit volumes for Firebox SOHO, Firebox III and Firebox Vclass products, in connection with new product introductions, such as Firebox Vclass products in
the second quarter of 2002 and Firebox SOHO 6 products in the third quarter of 2002 and, to a lesser extent, in connection with further additions of new products to the Firebox Vclass and Firebox III lines in the first quarter of 2003 and the
addition of Firebox SOHO Wireless products in the second quarter of 2003. The rate of increase in product revenues in the nine-month period ended September 30, 2003, as compared to the same period of 2002 was lower than the rate of increase in the
unit shipments due to price reductions and extension of larger discounts in the Firebox III line in response to competitive pressure, the launch of new promotional campaigns in 2003 intended to drive future demand and a shift in the product mix
towards lower priced Firebox SOHO line and towards lower priced products within the Firebox III line.



From a regional standpoint, in the three-month period ended September 2003, as compared to the same period of 2002, we experienced a decrease in revenue
from our international markets, while revenue for the Americas increased. The EMEA revenue decrease relates to an uncharacteristic seasonal weakness in Europe combined with the efforts of our channel partners to reduce their inventory levels in an
effort to allow for a faster competitive response to changes in market conditions. This decrease in EMEA revenue is also caused by the extension of discounts in response to competitive pressure, and partially by a large sale of $430,000 to one
customer in the third quarter of 2002 that did not recur in 2003. The decrease in APAC revenue is due to continued realignment of our APAC sales and marketing organization and channel strategy, which was started in the first quarter of 2003.



The increase in revenue in the nine-month period ended
September 30, 2003, as compared to the same period of 2002 was mostly achieved in the Americas and EMEA regions. The growth of international revenues was slowed by the decrease in sales in APAC, specifically in Japan. In the first quarter of 2003,
we were in the early stages of the realignment of our APAC business focused on improving the performance of our sales channels and localization of some of our products, and we continued this process in the second and third quarters of 2003.



Given these realignment efforts in the APAC region and the
current economic uncertainty and deferral in spending by businesses on information technology, it is difficult to predict revenue levels in future quarters, which may decrease or fluctuate more than they have historically. We may be unable to
maintain or increase the demand for our products, our revenues may not continue to grow at the same rate as in the past, may not grow at all or may decline, and we may be unable to achieve similar results in future periods.



The service revenues increase in both absolute dollars and as a percentage of
total revenues for the three- and nine-month periods ended September 30, 2003 as compared to the same periods of 2002 was primarily due to a growing installed base of customers purchasing LiveSecurity Service renewals in addition to initial service
subscriptions included as part of the product bundle.



The
increase in service revenues for the nine-month period ended September 30, 2003 as compared to the same period of 2002 is also partially attributable to service revenue of $620,000 in the nine-month period ended September 30, 2003 generated from
LiveSecurity services that were provided through certain managed security customers to their end-users in prior periods, but were identified by WatchGuard through a license compliance initiative as being previously unreported to WatchGuard by those
customers.



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Service revenue is generally related to product shipments in preceding quarters, as a substantial portion
of service revenue results from amortization of the initial service fee bundled with the original product purchase. Our product shipments declined for the first three quarters of 2003 as compared to the last quarter of 2002. A decline in product
shipments will result in lower initial LiveSecurity service subscriptions bundled with the products, while an increase in our installed customer base will increase the number of customers with the opportunity to renew their LiveSecurity service
subscriptions. Because of this, it is difficult to predict service revenue levels in the future.



The provision for estimated sales returns, price protection rights and promotional rebates was $1.1 million, or 5% of total revenues before the provision
for the three-month period ended September 30, 2002, and $1.7 million, or 8% of total revenues before the provision for the same period of 2003. The higher provision in absolute dollars and as a percentage of revenue for the three-month period ended
September 30, 2003 as compared to the same period of 2002 relates to the increase in promotional offerings in 2003.



The provision for estimated sales returns, price protection rights and promotional rebates was $3.6 million, or 6% of total revenues before the provision
for the nine-month period ended September 30, 2002, and $5.4 million, or 8% of total revenues before the provision for the same period of 2003. The higher provision in absolute dollars for the nine-month period ended September 30, 2003 as compared
to the same period of 2002 corresponds to higher product sales. The higher provision as a percentage of revenue for the first nine months of 2003 as compared to the same period of 2002 relates to the increase in promotional offerings in 2003.



We expect to introduce new products and promotional programs
through the remainder of 2003, which may affect our reserve for sales returns and allowances.



Cost of Revenues and Gross Margin



|                                                      |  | Three Months EndedSeptember 30, |        |   | PercentIncrease(Decrease) |   |        | Nine Months EndedSeptember 30, |      |     | PercentIncrease |     
|----------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------- | - | ------ | ------------------------------ | ---- | --- | --------------- | ----
|                                                      |  | 2002                            |        |   | 2003                      |   |        |                                | 2002 |     |                 | 2003
|Cost of revenues (in thousands):                      |  |                                 |        |   |                           |   |        |                                |      |     |                 |     
|Product                                               |  | $                               | 5,332  |   |                           | $ | 5,848  |                                |      | 10  | %               |     
|Service                                               |  |                                 | 1,509  |   |                           |   | 1,707  |                                |      | 13  | %               |     
|                                                      |  |                                 |        |   |                           |   |        |                                |      |     |                 |     
|Total                                                 |  | $                               | 6,841  |   |                           | $ | 7,555  |                                |      | 10  | %               |     
|                                                      |  |                                 |        |   |                           |   |        |                                |      |     |                 |     
|Cost of revenues (as % of total revenues):            |  |                                 |        |   |                           |   |        |                                |      |     |                 |     
|Product                                               |  |                                 | 27     | % |                           |   | 32     | %                              |      |     |                 |     
|Service                                               |  |                                 | 7      | % |                           |   | 9      | %                              |      |     |                 |     
|                                                      |  |                                 |        |   |                           |   |        |                                |      |     |                 |     
|Total                                                 |  |                                 | 34     | % |                           |   | 41     | %                              |      |     |                 |     
|                                                      |  |                                 |        |   |                           |   |        |                                |      |     |                 |     
|Cost of revenues (as % of related revenue component): |  |                                 |        |   |                           |   |        |                                |      |     |                 |     
|Product (as % of product revenues)                    |  |                                 | 37     | % |                           |   | 49     | %                              |      |     |                 |     
|Service (as % of service revenues)                    |  |                                 | 26     | % |                           |   | 26     | %                              |      |     |                 |     
|                                                      |  |                                 |        |   |                           |  
|Gross margin (in thousands):                          |  |                                 |        |   |                           |   |        |                                |      |     |                 |     
|Product                                               |  | $                               | 8,892  |   |                           | $ | 6,200  |                                |      | (30 | )%              |     
|Service                                               |  |                                 | 4,342  |   |                           |   | 4,847  |                                |      | 12  | %               |     
|                                                      |  |                                 |        |   |                           |   |        |                                |      |     |                 |     
|Total                                                 |  | $                               | 13,234 |   |                           | $ | 11,047 |                                |      | (17 | )%              |     
|                                                      |  |                                 |        |   |                           |   |        |                                |      |     |                 |     
|Gross margin (as % of related revenue component):     |  |                                 |        |   |                           |   |        |                                |      |     |                 |     
|Product (as % of product revenues)                    |  |                                 | 63     | % |                           |   | 51     | %                              |      |     |                 |     
|Service (as % of service revenues)                    |  |                                 | 74     | % |                           |   | 74     | %                              |      |     |                 |     
|Total (as % of total revenues)                        |  |                                 | 66     | % |                           |   | 59     | %                              |      |     |                 |     



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



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



The dollar increase in cost of product revenues for the three-month period ended September 30, 2003 as compared to the same period of 2002 were primarily
due to an approximate $700,000 increase in the provision for inventory reserves. Quantities of shipments of our products and related consumption of component inventory have been below our expectations. Our projections for future quarters in
combination with our product life cycle planning process resulted in our recording of the additional provision for inventory reserves mentioned above for certain of our products and related components, including our RapidStream Secured by
Check Point brand products. This brand is a subset of the products and technology obtained as a result of our April 2002 acquisition of RapidStream, Inc. If the provision for inventory reserves were excluded from the calculation of product
margin, the product gross margin as a percentage of product revenue would have been approximately 65% and 57% for the three-month period ended September 30, 2002 and the same period of 2003 respectively. The decline in product margins as a
percentage of the product revenues was negatively affected by continued competitive pricing in the marketplace for our products, which included aggressive trade-up and competitive trade-in programs relating to the Firebox III line, the introduction
of new lower margin product models within the Firebox III and Firebox Vclass product lines in the beginning of 2003 as well as by relatively fixed nature of distribution and manufacturing support cost on lower revenues.



The dollar increase in cost of product revenues for the nine-month period
ended September 30, 2003 as compared to the same period of 2002 was primarily due to the increase in unit volume and the increase in the provision for inventory reserves. The provision for inventory reserves increased by $1.2 million for the
nine-month period ended September 30, 2003 as compared to the same period of 2002. If the provision for inventory reserves were excluded from the calculation of product margin, the product margin as a percentage of product revenue would have been
approximately 63% for both nine-month periods ended September 30, 2002 and September 30, 2003. The downward effect of the competitive pricing, including aggressive trade-up and competitive trade-in programs relating to the Firebox III line in the
third quarter of 2003, was offset by the increase in unit volume for the nine-month period ended September 30, 2003 as compared to the same period of 2002.



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



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



Cost of service revenues increased in absolute dollars and remained unchanged as a percentage of related revenue for the
three-month period ended September 30, 2003 as compared to the same period of 2002. The dollar increase in costs of services is related to additional expenses incurred in transitioning between the providers of the first level of support. Service
margins increased in absolute dollars due to service revenue growth. Service margin as a percentage of related revenue remained unchanged between two periods compared.



Cost of service revenues increased in absolute dollars but decreased as a percentage of related revenue for the nine-month
period ended September 30, 2003 as compared to the same period of 2002. The dollar and percentage service margin increased due to operational and cost efficiencies we have realized at the same time that we have expanded our customer base. The larger
percentage increase in service margins for comparative nine-month periods than for comparative three-month periods is also partially attributable to service revenue of $620,000 generated in the nine-month period ended September 30, 2003 without
significant additional costs, from our license compliance initiative mentioned above in the discussion of our service revenues.



We expect service costs to decrease slightly in absolute dollars and as a percentage of related revenues for the remainder of 2003 as compared to the
level incurred in the third quarter of 2003. This is expected to result in higher service margins for the remainder of 2003, as compared to the third quarter of 2003. Actual service costs and margins could differ materially from those anticipated,
which could have an adverse effect on our results of operations.



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Operating Expenses



Sales and Marketing



|                                                      |  | Three MonthsEnded September 30, |       |   | Percent(Decrease) |   |       | Nine Months Ended September 30, |      |     | Percent(Decrease) |     
|----------------------------------------------------- |  | ------------------------------- | ----- | - | ----------------- | - | ----- | ------------------------------- | ---- | --- | ----------------- | ----
|                                                      |  | 2002                            |       |   | 2003              |   |       |                                 | 2002 |     |                   | 2003
|Sales and marketing expenses (in thousands)           |  | $                               | 8,859 |   |                   | $ | 7,285 |                                 |      | (18 | )%                |     
|Sales and marketing expenses (as % of total revenues) |  |                                 | 44    | % |                   |   | 39    | %                               |      |     |                   |     



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



The dollar and percentage decline in sales and marketing expenses for the
three-month period ended September 30, 2003 as compared to the same period of 2002 was primarily due to decreases in marketing programs. Costs of marketing programs declined from $2.9 million for the three-month period ended September 30, 2002 to
$1.5 million in the same period of 2003. The decline in these costs is primarily related to the approximate $570,000 reduction in certain marketing promotional costs, as we attempt to balance those activities with increases in sales promotions and
at the same time as we removed the promotional costs recorded earlier that remained unclaimed by our channel partners, due to expiration of the terms of those promotions. The decline in marketing programs for advertising, trade shows, public
relations and direct marketing is due to the fact that in the third quarter of 2002 we incurred higher costs in those areas required to support the international rollout of the new Firebox Vclass product line.



The dollar decrease in sales and marketing expenses for the nine-month period
ended September 30, 2003 as compared to the same period of 2002 was primarily due to the decline in marketing expenditures, especially due to a reduction of marketing promotional programs. Costs of marketing programs declined from $7.9 million for
the nine-month period ended September 30, 2002 to $6.4 million for the same period of 2003, as we focused on controlling those expenses. The decrease in the costs of marketing programs was partially offset by the increase in compensation, benefits,
recruiting and consulting costs.



Sales and marketing expenses
declined as a percentage of revenue for the three- and nine-month periods ended September 30, 2003 as compared to the same periods of 2002, as we focused on improving the productivity of our sales channels and the efficiency of our marketing
campaigns.



We expect the sales and marketing expenses to
remain at the level comparable to the third quarter of 2003 for the remainder of 2003. Our actual sales and marketing expenses could differ materially from those anticipated, which could have an adverse effect on our results of operations.



Research and Development



|                                                           |  | Three MonthsEnded September 30, |       |   | PercentIncrease |   |       | Nine Months Ended September 30, |      |   | Percent(Decrease) |     
|---------------------------------------------------------- |  | ------------------------------- | ----- | - | --------------- | - | ----- | ------------------------------- | ---- | - | ----------------- | ----
|                                                           |  | 2002                            |       |   | 2003            |   |       |                                 | 2002 |   |                   | 2003
|Research and development expenses (in thousands)           |  | $                               | 5,306 |   |                 | $ | 5,323 |                                 |      | 0 | %                 |     
|                                                           |  |                                 |       |   |                 |  
|Research and development expenses (as % of total revenues) |  |                                 | 26    | % |                 |   | 29    | %                               |      |   |                   |     



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



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Research and development expenses for the three-month period ended September 30, 2003 remained comparable
in absolute dollars to the same period of 2002 and increased as a percentage of revenue. Compensation related costs of research and development declined from $3.4 million for the three-month period ended September 30, 2002 to $2.9 million for the
related period of 2003 as lower than expected ServerLock revenue in 2003 resulted in reductions of related headcount. These cost savings were offset by the additional costs of outsourced development associated with prototype development, consulting
and hardware and software supplies consumption. Those outsourced development costs increased from $600,000 for the three-month period ended September 2002 to $1.1 million for the related period of 2003, due to the additional costs of undergoing the
evaluation for Common Criteria Evaluation Assurance Level 4 and Federal Information Processing Standards Certification for the Firebox Vclass product line in 2003 and well as due to the increased costs of prototypes.



Research and development expenses decreased in both absolute dollars and as a
percentage of revenue for the nine-month period ended September 30, 2003 as compared to the same period of 2002. This decline is primarily related to the decline in salaries and benefits associated with the reduction in research and development
personnel. Compensation related expenses decreased from $9.7 million for the nine month period ended September 2002 to $9.3 million for the related period of 2003. Headcount related compensation costs and other research and development costs
increased substantially in the second quarter of 2002 as a result of the RapidStream acquisition and due to the product integration efforts to accelerate the rollout of new Vclass products based on the RapidStream technology. Headcount was gradually
brought down to the pre-acquisition levels by the end of the second quarter of 2003 as redundant functions were eliminated. Also, lower than expected ServerLock revenue in 2003 resulted in reductions of related research and development costs for
this product line. These cost savings were partially offset by the increase in outsourced development. Costs of outsourced development increased from $2.3 million for the nine-month period ended September 30, 2002 to $2.9 million for the related
period of 2003, due primarily to the additional cost of undergoing the evaluation for Common Criteria Evaluation Assurance Level 4 and Federal Processing Standards certification for the Firebox Vclass product line in 2003.



We believe that technological leadership is critical to our success, and we
intend to continue to fund our research and development efforts in order to meet the changing requirements of our customers, to provide for continued introduction of new products as technology advances and to enhance and expand our current product
offerings. We expect to continue investments in key areas aimed at the development of new generations of our products, further extension of our existing product lines and the development of future technologies. At the same time, for the remainder of
2003, we expect to maintain or reduce the overall cost of research and development expenses as compared to the third quarter of 2003 as we continue to concentrate on cost control and efficiency initiatives in our research and development activities.
Our actual research and development expenses could differ materially from those anticipated, which could have an adverse effect on our results of operations.



General and Administrative



|                                                             |  | Three MonthsEnded September 30, |       |   | PercentIncrease |   |       | Nine MonthsEnded September 30, |      |   | PercentIncrease |     
|------------------------------------------------------------ |  | ------------------------------- | ----- | - | --------------- | - | ----- | ------------------------------ | ---- | - | --------------- | ----
|                                                             |  | 2002                            |       |   | 2003            |   |       |                                | 2002 |   |                 | 2003
|General and administrative expenses (in thousands)           |  | $                               | 1,786 |   |                 | $ | 1,940 |                                |      | 9 | %               |     
|General and administrative expenses (as % of total revenues) |  |                                 | 9     | % |                 |   | 10    | %                              |      |   |                 |     



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



General and administrative expenses increased in both absolute
dollars and as a percentage of revenue for the three-month period ended September 30, 2003 as compared to the same period of 2002.



General and administrative expenses increased slightly in absolute dollars for the nine-month period ended September 30, 2003 as compared to the same
period of 2002. For the same periods, general and administrative expenses decreased as percentage of revenue, due primarily to improved revenues in 2003 as compared to 2002 and relatively fixed nature of those expenses.



The dollar increase in general and administrative expenses for the three- and
nine-month periods ended September 30, 2003 as compared to the same periods of 2002 reflects relatively stable headcount and related personnel costs coupled with the increase in legal and accounting fees as a result of enhanced corporate governance
requirements, partially offset by a reduction in travel costs.



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For the remainder of 2003, we expect general and administrative expenses, in terms of absolute dollars,
to increase from the level incurred in the third quarter of 2003 as we incur additional expenses in connection with enhanced regulatory and corporate governance requirements relating to additional internal controls and procedures pursuant to Section
404 of the Sarbanes-Oxley Act of 2002. Our actual general and administrative expenses could differ materially from those anticipated, which could have an adverse effect on our results of operations.



Stock-Based Compensation



Stock-based compensation expenses arise from amortization of previously
deferred stock-based compensation over the vesting periods of common stock subject to repurchase and stock options. Stock-based compensation expenses allocated by functional operating expense category were as follows (in thousands):



|                                               |  | Three MonthsEndedSeptember 30, |     | Percent(Decrease) |   |    | Nine MonthsEndedSeptember 30, |     | Percent(Decrease) | 
|---------------------------------------------- |  | ------------------------------ | --- | ----------------- | - | -- | ----------------------------- | --- | ----------------- | 
|                                               |  | 2002                           |     | 2003              |   |    | 2002                          |     | 2003              | 
|Sales and marketing                            |  | $                              | 15  |                   | $ | 4  |                               | (75 | )%                | 
|Research and development                       |  |                                | 244 |                   |   | 15 |                               | (94 | )%                | 
|General and administrative                     |  |                                | 29  |                   |   | 7  |                               | (76 | )%                | 
|                                               |  |                                |     |                   |   |    |                               |     |                   | 
|Total amortization of stock-based compensation |  | $                              | 288 |                   | $ | 26 |                               | (91 | )%                | 
|                                               |  |                                |     |                   |   |    |                               |     |                   | 



Deferred stock-based
compensation is initially recorded as a component of stockholders equity in the amount of the excess of the fair value of our common stock on the date of grant over the exercise price of options and also in the amount of the fair value of our
common stock that we issued in connection with our October 2000 acquisition of Qiave Technologies Corporation (Qiave) and our April 2002 acquisition of RapidStream that is subject to repurchase. In addition, deferred stock-based compensation is
recorded for the fair value of stock options granted to consultants. Deferred stock-based compensation is amortized into expense over the relevant vesting periods using the accelerated method.



Amortization of Other Intangible Assets Acquired



Amortization of other intangible assets acquired consists of amortization of
capitalized technology and other definite-lived intangibles related to our acquisitions of Qiave in 2000 and RapidStream in 2002. We are amortizing the intangible assets on a straight-line basis over useful lives ranging from three to five years.



Amortization of other intangible assets acquired was $1.2
million for the three-month period ended September 30, 2002 and $553,000 for the same period of 2003.



Amortization of other intangible assets acquired was $3.2 million for the nine-month period ended September 30, 2002 and $1.6 million for the same period
of 2003.



The decrease in amortization of other intangible
assets acquired for the three- and nine-month periods ended September 30, 2003 as compared to the same periods of 2002 resulted primarily from the following factors:



| |  | During the fourth quarter of 2002, we developed a business plan that, because of limited resources, constrained further development and integration of the technology we acquired in
connection with our acquisition of Qiave Technologies Corporation in October 2000. Separately, we continued to realize lower than expected revenue from products based on the Qiave technology. As a result, the expected future cash flows were
determined to be insufficient to support the carrying value of the Qiave capitalized technology. We therefore recorded an impairment charge of $6.7 million in the last quarter of 2002 of capitalized technology related to the acquisition of Qiave.
This impairment charge reduced the remaining amortization basis of the Qiave technology, which resulted in the decrease of quarterly amortization expense of approximately $670,000 for the three-month period ended September 30, 2003 as compared to
the same period of 2002 and the decrease of approximately $2.0 million in the nine-month amortization expense for the nine-month period ended September 30, 2003 as compared to the same period of 2002.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | As a result of the acquisition of RapidStream in April of 2002, the amortization expense increased for the nine-month period ended September 30, 2003 as compared to the same period
of 2002, by approximately $500,000 due to the amortization of intangible technology related to this acquisition, as the amortization began in the second quarter of 2002.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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For the remainder of 2003, we expect amortization expense to decrease from the level incurred in the
third quarter of 2003 due to the reduction in the amortizable basis of other intangible assets, caused by the impairment of the technology related to the RapidStream Secured by Check Point product brand, as discussed below.



Impairment of Other Intangible Assets Acquired



In addition to the amortization expense, a partial impairment of the
intangible assets related to 2002 RapidStream acquisition was recorded in the third quarter of 2003.



In accordance with SFAS 144 Accounting for the Impairment or Disposal of Long- Lived Assets, the carrying value of intangible assets is
reviewed on a regular basis for the existence of facts or circumstances, both internal and external, that may suggest impairment. During the third quarter of 2003, it was determined that an impairment existed for the intangible asset associated with
the RapidStream Secured by Check Point product brand based on the technology obtained in the 2002 acquisition of RapidStream. Our increased focus on our core market of small- to medium-size enterprises, resulting in a significant
reduction in our sales, marketing and development efforts in support of this brand, together with the historically poor performance of this brand led management to reduce the future sales projections for the brand. WatchGuard is also evaluating
strategic alternatives for this product. The revised undiscounted expected future cash flows, resulting from the reduced future sales projections, are based on sales of the brand by WatchGuard and do not include any revenue that might be generated
from identifying a strategic alternative. These expected cash flows were determined to be insufficient to recover the carrying value of the related capitalized technology. WatchGuard therefore recorded an impairment charge of $3.3 million determined
based on the estimate of the assets fair value using a discounted cash flow approach.



Acquired In-process Technology



Acquired in-process technology expenses of $1.2 million in the nine-month period ended September 30, 2002 consist of in-process research and development, or IPR&D, expense related to our acquisition of RapidStream.



Restructuring Charges



The restructuring charges in the nine-month periods ended September 30, 2002
are associated with the restructuring plans initiated in 2001 and 2002.



In the second quarter of 2001, we announced a restructuring plan designed to streamline operations and reduce operating costs, which included a reduction in workforce and a consolidation of excess facilities, in addition to other
cost-saving strategies. As part of the restructuring plan, we exited the consumer security market and terminated various original equipment manufacturer agreements to develop products and services for that market, and streamlined operations in
support of new products and services aimed at business customers. In the nine-month period ended September 30, 2002, we recorded additional restructuring charges of $524,000, relating to revised estimates of the costs associated with the
consolidation and sublease of excess facilities.



In the second
quarter of 2002, we implemented a second restructuring plan primarily designed to eliminate redundancies and excess headcount resulting from the acquisition of RapidStream, which included a reduction in workforce, consolidation of excess facilities
and elimination of technology-related contracts that are no longer required or part of our strategy. As a result of this restructuring, we recorded a $3.7 million restructuring charge in the nine-month period ended September 30, 2002.



Interest Income, Net



Interest income, net is generated primarily from our investment of proceeds
from the sale of common stock in our initial public offering in 1999 and our follow-up public offering in February 2000. Net interest income also includes financing costs incurred due to term discounts taken by our customers.



Interest income decreased from $636,000 for the three-month period ended
September 30, 2002 to $122,000 for the same period of 2003. The decrease is caused by both a decrease in the average balance invested and a decline in the average rates of return. Additionally, the decline in net interest revenue was caused by the
increase of approximately $90,000 in financing costs from term discounts taken by our customers.



Interest income decreased from $2.5 million for the nine-month period ended September 30, 2002 to $568,000 for the same period of 2003. These decreases
resulted from all three factors mentioned above. The decline in the invested balance in the nine-month period ended September 30, 2003 was primarily due to cash used for the acquisition of RapidStream in April of 2002. Approximately $350,000 decline
in net interest income is due to the increase in financing costs from term discounts.



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If interest rates stay the same in the future, it is expected that interest income would decline due to
maturing of investments having higher rates than current investments. Additionally, financing costs from term discounts taken by our customers will reduce interest income.



Income Taxes



Income tax expense was zero for the three-month period ended September 30, 2002 and $10,000 for the same period of 2003. Income tax expense was $29,000
for the nine-month period ended September 30, 2002 and $24,000 for the same period of 2003. Income tax primarily relates to our provision for foreign income taxes associated with our international operations. We have experienced losses since
inception, resulting in a net operating loss carry forward position for federal income tax purposes of approximately $193.2 million as of September 30, 2003. These carry forwards, if not utilized, will begin to expire in 2011, and may be subject to
limitations under Section 382 of the Internal Revenue Code of 1986, as amended. In addition, approximately $102.7 million of the net operating losses generated for federal income tax purposes are not available to reduce income tax expense for
financial reporting purposes because the tax effects of tax deductions for employee stock options in excess of the related financial reporting compensation expense are recognized through equity. A valuation allowance has been established to reflect
the uncertainty of generating future taxable income necessary to utilize available tax loss carry forwards.



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Quarterly Results of Operations



The following tables provide our unaudited results of operations expressed both in dollar amounts and as a percentage of
total revenues for each quarter in the five-quarter period ended September 30, 2003. In our opinion, this unaudited information has been prepared on the same basis as our audited consolidated financial statements. This information includes all
adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the information for the quarters presented, when read in conjunction with our unaudited consolidated financial statements and the notes to the
consolidated financial statements. The results of operations for any quarter are not necessarily indicative of our future results.



|                                                                   |  | Three Months Ended                    |       
|------------------------------------------------------------------ |  | ------------------------------------- | ------
|                                                                   |  | Sept. 30,2002                         |       
|                                                                   |  | (In thousands, except per share data) |       
|Consolidated Statements of Operations Data:                        |  |                                       |       
|                                                                   |  |                                       |       
|Revenues:                                                          |  |                                       |       
|Product                                                            |  | $                                     | 14,224
|Service                                                            |  |                                       | 5,851 
|                                                                   |  |                                       |       
|Total revenues                                                     |  |                                       | 20,075
|                                                                   |  |                                       |       
|Cost of revenues:                                                  |  |                                       |       
|Product                                                            |  |                                       | 5,332 
|Service                                                            |  |                                       | 1,509 
|                                                                   |  |                                       |       
|Total cost of revenues                                             |  |                                       | 6,841 
|                                                                   |  |                                       |       
|Gross margin                                                       |  |                                       | 13,234
|                                                                   |  |                                       |       
|Operating expenses:                                                |  |                                       |       
|Sales and marketing                                                |  |                                       | 8,859 
|Research and development                                           |  |                                       | 5,306 
|General and administrative                                         |  |                                       | 1,786 
|Stock-based compensation                                           |  |                                       | 288   
|Amortization of other intangible assets acquired                   |  |                                       | 1,219 
|Impairment of other intangible assets acquired                     |  |                                       |      
|Acquired in-process technology                                     |  |                                       |      
|Restructuring charges                                              |  |                                       |      
|                                                                   |  |                                       |       
|Total operating expenses                                           |  |                                       | 17,458
|                                                                   |  |                                       |       
|Operating loss                                                     |  |                                       | (4,224
|Interest income, net                                               |  |                                       | 636   
|                                                                   |  |                                       |       
|Loss before income taxes                                           |  |                                       | (3,588
|Provision for income taxes                                         |  |                                       |      
|                                                                   |  |                                       |       
|Net loss                                                           |  | $                                     | (3,588
|                                                                   |  |                                       |       
|Basic and diluted net loss per share                               |  | $                                     | (0.11 
|                                                                   |  |                                       |       
|Shares used in calculation of basic and diluted net loss per share |  |                                       | 32,341
|                                                                   |  |                                       |       



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|                                                 |  | Three Months Ended |   
|------------------------------------------------ |  | ------------------ | --
|                                                 |  | Sept. 30,2002      |   
|Consolidated Statements of Operations Data:      |  |                    |   
|                                                 |  |                    |   
|Revenues:                                        |  |                    |   
|Product                                          |  | 70.9               | % 
|Service                                          |  | 29.1               |   
|                                                 |  |                    |   
|Total revenues                                   |  | 100.0              |   
|                                                 |  |                    |   
|Cost of revenues:                                |  |                    |   
|Product                                          |  | 26.6               |   
|Service                                          |  | 7.5                |   
|                                                 |  |                    |   
|Total cost of revenues                           |  | 34.1               |   
|                                                 |  |                    |   
|Gross margin                                     |  | 65.9               |   
|                                                 |  |                    |   
|Operating expenses:                              |  |                    |   
|Sales and marketing                              |  | 44.1               |   
|Research and development                         |  | 26.4               |   
|General and administrative                       |  | 8.9                |   
|Stock-based compensation                         |  | 1.4                |   
|Amortization of other intangible assets acquired |  | 6.1                |   
|Impairment of other intangible assets acquired   |  |                    |   
|Acquired in-process technology                   |  |                   |   
|Restructuring charges                            |  |                   |   
|                                                 |  |                    |   
|Total operating expenses                         |  | 86.9               |   
|                                                 |  |                    |   
|Operating loss                                   |  | (21.0              | ) 
|Interest income, net                             |  | 3.2                |   
|                                                 |  |                    |   
|Loss before income taxes                         |  | (17.8              | ) 
|Provision for income taxes                       |  |                   |   
|                                                 |  |                    |   
|Net loss                                         |  | (17.8              | )%
|                                                 |  |                    |   



During 2002 and the
first nine months of 2003, global economic, political and other uncertainties, as well as constrained corporate information technology spending, appeared to slow the demand for our products and services. We believe that both our revenues and our
operating results for the five-quarter period presented above were negatively affected by the worldwide economic conditions and an overall reduction in capital spending by businesses.



As a result of realigning of our sales and marketing organization and refocusing our distribution and channel partner
strategy in late 2001, we achieved growth in revenues in all quarters of 2002. The sequential decline in revenues in the first, second and third quarters of 2003 was primarily driven by overall economic conditions, the realignment of our APAC sales
organization and channel strategy, competitive pricing for our products, which included the aggressive trade-up and competitive trade-in programs relating to the Firebox III line, and a reduction in overall channel inventory by the end of the third
quarter of 2003. The decline in APAC regional revenue began in the last quarter of 2002. In response to the declining APAC revenues, we focused on rebuilding our regional operation, including strengthening our sales channels and support
infrastructure, as well as localizing some of our products. APAC revenues continued to decline through the first three quarters of 2003. We are continuing our realignment efforts in APAC in the remainder of 2003. These efforts, however, may not be
successful as soon as expected or at all.



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Our gross margins, both in absolute dollars and as a percentage of total revenues, increased sequentially
in the three-quarter period between the third quarter of 2002 and the first quarter of 2003. The gross margin improvements in 2002 were caused by sequential revenue growth and the introduction of new higher-margin, lower-cost products, improved
pricing obtained from original equipment manufacturers and lower provision for inventory reserves. The percentage margin improvement in the first quarter of 2003 is primarily due to a larger percentage of higher-margin service revenues included in
total revenues. The dollar margin improvement in the first quarter of 2003 is attributable to an additional $600,000 of service revenue generated without significant additional costs from our license compliance initiative mentioned above in the
discussion of our service revenues. Gross margins declined sequentially in both dollar and percentage amounts in the second and third quarter of 2003, mostly due to competitive pricing for our products, which included the aggressive trade-up and
competitive trade-in programs relating to the Firebox III line, as well as due to the higher provision for inventory reserves.



The five-quarter trends in components of the total operating expense are as follows:



| |  | Sales and marketing expenses decreased by $230,000 between the third and fourth quarters of 2002, remained relatively comparable to prior levels in the first quarter of 2003, and
declined by $470,000 and by $920,000 in the second and third quarters of 2003 respectively. Higher level of sales and marketing expenses in the third quarter of 2002 was required to support international and domestic rollout of the new Firebox
Vclass product line, launched in the second quarter of 2002 and the introduction of Firebox SOHO 6 products in the third quarter of 2002. The decline in the second quarter of 2003 was primarily due to the decrease in incentive compensation tied to
revenue goals and partially due to the reduction in certain marketing promotional costs, as we attempt to balance those activities with the increase in the sales promotions. Further decrease in sales and marketing costs in the third quarter of 2003
resulted primarily from decrease in discretionary marketing programs, such as advertising, trade shows, public relations and direct marketing, as we were focused on improving the operational efficiency of those activities.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Research and development expenses decreased by $440,000 between the third and fourth quarters of 2002 due to the elimination of redundant resources resulting from RapidStream
acquisition in April of 2002. Our research and development expenses increased sequentially by $350,000 in the first quarter of 2003 and by $120,000 in the second quarter of 2003 compared to the prior quarter, as we devoted more internal and
outsourced resources for new product initiatives and development of new generation technologies. Research and development expenses remained relatively comparable to period levels in the third quarter of 2003.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | General and administrative expenses have been relatively stable for the five-quarter period ended September 30, 2003.
| | - | ---------------------------------------------------------------------------------------------------------------------



| |  | Stock-based compensation charges, primarily associated with our October 2000 acquisition of Qiave and our April 2002 acquisition of RapidStream, have decreased sequentially for all
quarters presented, due to the use of the accelerated method of amortization.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Impairment charges were recorded in the fourth quarter of 2002 for capitalized technology related to the 2000 acquisition of Qiave and in the third quarter of 2003 for RapidStream
Secured by Check Point product brand technology related to the 2002 acquisition of Rapid Stream.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Amortization of other intangible assets acquired decreased from the fourth quarter of 2002 to the first quarter of 2003, due the reduction in amortizable basis of the Qiave
capitalized technology due to impairment of this asset as discussed above.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Restructuring charges were recorded in the fourth quarter of 2002 and were associated with our 2001 and 2002 restructuring plans. In the fourth quarter of 2002, we revised upwards
our estimates of restructuring losses on abandoned facilities due to the declining real estate market conditions in the areas where these excess facilities are located.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Liquidity and Capital Resources



As of September 30, 2003, we had $83.1 million in cash, cash equivalents and short-term investments. The cash equivalents and short-term investments were
invested primarily in high-quality money market accounts and marketable securities. We believe that the market risk arising from our holdings of these financial instruments is not material. We currently have outstanding a $3.0 million unconditional
letter of credit that we issued in September 2000 to our landlord in conjunction with the building lease for our corporate headquarters. Currently, our letter of credit is collateralized by short-term investments with our bank. Our working capital
as of September 30, 2003 was $64.6 million.



Operating
Activities



Our operating activities resulted in net
cash outflows of $5.6 million in the nine-month period ended September 30, 2002, and $5.6 million in the same period of 2003. The operating cash outflows during these periods primarily resulted from significant investments in sales and marketing and
research and development, all of which led to operating losses.



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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, |        
|----------------------------------------------------------- |  | ------------------------------ | -------
|                                                            |  | 2002                           |        
|Net loss                                                    |  | $                              | (19,925
|Add: noncash expenses                                       |  |                                | 7,722  
|Add (Subtract): changes in operating assets and liabilities |  |                                | 6,586  
|                                                            |  |                                |        
|Net cash used in operating activities                       |  | $                              | (5,617 
|                                                            |  |                                |        



The noncash expenses
are associated with the amortization and impairment of other intangible assets acquired, depreciation and amortization of property and equipment, and compensation charges resulting from the issuance of stock options and common stock subject to
repurchase by WatchGuard. In the nine-month period ended September 30, 2002, these expenses also included the cost of acquired in-process technology recorded in connection with the acquisition of RapidStream.



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



| | a) | Trade Accounts Receivable, Netdecreased from $8.8 million at December 31, 2002 to $6.1 million at September 30, 2003, primarily reflecting lower total revenues in the third
quarter of 2003 as compared to the fourth quarter of 2002. Days sales outstanding, or DSOs, calculated on a quarterly basis, decreased from 36 days at December 31, 2002 to 30 days at September 30, 2003. DSOs are affected by the payment terms
contained in our customer contracts, including term discounts taken by our customers and risks associated with the uncertain economy. DSOs also depend on 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). Based on our current sales mix, the linearity of revenues in past and future quarters and timing differences arising from the varying payment terms in our customer
agreements we expect our DSOs to generally range from 40 to 50 days in the future. Any change in these factors, however, could negatively affect expected DSO results.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) | Net Inventoriesremained at the comparable level of $4.4 million at both December 31, 2002 and at September 30, 2003. The increase in gross inventories, due to an expansion
of product offerings resulting from the RapidStream acquisition and introduction of new products in 2002 and 2003, was offset by increases in inventory reserves in 2003.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | c) | Accrued Restructuring and Acquisition Costsdecreased from $9.0 million at December 31, 2002 to $6.1 million at September 30, 2003, due to settlements of an abandoned lease
and a technology-related contract, as well as to the ongoing payment of rents on excess facilities.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | d) | Deferred Revenuedecreased from $18.5 million at December 31, 2002 to $17.1 million at September 30, 2003. The decrease of deferred revenue balance is related to the decrease
in the number of initial service subscriptions bundled with the original product purchases, as the product shipments sequentially declined in the first three quarters of 2003 compared to shipments in the last quarter of 2002.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Investing Activities



Cash provided by investing activities was $1.4 million in the nine-month
period ended September 30, 2002 and $2.2 million in the same period of 2003. In the nine-month period ended September 30, 2003, these activities primarily relate to short-term investment of the proceeds received from our public offerings, offset by
capital expenditures for property and equipment. In the nine-month period ended September 30, 2002, the investing activities also included the net cash consideration paid in connection with the acquisition of RapidStream.



Financing Activities



Cash provided by financing activities totaled $1.0 million in the nine-month
period ended September 30, 2002 and $1.3 million in the same period of 2003. 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.



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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, as well as to provide for potential acquisitions or technology investments, for at least the next 12 months. We may need to seek additional funding before that time
through public or private financings or other arrangements, however, if the underlying assumed levels of spending for other potential acquisitions of or investments in complementary businesses or technologies prove to be inaccurate.



Contractual Obligations and Contingencies



We lease office space and some computer equipment under operating leases
that are not cancelable. Our facilities commitments include a lease for our corporate headquarters in Seattle, Washington, which expires in September 2010. We have the option to extend this lease for an additional five-year term. We also lease a
product fulfillment and distribution warehouse in Seattle with a lease term through April 2006. We lease facilities in Aliso Viejo and San Jose, California and Waltham, Massachusetts under operating leases that expire between 2004 and 2006, in
addition to leases for other sales offices under operating leases or other lease obligations that expire over various terms. Our excess facilities at our corporate headquarters in Seattle, and in Aliso Viejo and San Jose, California, are partially
subleased to tenants, with sublease terms that expire between 2003 and 2010. We also have several operating leases for computer equipment. WatchGuard is also a party to several noncancelable and nonrefundable agreements to purchase inventory.



Our contractual commitments at September 30, 2003 associated
with lease obligations and purchase obligations, net of future minimum rental income from subleases of $2.0 million, are presented below (in thousands). This future rental income from subleases may be adversely affected if the financial condition of
our renters were to deteriorate, resulting in an impairment of their ability to make lease payments.



|                            |  | Payment due by period
|--------------------------- |  | ---------------------
|                            |  | Total                
|                            |  |                      
|Operating lease obligations |  | $                    
|Purchase obligations        |  |                      
|                            |  |                      
|Total                       |  | $                    
|                            |  |                      



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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 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
profitability, which could result in a decline in the value of our common stock.



Since inception, we have incurred net losses and experienced negative cash flows from operations in each quarter, except that we had net income and a positive cash flow from operations in the third quarter of 2000 and
a positive cash flow from operations in the third quarter of 2001. As of September 30, 2003, we had an accumulated deficit of approximately $126 million. Although our revenues have increased each year since we began operations, we may not be able to
continue to grow our revenues as expected and revenues may in fact decrease, and even if we are able to grow our revenues, we do not believe that the historical percentage growth rate of our revenues will be sustainable as our revenue base increases
and we may not achieve or sustain profitability in future periods. 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;
| | - | -----------------------------------



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



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



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



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



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



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



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



The economic downturn in the U.S. economy and in other
economies worldwide has adversely affected the demand for our products and services and may continue to result in decreased revenue and growth rates. We do not know how long this economic downturn will last or whether it will become more severe. We
also cannot predict the extent of the effect of the economic downturn in the United States on economies in other countries and geographic regions in which we conduct business. To the extent that this downturn continues or grows deeper in the United
States or other geographic regions in which we operate, the Internet security industry and demand for our products and services are likely to be adversely affected.



Because a majority of our revenue is recognized when the related product is sold to our channel partners, rather than when
our channel partners sell our products to their customers, our operating results for any quarter or year are affected by the amount of inventory purchases made by our channel partners. Our channel partners level of inventory depends on many
factors beyond our control, including the amount and rate of purchases by their customers and economic and competitive pressures that may be specific to that channel partner or its geographic region. If our channel partners reduce their inventory
levels, or fail to purchase the amount of inventory we expect them to purchase, our operating results could fall below the expectations of securities analysts and investors resulting 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 adjust our spending in time to compensate for any unexpected quarterly or annual shortfall
in revenues. A failure to so adjust our spending in time also could cause operating results to fall below the expectations of securities analysts and investors, resulting in a decline in our stock price.



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



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



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



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



| |  | bad debt;
| | - | ---------



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



| |  | allocation of purchase price in business combinations to intangible assets; and
| | - | -------------------------------------------------------------------------------



| |  | analysis of 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, as provided in
our 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. Examples of such estimates include, but are not limited to, those associated with the costs of our 2001 and 2002 restructuring and impairment analysis of both our RapidStream intangible assets and goodwill relating to our
acquisitions. Although we do not anticipate further significant adjustments to our 2002 restructuring, the actual costs related to the restructuring may differ from estimates if it takes us longer than expected to find suitable tenants or if there
are further changes in the real estate market where excess facilities are located. We periodically review the carrying value of other intangible assets acquired for existence of facts and circumstances, both internal and external, which may suggest
potential impairment. Revenues from the RapidStream Secured by Check Point brand products based on the acquired RapidStream technology have not met our original expectations. It has become clear that this product is not properly aligned
with our increased focus on our core market of small- to medium-size enterprises and we are evaluating strategic alternatives for this product. We therefore recorded an impairment charge of $3.3 million related to the intangible asset associated
with this technology. Actual results may differ from these and other estimates if our assumptions change or if actual circumstances differ from those in our assumptions, which could cause our operating results to fall below the expectations of
securities analysts and investors, resulting in a decline in our stock price.



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



The market for Internet security products is intensely competitive and we expect competition to intensify in the future. An
increase in competitive pressures in our market or our failure to compete effectively has in the past and may in the future result in pricing reductions, reduced gross margins and loss of market share. Currently, the primary competitors in our
industry include Check Point, Cisco Systems, Inc., Fortinet Inc., NetScreen Technologies, Inc., Nokia Corporation, SonicWALL, Inc. and Symantec Corporation. Other competitors offering security products include hardware and software vendors such as
Lucent Technologies, Inc. and Network Associates, Inc., operating system vendors such as Microsoft Corporation, Novell, Inc. and Sun Microsystems, Inc., and a number of smaller companies. Competition has continued to increase and 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, our current and potential competitors may establish
cooperative relationships among themselves or with third parties that may further enhance their resources. As a result, they may 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.



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If we do not retain our key employees, or successfully identify and integrate new employees into our organization
to fill vacancies in positions, our ability to execute our business strategy will be impaired.



Our future success will depend largely on the efforts and abilities of our senior management and our key development, technical, operations, information
systems, customer support and sales and marketing personnel, and on our ability to retain them. These employees are not obligated to continue their employment with us and may leave us at any time. In addition, we have recently hired new senior
management into our Sales organization and have vacancies in some other senior positions. If we are unable to identify and hire employees for these positions, successfully integrate new key employees into our organization, or if our new key
employees are unable to successfully lead our Sales organization, our ability to execute our business strategy will be impaired and our revenues could fall below the expectations of securities analysts and investors, resulting in a decline in our
stock price.



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



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



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



We currently expect that future revenues will be primarily generated through sales of our Firebox products and any
next-generation products that replace these existing products, and the related LiveSecurity Service, including subscription fees, and we cannot succeed if the market does not accept these products and services. Our success depends on our ability and
the ability of our distribution network, which includes distributors, value-added resellers and Internet service providers and other managed service providers, to obtain and retain customers. In addition, our current product lines are based both on
technology that we have developed internally and technology based on the RapidStream technology we acquired in the second quarter of 2002. If we are unsuccessful in effectively integrating these technologies together, or the integration causes us to
lose customers, our future revenues may be adversely affected.



To receive our LiveSecurity Service, enterprises are required to pay an annual subscription fee, either to us or, if they obtain the LiveSecurity Service through one of our channel customers, to the channel customer. We are not aware of any
other Internet security product that allows enterprises to keep their security solution current by receiving software updates and comprehensive security information over the Internet. Enterprises may be unwilling to pay a subscription fee to keep
their Internet security up to date and to receive Internet security-related information. Because our LiveSecurity Service is an innovative service, we may not be able to accurately predict the rate at which our customers will renew their annual
subscriptions. In addition, most businesses implementing security services have traditionally managed their own Internet security rather than using the services of third-party service providers. As a result, our products and services and the
outsourcing of Internet security to third parties may not achieve significant market acceptance. In addition, we offered a third-party service through our LiveSecurity subscription service for the first time in October of 2003. Because this offering
is new and unproven, we may not be able to accurately predict the rate at which our customers will adopt this optional service, and we may not generate significant revenues from this service.



We may not realize any significant benefits from our relationship with Check Point
Software Technologies Ltd. or the RapidStream-branded Secured by Check Point line of products.



Following our acquisition of RapidStream in the second quarter of 2002, we entered into a relationship with Check Point under which we market a line of
products that includes Check Point security software. These products, which are sold under the RapidStream brand as Secured by Check Point, have not achieved market acceptance and have not generated significant revenues. As a result,
although we are continuing to sell and service this line of products, we have significantly reduced our focus on sales, marketing and development efforts in support of this brand. This reduction of focus also led management to conclude that
impairment existed for the underlying capitalized technology related to this product brand, obtained in the 2002 acquisition of RapidStream. As discussed above, we therefore recorded an impairment charge of $3.3 million related to the intangible
asset associated with this technology. We are also investigating other strategic alternatives, but we may be unsuccessful in finding any such alternatives, and this line of products may never generate any significant revenues. In addition, Check
Point is a competitor of ours in the Internet security industry, and our relationship with Check Point is terminable by either party at will. If Check Point discontinues its relationship with us, we may not be able to identify a strategic
alternative for this line of products.



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



We sell most of our products and services
through our distribution network, and we expect our success to continue to depend in large part on the performance of this network. Our channel customers have the ability to sell products and services that are competitive with ours, to devote more
resources to those competitive products or to cease selling our products and services altogether. In addition, our channel partners are subject to the economic and competitive pressures unique to their respective regions, which may adversely affect
their ability to sell our products and services. Two of our channel customers, Ingram Micro and Tech Data, together accounted for 44% of our revenues in the quarter ended September 30, 2003. The loss of one of these distributors, a reduction in
their sales, a reduction in our share of their sales of Internet security products, or a loss or reduction in sales involving one or more other channel customers, particularly if the reduction results in increased sales of competitive products,
could harm our business. In addition, we are in the process of realigning our channel by reducing the number of channel customers with whom we have a direct contract, in some areas and expanding the number in others while expanding our programs for
our indirect partners to improve overall performance and efficiencies. While we have made progress in the Americas and EMEA regions, and some initial progress in the APAC region outside of Japan, we have only recently been successful in making any
progress in Japan. The channel reorganization in the APAC region also includes identifying and hiring additional personnel to assist us in managing the channel. If the realignment and reorganization causes disruption in any region, or we are not
able to continue making progress on the realignment and reorganization in Japan, we could experience a loss or reduction in sales involving one or more of our channel customers. In addition, the aftermath or a renewed spread of severe acute
respiratory syndrome (SARS) in the APAC region may also result in a loss or reduction in sales from our channel customers in that region.



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. The short life cycles of our products and the difficulty of predicting future sales increase the risk that new product introductions, notification of the end-of-life of
existing products or price reductions by us or our competitors could result in significant product returns or price adjustments. When we introduced the Firebox II, and then later the Firebox III, security appliances, we experienced an increase in
returns of previous products and product versions. Provisions for estimated sales returns, price protection rights and promotional rebates were $1.9 million in 2000, $6.9 million in 2001 and $4.6 million in 2002 or 3%, 10% and 6% of total revenues
before the provisions. The provision for estimated sales returns, price protection rights and promotional rebates was $1.7 million, or 8% of revenues, before the provision, in the quarter ended September 30, 2003, and $5.4 million or 8% of total
revenues, before the provision, in the nine-month period ended September 30, 2003. 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 new products or notification of the end-of-life of existing products, the provision may still be inadequate.



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



We outsource
the manufacture of all of our products and these manufacturers obtain component parts for our hardware from a variety of additional manufacturers. While our contract manufacturers and component vendors have produced products and parts for us in
acceptable quantities and with acceptable quality and cost in the past, they may be unable to do so in the future. Companies in the electronics industry regularly experience lower-than-required component allocations, and the industry is subject to
frequent component shortfalls. Although we believe that we could find additional or replacement sources for our contract manufacturing or hardware components, our operations could be disrupted if we have to add or switch to a replacement contract
manufacturer or vendor or if our component supply is interrupted for an extended period. This could result in loss of customer orders and revenue.



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



To succeed, we must continually change and improve our products in response to rapid technological developments and changes in operating systems, Internet access and communications, application and networking
software, computer and communications hardware, programming tools, computer language technology and hacker techniques. We may be unable to successfully and timely develop these new products and services or achieve and maintain market acceptance. The
development of new, technologically advanced products and services is a complex and uncertain process that requires great innovation and the ability to anticipate technological and market trends. Because Internet security technology is complex, it
can require long development and testing periods.



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



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.



Our
domestic and international sales has been and may in the future be lower in the summer months, when businesses often defer purchasing decisions. If a decrease in revenues during these months is not offset by an increase in revenues following these
months, our revenues for that quarter could fall below the expectations of securities analysts and investors, resulting in a decline in our stock price. Also, as a result of customer buying patterns and the efforts of our sales force to meet or
exceed quarterly and year-end quotas, historically we have received a substantial portion of a quarters sales orders and earned a substantial portion of a quarters revenues during the quarters last month and the latter half of the
last month. If expected revenues at the end of any quarter are delayed, our revenues for that quarter could fall below the expectations of securities analysts and investors, resulting in a decline in our stock price.



We may be unable to adequately expand our operational systems to accommodate growth,
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. We may encounter performance difficulties when operating with a substantially greater number of customers. These
performance difficulties could harm our ability to deliver our products and services. An inability to add software and hardware or to develop and upgrade existing technology or operational systems to handle increased traffic may cause unanticipated
system disruptions, slower response times and poor customer service, including problems filling customer orders.



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



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



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



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



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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.



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



Our
success will depend in part on our continued ability to license and use hardware and software technology, including open-source technology, that is important for the functionality of our products. Some of our existing products and planned future
products also utilize entire hardware platforms designed by third parties. In addition, the open source software that we use in our products is governed by standard open source licenses that are subject to differing interpretations within the
industry. To the extent that our interpretation of any open source license is deemed incorrect, or we are otherwise found to be in breach of any such license, our ability to continue to use that open source software may be interrupted. A significant
interruption in the supply of a third-party technology could delay our development and product sales until we can find, license and integrate or manufacture equivalent technology. This could damage our brand and result in loss of current and
potential customers. Although we believe that we could find other sources for the technology we license, alternative technologies may be unavailable on acceptable terms, if at all. We depend on our third-party licensors to deliver reliable,
high-quality products, develop new products on a timely and cost-effective basis and respond to evolving technology and changes in industry standards. We also depend on the continued compatibility of our third-party software with future versions of
our products.



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



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



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



Despite our efforts to protect our proprietary rights, unauthorized parties may misappropriate or infringe on our trade secrets, copyrights,
trademarks, service marks and similar proprietary rights. We face additional risk when conducting business in countries that have poorly developed or inadequately enforced intellectual property laws, particularly those in which we outsource
engineering or technical expertise as those activities entail greater exposure of our proprietary technology. 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. In addition, because licenses governing the use of open source software in our products in some circumstances require sharing of improvements on the open
source software, we face the risk that portions of our software that we regard as proprietary may be deemed subject to the open source licenses and therefore subject to public disclosure.



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If we fail to obtain and maintain patent protection for our technology, we may be unable to compete
effectively. We have 4 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.



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.
| | - | ---------------------------------------------------------------------



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



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



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



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.
| | - | ----------------------------------------------------------------



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.



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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 47% and 50% of our revenues in the three- and nine-month periods ended September 30, 2003 respectively. 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 or those requiring local content;
| | - | -----------------------------------------------------------------------------------------------------------------------------



| |  | 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, an increase in the value of the U.S. dollar relative to foreign currencies has
made and may continue to make our products less competitive in international markets.



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



Our future revenues may 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.
| | - | ---------------------------



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, as well as to provide for potential acquisitions or technology investments, 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.
| | - | ---------------------------------------------



Financing 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.



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|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 nine-month period ended September 30, 2003 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.



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



The term disclosure controls and procedures is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, or the
Exchange Act. These rules refer to the controls and other procedures of a company that are designed to ensure that the information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded,
processed, summarized and reported within required time periods. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our Exchange Act reports is
accumulated and communicated to management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.



Our chief executive officer and our chief financial officer have evaluated
the effectiveness of our disclosure controls and procedures as of the end of the period covered by this quarterly report, and they have concluded that, as of that date, our disclosure controls and procedures were effective.



There were no significant changes to our internal controls during the period
covered by this quarterly report that have materially affected, or are reasonably likely to materially affect, our internal controls.



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PART II. OTHER INFORMATION



|ITEM4. |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS
|------ |  | ---------------------------------------------------



None



|ITEM6. |  | EXHIBITS AND REPORTS ON FORM 8-K
|------ |  | --------------------------------



(a) Exhibits



| | 3.1 | Restated Certificate of Incorporation of WatchGuard Technologies, Inc. (incorporated by reference to Exhibit 3.1 to WatchGuards Registration Statement on Form S-1 (file number
333-78813), filed July 30, 1999).
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 3.2 | Restated Bylaws of WatchGuard Technologies, Inc. (incorporated by reference to Exhibit 3.2 to WatchGuards Registration Statement on Form S-1 (file number 333-78813), filed
July 30, 1999).
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 10.1 | Offer letter to Dale Bastian dated July 8, 2003.
| | ---- | ------------------------------------------------



| | 31.1 | Certification of Chief Executive Officer required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.
| | ---- | -----------------------------------------------------------------------------------------------------------------------------------------



| | 31.2 | Certification of Chief Financial Officer required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.
| | ---- | -----------------------------------------------------------------------------------------------------------------------------------------



| | 32.1 | Certifications of Chief Executive Officer and Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C.
Section 1350.
| | ---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



(b) Reports Filed on Form 8-K



We did not file any current reports on Form 8-K with the
SEC during the three-month period ended September 30, 2003.



(c) Reports
Furnished on Form 8-K



We furnished current reports on
Form 8-K to the SEC on (i) July 7, 2003 announcing our preliminary financial results for the three-month period ended June 30, 2003 and (ii) July 24, 2003 announcing our financial results for the three-month period ended June 30, 2003.



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SIGNATURES



Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.



November 13, 2003



WATCHGUARD TECHNOLOGIES, INC.By:

/s/ Michael E. McConnellMichael E. McConnellSenior Vice President, Chief FinancialOfficer and Treasurer(Principal Financial and Accounting Officer)




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WATCHGUARD TECHNOLOGIES, INC.



INDEX TO EXHIBITS



|Exhibit |  | Description                                                                                                                                                                                                       
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|        | 
|3.1     |  | Restated Certificate of Incorporation of WatchGuard Technologies, Inc. (incorporated by reference to Exhibit 3.1 to WatchGuards Registration Statement on Form S-1 (file
number 333-78813), filed July 30, 1999).
|        | 
|3.2     |  | Restated Bylaws of WatchGuard Technologies, Inc. (incorporated by reference to Exhibit 3.2 to WatchGuards Registration Statement on Form S-1 (file number 333-78813), filed
July 30, 1999).                      
|        | 
|10.1    |  | Offer letter to Dale Bastian dated July 8, 2003.                                                                                                                                                                  
|        | 
|31.1    |  | Certification of Chief Executive Officer required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.                                                                         
|        | 
|31.2    |  | Certification of Chief Financial Officer required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.                                                                         
|        | 
|32.1    |  | Certifications of Chief Executive Officer and Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934, as amended, and 18
U.S.C. Section 1350.                





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