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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



FORM 10-Q



Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange
Act of 1934



For the quarterly period ended March 31, 2005



Commission File Number 000-26819



WATCHGUARD TECHNOLOGIES, INC.

(Exact Name of Registrant as Specified in Its Charter)



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



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

(Address of Principal Executive Offices) (Zip Code)



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



Not Applicable

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



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



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



33,788,608 shares of WatchGuard common stock were outstanding as of April 30, 2005.



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##### Table of Contents



WATCHGUARD TECHNOLOGIES,
INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED MARCH 31, 2005



TABLE OF CONTENTS



|                              |  |                                                                                       |  |   
|----------------------------- |  | ------------------------------------------------------------------------------------- |  | --
|PART I. FINANCIAL INFORMATION |  |                                                                                      
|                              |  |                                                                                      
|ITEM 1.                       |  | FINANCIAL STATEMENTS                                                                  |  | 3 
|                              |  |                                                                                      
|ITEM 2.                       |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS |  | 13
|                              |  |                                                                                      
|ITEM 3.                       |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            |  | 35
|                              |  |                                                                                      
|ITEM 4.                       |  | CONTROLS AND PROCEDURES                                                               |  | 35
|                              | 
|PART II. OTHER INFORMATION    |  |                                                                                      
|                              |  |                                                                                      
|ITEM 1.                       |  | LEGAL PROCEEDINGS                                                                     |  | 37
|                              |  |                                                                                      
|ITEM 6.                       |  | EXHIBITS                                                                              |  | 37



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PART I. FINANCIAL INFORMATION



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



WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)



|                                                                                                |  |                   |          |   |                |   |          |  
|----------------------------------------------------------------------------------------------- |  | ----------------- | -------- | - | -------------- | - | -------- | -
|                                                                                                |  | December 31, 2004 |          |   | March 31, 2005 |  
|                                                                                                |  |                   |          |   | (unaudited)    |  
|ASSETS                                                                                          |  |                   |          |   |                |   |          |  
|Current assets:                                                                                 |  |                   |          |   |                |   |          |  
|Cash and cash equivalents                                                                       |  | $                 | 4,660    |   |                | $ | 8,067    |  
|Short-term available-for-sale investments                                                       |  |                   | 72,189   |   |                |   | 65,522   |  
|Trade accounts receivable, net                                                                  |  |                   | 7,305    |   |                |   | 6,811    |  
|Inventories, net                                                                                |  |                   | 3,145    |   |                |   | 4,800    |  
|Prepaid expenses and other current assets                                                       |  |                   | 2,780    |   |                |   | 2,970    |  
|                                                                                                |  |                   |          |   |                |   |          |  
|Total current assets                                                                            |  |                   | 90,079   |   |                |   | 88,170   |  
|Property and equipment, net                                                                     |  |                   | 6,303    |   |                |   | 5,714    |  
|Restricted cash                                                                                 |  |                   | 3,000    |   |                |   | 3,000    |  
|Goodwill                                                                                        |  |                   | 66,605   |   |                |   | 66,605   |  
|Other intangibles, net and other assets                                                         |  |                   | 2,494    |   |                |   | 2,234    |  
|                                                                                                |  |                   |          |   |                |   |          |  
|Total assets                                                                                    |  | $                 | 168,481  |   |                | $ | 165,723  |  
|                                                                                                |  |                   |          |   |                |   |          |  
|                                                                                                |  |                  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                            |  |                   |          |   |                |   |          |  
|Current liabilities:                                                                            |  |                   |          |   |                |   |          |  
|Accounts payable                                                                                |  | $                 | 3,214    |   |                | $ | 2,923    |  
|Accrued expenses and other liabilities                                                          |  |                   | 7,581    |   |                |   | 9,516    |  
|Short-term accrued restructuring costs                                                          |  |                   | 1,289    |   |                |   | 1,129    |  
|Short-term deferred revenues                                                                    |  |                   | 17,402   |   |                |   | 16,833   |  
|                                                                                                |  |                   |          |   |                |   |          |  
|Total current liabilities                                                                       |  |                   | 29,486   |   |                |   | 30,401   |  
|Long-term deferred rent                                                                         |  |                   | 1,447    |   |                |   | 1,415    |  
|Long-term accrued restructuring costs                                                           |  |                   | 3,599    |   |                |   | 3,444    |  
|Long-term deferred revenues                                                                     |  |                   | 1,818    |   |                |   | 2,067    |  
|                                                                                                |  |                   |          |   |                |   |          |  
|Total liabilities                                                                               |  |                   | 36,350   |   |                |   | 37,327   |  
|Stockholders equity:                                                                           |  |                   |          |   |                |   |          |  
|Preferred stock, $0.001 par value:                                                              |  |                   |          |   |                |   |          |  
|Authorized shares: 10,000,000                                                                   |  |                   |          |   |                |   |          |  
|No shares issued and outstanding                                                                |  |                   |         |   |                |   |         |  
|Common stock, $0.001 par value:                                                                 |  |                   |          |   |                |   |          |  
|Authorized shares: 80,000,000                                                                   |  |                   |          |   |                |   |          |  
|Shares issued and outstanding: 33,677,830 at December 31, 2004 and 33,788,281 at March 31, 2005 |  |                   | 34       |   |                |   | 34       |  
|Additional paid-in capital                                                                      |  |                   | 270,282  |   |                |   | 270,628  |  
|Accumulated other comprehensive loss                                                            |  |                   | (226     | ) |                |   | (389     | )
|Accumulated deficit                                                                             |  |                   | (137,959 | ) |                |   | (141,877 | )
|                                                                                                |  |                   |          |   |                |   |          |  
|Total stockholders equity                                                                      |  |                   | 132,131  |   |                |   | 128,396  |  
|                                                                                                |  |                   |          |   |                |   |          |  
|Total liabilities and stockholders equity                                                      |  | $                 | 168,481  |   |                | $ | 165,723  |  
|                                                                                                |  |                   |          |   |                |   |          |  

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See accompanying
notes.



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WATCHGUARD TECHNOLOGIES,
INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(unaudited)



|                                                                   |  |                             |        |   |      |   |        |  
|------------------------------------------------------------------ |  | --------------------------- | ------ | - | ---- | - | ------ | -
|                                                                   |  | Three Months EndedMarch 31, |       
|                                                                   |  | 2004                        |        |   | 2005 |  
|                                                                   |  | (restated)                  |        |   |      |  
|Revenues:                                                          |  |                             |        |   |      |   |        |  
|Product                                                            |  | $                           | 13,644 |   |      | $ | 9,131  |  
|Service                                                            |  |                             | 6,562  |   |      |   | 7,484  |  
|                                                                   |  |                             |        |   |      |   |        |  
|Total revenues                                                     |  |                             | 20,206 |   |      |   | 16,615 |  
|                                                                   |  |                             |        |   |      |   |        |  
|Cost of revenues:                                                  |  |                             |        |   |      |   |        |  
|Product                                                            |  |                             | 6,397  |   |      |   | 4,083  |  
|Service                                                            |  |                             | 1,344  |   |      |   | 1,471  |  
|                                                                   |  |                             |        |   |      |   |        |  
|Total cost of revenues                                             |  |                             | 7,741  |   |      |   | 5,554  |  
|                                                                   |  |                             |        |   |      |   |        |  
|Gross margin                                                       |  |                             | 12,465 |   |      |   | 11,061 |  
|                                                                   |  |                             |        |   |      |   |        |  
|Operating expenses:                                                |  |                             |        |   |      |   |        |  
|Sales and marketing                                                |  |                             | 8,395  |   |      |   | 7,946  |  
|Research and development                                           |  |                             | 4,539  |   |      |   | 4,443  |  
|General and administrative                                         |  |                             | 2,263  |   |      |   | 2,756  |  
|Amortization of other intangible assets                            |  |                             | 244    |   |      |   | 244    |  
|                                                                   |  |                             |        |   |      |   |        |  
|Total operating expenses                                           |  |                             | 15,441 |   |      |   | 15,389 |  
|                                                                   |  |                             |        |   |      |   |        |  
|Operating loss                                                     |  |                             | (2,976 | ) |      |   | (4,328 | )
|Interest and other income, net                                     |  |                             | 266    |   |      |   | 452    |  
|                                                                   |  |                             |        |   |      |   |        |  
|Loss before income taxes                                           |  |                             | (2,710 | ) |      |   | (3,876 | )
|Provision for income taxes                                         |  |                             | 14     |   |      |   | 42     |  
|                                                                   |  |                             |        |   |      |   |        |  
|Net loss                                                           |  | $                           | (2,724 | ) |      | $ | (3,918 | )
|                                                                   |  |                             |        |   |      |   |        |  
|Basic and diluted net loss per share                               |  | $                           | (0.08  | ) |      | $ | (0.12  | )
|                                                                   |  |                             |        |   |      |   |        |  
|Shares used in calculation of basic and diluted net loss per share |  |                             | 33,250 |   |      |   | 33,717 |  
|                                                                   |  |                             |        |   |      |   |        |  

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See accompanying
notes.



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WATCHGUARD TECHNOLOGIES,
INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)



|                                                                                                          |  |                             |        |   |      |   |         |  
|--------------------------------------------------------------------------------------------------------- |  | --------------------------- | ------ | - | ---- | - | ------- | -
|                                                                                                          |  | Three Months EndedMarch 31, |       
|                                                                                                          |  | 2004                        |        |   | 2005 |  
|                                                                                                          |  | (restated)                  |        |   |      |  
|Operating activities:                                                                                     |  |                             |        |   |      |   |         |  
|Net loss                                                                                                  |  | $                           | (2,724 | ) |      | $ | (3,918  | )
|Adjustments to reconcile net loss to net cash used in operating activities:                               |  |                             |        |   |      |   |         |  
|Noncash expenses:                                                                                         |  |                             |        |   |      |   |         |  
|Depreciation and amortization of property and equipment                                                   |  |                             | 762    |   |      |   | 656     |  
|Amortization of other intangible assets                                                                   |  |                             | 244    |   |      |   | 244     |  
|Stock-based compensation                                                                                  |  |                             | 11     |   |      |   |        |  
|Changes in operating assets and liabilities:                                                              |  |                             |        |   |      |   |         |  
|Trade accounts receivable, net                                                                            |  |                             | (1,126 | ) |      |   | 494     |  
|Inventories, net                                                                                          |  |                             | (582   | ) |      |   | (1,655  | )
|Prepaid expenses and other current assets                                                                 |  |                             | 666    |   |      |   | (190    | )
|Other assets                                                                                              |  |                             | 6      |   |      |   | 17      |  
|Accounts payable                                                                                          |  |                             | 499    |   |      |   | (291    | )
|Accrued expenses, other liabilities and deferred rent                                                     |  |                             | (358   | ) |      |   | 1,902   |  
|Accrued restructuring costs                                                                               |  |                             | (528   | ) |      |   | (315    | )
|Deferred revenues                                                                                         |  |                             | 1,125  |   |      |   | (320    | )
|                                                                                                          |  |                             |        |   |      |   |         |  
|Net cash used in operating activities                                                                     |  |                             | (2,005 | ) |      |   | (3,376  | )
|                                                                                                          |  |                             |        |   |      |   |         |  
|                                                                                                          |  |                            
|Investing activities:                                                                                     |  |                             |        |   |      |   |         |  
|Purchases of property and equipment                                                                       |  |                             | (471   | ) |      |   | (67     | )
|Proceeds from maturities of marketable securities                                                         |  |                             | 9,115  |   |      |   | 26,647  |  
|Purchases of marketable securities                                                                        |  |                             | (7,231 | ) |      |   | (20,143 | )
|                                                                                                          |  |                             |        |   |      |   |         |  
|Net cash provided by investing activities                                                                 |  |                             | 1,413  |   |      |   | 6,437   |  
|                                                                                                          |  |                             |        |   |      |   |         |  
|                                                                                                          |  |                            
|Financing activities:                                                                                     |  |                             |        |   |      |   |         |  
|Proceeds from stock option exercises and issuances of common stock under the employee stock purchase plan |  |                             | 1,390  |   |      |   | 346     |  
|                                                                                                          |  |                             |        |   |      |   |         |  
|Net cash provided by financing activities                                                                 |  |                             | 1,390  |   |      |   | 346     |  
|                                                                                                          |  |                             |        |   |      |   |         |  
|Net increase in cash and cash equivalents                                                                 |  |                             | 798    |   |      |   | 3,407   |  
|Cash and cash equivalents at beginning of period                                                          |  |                             | 3,899  |   |      |   | 4,660   |  
|                                                                                                          |  |                             |        |   |      |   |         |  
|Cash and cash equivalents at end of period                                                                |  | $                           | 4,697  |   |      | $ | 8,067   |  
|                                                                                                          |  |                             |        |   |      |   |         |  

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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 e-commerce and secure communications.



Interim Financial Information



The accompanying consolidated unaudited financial statements of WatchGuard, including the December 31, 2004 balance sheet
that was derived from audited consolidated financial statements, have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Rule
10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the unaudited financial statements
include all adjustments, consisting of normal recurring accruals, necessary for a fair presentation. Operating results for the three months ended March 31, 2005 are not necessarily indicative of the results that may be expected for future quarters
or for the year ending December 31, 2005. The financial statements should be read in conjunction with the financial statements and related notes for the year ended December 31, 2004 included in WatchGuards annual report on Form 10-K, filed
with the Securities and Exchange Commission (SEC) on March 31, 2005.



Restatement of Prior Period Information



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



NOTE 2  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



Principles of Consolidation



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



Revenue
Recognition



WatchGuard generates revenues through
sales of its Firebox products, licenses and subscriptions for related software options and services, and subscriptions for its LiveSecurity Service which includes access to technical support, software updates (if and when available), early-warning
vulnerability alerts and expert instruction and training.



Because each Firebox hardware product contains embedded software, whereby significant software development costs are incurred in developing the embedded software, and because the Firebox and the embedded software includes the rights to
receive technical support and software updates on an if, and when, available basis, WatchGuard recognizes revenue in accordance with accounting standards for software companies, including Statement of Position (SOP) 97-2, Software Revenue
Recognition, as amended by SOP 98-9, and related interpretations, including Technical Practice Aids and the SEC Topic 13, Revenue Recognition of the codification of the Staff Accounting Bulletins. Topic 13 summarizes certain of the
SECs views in applying generally accepted accounting principles to revenue recognition in financial statements. WatchGuard believes its revenue recognition policies and practices are consistent with the accounting standards.



Software license revenues are generated from licensing the rights to use
WatchGuards products directly to end-users, from sublicense fees from resellers and distributors and from sales of WatchGuards managed security solution products to Internet service providers and other service providers that utilize
WatchGuards products to provide managed security services to their customers.



Most of WatchGuards Firebox products and certain software products include an initial period of service subscription bundled in the product price. Because the timing of revenue recognition differs between the
product and the service subscription, the related revenues must be allocated to the product and the subscription service. The allocation of revenues is determined by using the residual method, as defined in SOP 98-9, if vendor-specific objective
evidence of fair value for undelivered elements of the arrangement (typically services) has been established. Under the residual method, the amounts allocated to the undelivered elements (typically services) are equal to their fair value, as
established by vendor-specific objective evidence. The residual revenues in the arrangement are then allocated to the delivered elements (typically products). Vendor-specific objective evidence of fair value is based on the price charged when an
element is sold separately or, if an element is not yet sold separately, on the price established by authorized management, if it is probable that the price, once established, will not



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



change before the element is separately introduced into the marketplace. Prior to recognizing any revenues, WatchGuard ensures that there is persuasive
evidence of the arrangement, collection is probable, and the fee is fixed or determinable.



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



During the first quarter of 2005, WatchGuard negotiated changes in contractual obligations with certain channel customers in
North America, Australia and New Zealand which provided such customers with unlimited return rights. The changes were triggered by the need to offer promotional programs to give WatchGuard the flexibility in the respective markets to be more
competitive, responsive and effective. As a result, WatchGuard converted these customers to a sell through method beginning in the first quarter of 2005. When a channel customer is converted from the sell in method to the sell through method of
revenue recognition, revenue can no longer be recognized when product is sold to the channel customer, while revenue from products already in that channel customers inventory was already recognized in the prior periods. Therefore, revenue on
individual inventory items sold subsequent to the conversion can only be recognized after the converted channel customer has disposed of their inventories predating the conversion. As of December 31, 2004, the converted customers held inventories,
the revenues from which were $2.3 million and were recognized by WatchGuard during 2004. During the first quarter of 2005, these customers sold through approximately $2.0 million of these inventories with approximately $0.3 million carried over to
later quarters. While the contractual changes and the resulting conversion of these customers from a sell in method to a sell through method of revenue recognition resulted in a reduction of revenues during the first quarter of 2005, the effect of
this reduction cannot be measured reliably due to a change in customer buying pattern upon conversion to the sell through method.



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



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



Stock-Based Compensation



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



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



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



Pro Forma Disclosures Under SFAS 123



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



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



|                                                                          |  |                             |        |   |      |   |        |  
|------------------------------------------------------------------------- |  | --------------------------- | ------ | - | ---- | - | ------ | -
|                                                                          |  | Three Months EndedMarch 31, |       
|                                                                          |  | 2004                        |        |   | 2005 |  
|                                                                          |  | (restated)                  |        |   |      |  
|Net loss  as reported                                                    |  | $                           | (2,724 | ) |      | $ | (3,918 | )
|Add: stock-based compensation, as reported                                |  |                             | 11     |   |      |   |       |  
|Deduct: stock-based compensation determined under fair-value-based method |  |                             | (2,852 | ) |      |   | (1,734 | )
|                                                                          |  |                             |        |   |      |   |        |  
|Net loss  pro forma                                                      |  | $                           | (5,565 | ) |      | $ | (5,652 | )
|                                                                          |  |                             |        |   |      |   |        |  
|Net loss per share, basic and diluted  as reported                       |  | $                           | (0.08  | ) |      | $ | (0.12  | )
|Net loss per share, basic and diluted  pro forma                         |  | $                           | (0.17  | ) |      | $ | (0.17  | )



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



In April 2005, the SEC delayed the
effective date of SFAS 123(R) such that each company that is not a small business issuer will be required to prepare financial statements in accordance with SFAS 123(R) no later than the first interim reporting period of the companys first
fiscal year beginning on or after June 15, 2005. WatchGuard is currently evaluating valuation models and the transition provisions of this standard. WatchGuard has not yet decided as of which date it will adopt the provisions of SFAS 123(R).



As permitted by SFAS 123, WatchGuard currently accounts for
share-based payments to employees using APB Opinion No. 25s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123(R)s fair value method will have
a significant effect on WatchGuards operating results. The effect of adoption of SFAS 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had WatchGuard adopted SFAS
123(R) in prior periods, the effect of that standard would have approximated the amounts of pro forma stock compensation expense reflected in accordance with SFAS 123 in the disclosure of pro forma net income and earnings per share in Note 1 to
these consolidated financial statements.



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.



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



Comprehensive Loss



WatchGuards investments consist of commercial paper, corporate and government debt securities and auction rate
securities. WatchGuards investment securities are considered available-for-sale, and are stated at fair value, with unrealized gains and losses included as a component of stockholders equity. During the three months ended March 31, 2004
and March 31, 2005, 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 EndedMarch 31, |       
|                               |  | 2004                        |        |   | 2005 |  
|                               |  | (restated)                  |        |   |      |  
|Net loss                       |  | $                           | (2,724 | ) |      | $ | (3,918 | )
|Unrealized loss on investments |  |                             | (10    | ) |      |   | (163   | )
|                               |  |                             |        |   |      |   |        |  
|Comprehensive loss             |  | $                           | (2,734 | ) |      | $ | (4,081 | )
|                               |  |                             |        |   |      |   |        |  



Reclassifications



Certain prior-period
items have been reclassified to conform to the current-period presentation, including the reclassification of (i) customer early pay incentive discounts from interest expense to product revenues, (ii) certain leasehold improvements previously netted
against the related deferred rent liability from accrued expenses and other liabilities to property and equipment, and (iii) certain deferred rent liabilities from accrued expenses and other liabilities to long-term deferred rent.



NOTE 3  BALANCE SHEET ACCOUNT DETAIL



Trade Accounts Receivable, Net



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



|                                   |  |                  |        |   |               |   |        |  
|---------------------------------- |  | ---------------- | ------ | - | ------------- | - | ------ | -
|                                   |  | December 31,2004 |        |   | March 31,2005 |  
|Trade accounts receivable          |  | $                | 9,874  |   |               | $ | 9,120  |  
|Reserve for returns and allowances |  |                  | (2,299 | ) |               |   | (2,069 | )
|Allowance for doubtful accounts    |  |                  | (270   | ) |               |   | (240   | )
|                                   |  |                  |        |   |               |   |        |  
|                                   |  | $                | 7,305  |   |               | $ | 6,811  |  
|                                   |  |                  |        |   |               |   |        |  



Inventories, Net



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



|                    |  |                  |       |   |               |   |       |  
|------------------- |  | ---------------- | ----- | - | ------------- | - | ----- | -
|                    |  | December 31,2004 |       |   | March 31,2005 |  
|Finished goods      |  | $                | 2,570 |   |               | $ | 3,483 |  
|Components          |  |                  | 1,510 |   |               |   | 2,194 |  
|                    |  |                  |       |   |               |   |       |  
|                    |  |                  | 4,080 |   |               |   | 5,677 |  
|Inventory allowance |  |                  | (935  | ) |               |   | (877  | )
|                    |  |                  |       |   |               |   |       |  
|                    |  | $                | 3,145 |   |               | $ | 4,800 |  
|                    |  |                  |       |   |               |   |       |  



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



Accrued Expenses and Other Liabilities



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



|                                     |  |                  |       |               |   |      
|------------------------------------ |  | ---------------- | ----- | ------------- | - | -----
|                                     |  | December 31,2004 |       | March 31,2005
|Accrued payroll-related liabilities  |  | $                | 2,811 |               | $ | 2,814
|Deposits from sell through customers |  |                  | 1,039 |               |   | 2,441
|Other accrued liabilities            |  |                  | 3,731 |               |   | 4,261
|                                     |  |                  |       |               |   |      
|                                     |  | $                | 7,581 |               | $ | 9,516
|                                     |  |                  |       |               |   |      



NOTE 4  GUARANTEES



WatchGuards operating lease for its corporate
headquarters includes a collateral restriction that requires WatchGuard to maintain an irrevocable standby letter of credit issued to WatchGuards landlord and secured by restricted cash. At December 31, 2004 and at March 31, 2005,
WatchGuards restricted cash balance was $3 million in conjunction with this facilities lease.



WatchGuards hardware products carry a one-year warranty from the delivery date that includes factory repair services or replacement products as
needed. WatchGuard accrues estimated expenses for warranty obligations at the time that products are shipped based on historical product repair and replacement information. WatchGuards liability is affected by the warranty terms provided to
WatchGuard by the original equipment manufacturers ranging from 16 to 24 months from the manufacture date. Other factors that affect WatchGuards warranty liability include the number of installed units, historical rates of warranty claims and
cost per claim. WatchGuard periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary. WatchGuards estimated product warranty liability was $530,000 and $486,000 at December 31, 2004 and at
March 31, 2005, respectively.



Changes to WatchGuards
estimated product warranty liability during the three months ended March 31, 2005 were as follows (in thousands):



|                                                        |  |   |      |  
|------------------------------------------------------- |  | - | ---- | -
|Balance at December 31, 2004                            |  | $ | 530  |  
|Additions charged to cost of revenues during the period |  |   | 65   |  
|Settlements made during the period                      |  |   | (109 | )
|                                                        |  |   |      |  
|Balance at March 31, 2005                               |  | $ | 486  |  
|                                                        |  |   |      |  



NOTE 5  BUSINESS
RESTRUCTURINGS



2001 Restructuring



In the second quarter of 2001, WatchGuard announced a
restructuring plan designed to streamline operations and reduce operating costs. All costs related to this restructuring have been paid or settled, except for accrued amounts related to losses for the lease commitments, net of estimated proceeds
from subleases of abandoned facilities, which are expected to be paid through 2010. The accrued liabilities relating to this restructuring at December 31, 2004 and at March 31, 2005, and activity recorded through March 31, 2005, are as follows (in
thousands):



|                               |  |                   |       |                        |   |      |                |  |   |      
|------------------------------ |  | ----------------- | ----- | ---------------------- | - | ---- | -------------- |  | - | -----
|                               |  | December 31, 2004 |       | Amounts Paidor Charged |   |      | March 31, 2005
|Abandoned facilities and other |  | $                 | 1,492 |                        | $ | (126 | )              |  | $ | 1,366
|                               |  |                   |       |                        |   |      |                |  |   |      



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



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. in April 2002, which included a reduction in workforce, consolidation of excess facilities and elimination of technology-related contracts that are no longer required or part of
WatchGuards strategy. All costs related to this restructuring have been paid or settled, except for accrued amounts related to losses for the lease commitments, net of estimated proceeds from subleases of abandoned facilities, which are
expected to be paid through 2010. The accrued liabilities relating to this restructuring at December 31, 2004 and at March 31, 2005, and activity recorded through March 31, 2005, are as follows (in thousands):



|                               |  |                   |       |                        |   |      |                |  |   |      
|------------------------------ |  | ----------------- | ----- | ---------------------- | - | ---- | -------------- |  | - | -----
|                               |  | December 31, 2004 |       | Amounts Paidor Charged |   |      | March 31, 2005
|Abandoned facilities and other |  | $                 | 3,396 |                        | $ | (189 | )              |  | $ | 3,207
|                               |  |                   |       |                        |   |      |                |  |   |      



NOTE 6  CONTINGENCIES



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



Intellectual Property Employment Litigation



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



NOTE 7
 SUBSEQUENT EVENTS



Revisions to Compensation
Plans



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



Under the stock option exchange program, holders of eligible options have the opportunity to exchange their options with exercise prices of $6.00 or more for a lesser number of replacement options having an exercise
price equal to the fair market value of WatchGuards common stock on the grant date of the replacement options, currently expected to be May 19, 2005. The exchange ratio is 90% for options with an exercise price from $6.00 to $8.00 per share,
75% for options with an exercise price from $8.01 to $10.00 per share, and 33.3% for options with an exercise price of $10.01 or more. Each replacement option will be vested and exercisable upon grant to the same degree as the original option on the
same date. WatchGuard will not return net options that are eliminated as a result of the reduction in the number of options outstanding to the pool of



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



options available to be granted. In addition, when the exchange program is consummated, WatchGuard will eliminate all shares available for grant pursuant to
non-shareholder-approved stock option plans, which would further reduce the number of shares available for grant under its option plans by approximately 4.4 million shares. For financial reporting purposes, WatchGuard expects to account for all
replacement stock options, as well as all options that were subject to the exchange program but were retained by employees, using variable accounting until adoption of SFAS 123(R). Under variable accounting, cumulative stock compensation expense at
any balance sheet date would equal accumulated amortization of the current intrinsic value of the outstanding variable stock awards over their vesting periods. Upon adoption of SFAS 123(R), in accordance with its rules, the amount of stock
compensation expense will be fixed based on initial estimated fair values of the replacement stock options and amortized over the remaining vesting periods of these options. Stock compensation expense recognized until adoption of SFAS 123(R) using
variable accounting will not be reversed upon adoption.



The
new stock ownership program for executive officers and non-employee directors provides for voluntary purchases of WatchGuards capital stock to be matched by WatchGuard in the form of a restricted stock grant equal to 50% of the number of
shares purchased in the open market, up to a maximum of 5,000 matching restricted shares per participant per year. The matching restricted shares granted by WatchGuard will vest annually over three years, and any unvested matching restricted stock
shares will be forfeited if the shares that were matched are sold.



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



Class-Action Securities Litigation



On April 8, 2005, a holder of WatchGuard common stock, on behalf of himself
and purportedly on behalf of a class of WatchGuard stockholders, filed an action in the United States District Court for the Western District of Washington against WatchGuard and some of its current and former officers, alleging violations of the
federal securities laws arising out of, among other things, its announcement on March 15, 2005 that it was restating some of its financial results for interim periods of 2004; related actions have been subsequently filed, which together with the
April 8, 2005 action are referred to as the Action. Pursuant to Delaware law, WatchGuard is obligated to indemnify its officers in connection with the Action, and have insurance for such individuals, to the extent of the limits of the applicable
insurance policies and subject to potential reservations of rights. WatchGuard intends to vigorously defend against the Action. WatchGuard is unable, however, to predict the ultimate outcome of the Action. At this time, WatchGuard has not recorded
any liability associated with this litigation as the associated cost and outcome are currently not determinable. There can be no assurance WatchGuard will be successful in defending against the Action and if WatchGuard is unsuccessful it may be
subject to significant damages which could have a material adverse effect on WatchGuards results of operations and financial position. Even if WatchGuard is successful, defending against the Action is likely to be expensive and may divert
managements attention from other business concerns and harm its business, which could have a material adverse effect on WatchGuards operating results.



Shareholder Rights Agreement



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



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



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|ITEM2. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
|------ | -------------------------------------------------------------------------------------



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



Forward-Looking
Statements



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



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



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



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



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



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



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



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



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



Overview



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



Thousands of enterprises worldwide use our award-winning products and services to meet these requirements. The core of our products and services is our
family of integrated, expandable Firebox X security solutions. We offer firewall protection and intrusion prevention technology for access control, virtual private networking for secure communications, content and spam filtering, gateway and desktop
anti-virus protection and vulnerability assessment services. Our Firebox X security solutions allow users to upgrade to any higher model in the particular line simply by applying a software license key. We also offer our customers a unified
management interface that allows even the non-security professional to effectively install,



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configure and monitor our security products as well as the networking features required for more complex network installations. In addition, our innovative
subscription-based LiveSecurity Service provides our customers with access to expert guidance and support so they can protect their data and communications in a continuously changing environment.



Our market spans the SME market, from smaller-sized companies for which
ease-of-use is a primary requirement, to medium-sized companies (including those with high-speed connections supporting VPNs between the corporate headquarters and geographically dispersed branch offices) for which performance, scalability and
networking features are key requirements. Our security solutions also give enterprises a security management choice. An enterprise can manage its own Internet security with our product offerings or outsource its security management to an Internet
service provider or other managed service provider implementing our managed security solutions. For the service provider, our technology improves the economics of managed security services through a scalable delivery platform that enables the
service provider to remotely configure and manage thousands of customer sites quickly and easily.



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



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



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



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



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



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



Critical Accounting Policies and Estimates



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



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



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



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



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



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



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



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##### Table of Contents

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



Revenue Recognition



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



We generate revenues
through:



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



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



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



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



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



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



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



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



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



Service revenues primarily include the allocated fees for the initial LiveSecurity Service and other services subscriptions
and for LiveSecurity Service and other services subscription renewals. These service fees provide our customers access to our LiveSecurity Service and other services for product updates, security threat responses, general security information and
technical support. These service fees also enable our service provider customers access to the LiveSecurity Service and the ability to manage and update a specific number of their customers security appliances. Service subscription revenues
are recognized ratably on a monthly basis over the subscription period.



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



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announced, additional allowances will be required. Alternatively, if actual promotional rebates fall below maximum exposure levels, we will reduce the
allowances and recognize additional revenue.



Provision for Doubtful
Accounts



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



Inventory Valuation



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



Restructuring



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



Accounting for Goodwill and Other Long-Lived Intangible Assets



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



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



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



Recent Accounting Pronouncement



In
December 2004, the Financial Accounting Standards Board issued SFAS 123 revised 2004 (SFAS 123(R)), Share-Based Payment, which is a revision of SFAS 123, Accounting for Stock-Based Compensation. SFAS 123(R) supersedes
Accounting Principles Board, or APB, Opinion No. 25, Accounting for Stock Issued to Employees. Generally, the approach described in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all
share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure will no longer be an alternative. SFAS 123(R) allows public companies



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to transition using either of the two methods described below. Under the modified prospective method, stock compensation expense is recognized starting from
the date of the adoption for all outstanding unvested stock awards, as well as for all awards granted, modified or settled after the date of the adoption. Under the modified retrospective method, entities would restate prior period financial
statements using the amounts previously reflected in pro forma disclosures under SFAS 123 either for all prior periods presented or for prior interim periods of the year of adoption.



In April 2005, the SEC delayed the effective date of SFAS 123(R) such that each company that is not a small business issuer
will be required to prepare financial statements in accordance with SFAS 123(R) no later than the first interim reporting period of the companys first fiscal year beginning on or after June 15, 2005. We are currently evaluating valuation
models and the transition provisions of this standard. We have not yet decided as of which date we will adopt the provisions of SFAS 123(R).



As permitted by SFAS 123, we currently account for share-based payments to employees using APB Opinion No. 25s intrinsic value method and, as such,
generally recognize no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123(R)s fair value method will have a significant effect on our operating results. The effect of adoption of SFAS 123(R) cannot be predicted
at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted SFAS 123(R) in prior periods, the effect of that standard would have approximated the amounts of pro forma stock compensation
expense reflected in accordance with SFAS 123 in our disclosure of pro forma net income and earnings per share in Note 1 to our consolidated financial statements.



Results of Operations



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



|                                        |  |                             |    |  |       |   
|--------------------------------------- |  | --------------------------- | -- |  | ----- | --
|                                        |  | Three Months EndedMarch 31, |   
|                                        |  | 2004                        |    |  | 2005  |   
|Revenues:                               |  |                             |    |  |       |   
|Product                                 |  | 67.5                        | %  |  | 55.0  | % 
|Service                                 |  | 32.5                        |    |  | 45.0  |   
|                                        |  |                             |    |  |       |   
|Total revenues                          |  | 100.0                       |    |  | 100.0 |   
|                                        |  |                             |    |  |       |   
|Cost of revenues:                       |  |                             |    |  |       |   
|Product                                 |  | 31.7                        |    |  | 24.6  |   
|Service                                 |  | 6.6                         |    |  | 8.8   |   
|                                        |  |                             |    |  |       |   
|Total cost of revenues                  |  | 38.3                        |    |  | 33.4  |   
|                                        |  |                             |    |  |       |   
|Gross margin                            |  | 61.7                        |    |  | 66.6  |   
|                                        |  |                             |    |  |       |   
|Operating expenses:                     |  |                             |    |  |       |   
|Sales and marketing                     |  | 41.5                        |    |  | 47.8  |   
|Research and development                |  | 22.5                        |    |  | 26.7  |   
|General and administrative              |  | 11.2                        |    |  | 16.6  |   
|Amortization of other intangible assets |  | 1.2                         |    |  | 1.5   |   
|                                        |  |                             |    |  |       |   
|Total operating expenses                |  | 76.4                        |    |  | 92.6  |   
|                                        |  |                             |    |  |       |   
|Operating loss                          |  | (14.7                       | )  |  | (26.0 | ) 
|Interest and other income, net          |  | 1.3                         |    |  | 2.7   |   
|                                        |  |                             |    |  |       |   
|Loss before income taxes                |  | (13.4                       | )  |  | (23.3 | ) 
|Provision for income taxes              |  | 0.1                         |    |  | 0.3   |   
|                                        |  |                             |    |  |       |   
|Net loss                                |  | (13.5                       | )% |  | (23.6 | )%
|                                        |  |                             |    |  |       |   



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Three Months Ended March 31, 2004 and 2005



Revenues



|                                   |  |                             |        |   |                                |   |        |   |  |       |   
|---------------------------------- |  | --------------------------- | ------ | - | ------------------------------ | - | ------ | - |  | ----- | --
|                                   |  | Three Months EndedMarch 31, |        |   | Percentage Increase (Decrease) |  
|                                   |  | 2004                        |        |   | 2005                           |   |       
|Revenues (in thousands):           |  |                             |        |   |                                |   |        |   |  |       |   
|Product                            |  | $                           | 13,644 |   |                                | $ | 9,131  |   |  | (33.1 | )%
|Service                            |  |                             | 6,562  |   |                                |   | 7,484  |   |  | 14.1  | % 
|                                   |  |                             |        |   |                                |   |        |   |  |       |   
|Total                              |  | $                           | 20,206 |   |                                | $ | 16,615 |   |  | (17.8 | )%
|                                   |  |                             |        |   |                                |   |        |   |  |       |   
|Revenues (as % of total revenues): |  |                             |        |   |                                |   |        |   |  |       |   
|Product                            |  |                             | 67.5   | % |                                |   | 55.0   | % |  |       |   
|Service                            |  |                             | 32.5   |   |                                |   | 45.0   |   |  |       |   
|                                   |  |                             |        |   |                                |   |        |   |  |       |   
|Total                              |  |                             | 100.0  | % |                                |   | 100.0  | % |  |       |   
|                                   |  |                             |        |   |                                |   |        |   |  |       |   



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



|                                   |  |                             |        |   |                       |   |        |   |  |       |   
|---------------------------------- |  | --------------------------- | ------ | - | --------------------- | - | ------ | - |  | ----- | --
|                                   |  | Three Months EndedMarch 31, |        |   | Percentage (Decrease) |  
|                                   |  | 2004                        |        |   | 2005                  |   |       
|Revenues (in thousands):           |  |                             |        |   |                       |   |        |   |  |       |   
|Americas                           |  | $                           | 10,127 |   |                       | $ | 7,448  |   |  | (26.4 | )%
|EMEA                               |  |                             | 7,418  |   |                       |   | 6,785  |   |  | (8.5  | )%
|APAC                               |  |                             | 2,661  |   |                       |   | 2,382  |   |  | (10.5 | )%
|                                   |  |                             |        |   |                       |   |        |   |  |       |   
|Total                              |  | $                           | 20,206 |   |                       | $ | 16,615 |   |  | (17.8 | )%
|                                   |  |                             |        |   |                       |   |        |   |  |       |   
|Revenues (as % of total revenues): |  |                             |        |   |                       |   |        |   |  |       |   
|Americas                           |  |                             | 50.1   | % |                       |   | 44.8   | % |  |       |   
|EMEA                               |  |                             | 36.7   |   |                       |   | 40.8   |   |  |       |   
|APAC                               |  |                             | 13.2   |   |                       |   | 14.4   |   |  |       |   
|                                   |  |                             |        |   |                       |   |        |   |  |       |   
|Total                              |  |                             | 100.0  | % |                       |   | 100.0  | % |  |       |   
|                                   |  |                             |        |   |                       |   |        |   |  |       |   



The dollar and
percentage decrease in product revenues for the three months ended March 31, 2005, as compared to the same period of 2004, was primarily due to an overall decrease in product shipments during the period including the effects of the conversion of
certain customers from a sell in method to a sell through method of revenue recognition in the first quarter of 2005 as described below.



We recognize revenue from a majority of our channel customers when we sell product to them (the sell in method). Where the customer is a
distributor with unlimited stock returns and rotation rights, product revenues are not recognized until the distributors sell the products to their customers (the sell through method). During the first quarter of 2005, we negotiated
changes in contractual obligations with certain channel customers in North America, Australia and New Zealand which provided such customers with unlimited return rights. The changes were triggered by the need to offer promotional programs to give us
the flexibility in the respective markets to be more competitive, responsive and effective. As a result, we converted these customers to a sell through method beginning in the first quarter of 2005. When a channel customer is converted from the sell
in method to the sell through method of revenue recognition, revenue can no longer be recognized when product is sold to the channel customer, while revenue from products already in that channel customers inventory was already recognized in
the prior periods. Therefore, revenue on individual inventory items sold subsequent to the conversion can only be recognized after the converted channel customer has disposed of their inventories predating the conversion. As of December 31, 2004,
the converted customers held inventories, the revenues from which were $2.3 million and were recognized by us during 2004. During the first quarter of 2005, these customers sold through approximately $2.0 million of these inventories with
approximately $0.3 million carried over to later quarters. While the contractual changes and the resulting conversion of these customers from a sell in method to a sell through method of revenue recognition resulted in a reduction of revenues during
the first quarter of 2005, the effect of this reduction cannot be measured reliably due to a change in customer buying pattern upon conversion to the sell-through method. As a result of this transition, we expect that business conducted on a sell
through method beginning in the second quarter of 2005 will generate approximately 50% to 60% of our total worldwide revenues.



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



Lower product revenues in the first quarter of 2005, compared to the same
period of 2004, reflect decreased unit shipments of our Firebox X, Firebox SOHO and Firebox Vclass product lines, partially offset by shipments of our Firebox X Edge product line introduced in August 2004 and reduced discounts on our product
offerings during the three months ended March 31, 2005. The decrease in unit shipments of our Firebox X and Firebox SOHO product lines is partially due to conversion of certain of our customers to the sell through method of revenue recognition in
the first quarter of 2005. Lower shipments of our Firebox Vclass product line primarily reflects market expectation of the new Firebox X Peak product line introduced in April 2005. Lower revenue from our Firebox SOHO product line is also
attributable to introduction of the Firebox X Edge product line in August 2004.



From a regional standpoint, revenues decreased for both the Americas market and the international markets for the three months ended March 31, 2005 compared to the three months ended March 31, 2004. Revenues from the
Americas market decreased at a higher rate than revenues from the international markets, primarily due to the effects of converting the remaining channel customers in North America to a sell through method from a sell in method of revenue
recognition during the 2005 first quarter.



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



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



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



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##### Table of Contents

Cost of Revenues and Gross Margin



|                                                      |  |                             |        |   |                               |   |        |   |  |       |   
|----------------------------------------------------- |  | --------------------------- | ------ | - | ----------------------------- | - | ------ | - |  | ----- | --
|                                                      |  | Three Months EndedMarch 31, |        |   | PercentageIncrease (Decrease) |  
|                                                      |  | 2004                        |        |   | 2005                          |   |       
|Cost of revenues (in thousands):                      |  |                             |        |   |                               |   |        |   |  |       |   
|Product                                               |  | $                           | 6,397  |   |                               | $ | 4,083  |   |  | (36.2 | )%
|Service                                               |  |                             | 1,344  |   |                               |   | 1,471  |   |  | 9.4   | % 
|                                                      |  |                             |        |   |                               |   |        |   |  |       |   
|Total                                                 |  | $                           | 7,741  |   |                               | $ | 5,554  |   |  | (28.3 | )%
|                                                      |  |                             |        |   |                               |   |        |   |  |       |   
|Cost of revenues (as % of total revenues):            |  |                             |        |   |                               |   |        |   |  |       |   
|Product                                               |  |                             | 31.7   | % |                               |   | 24.6   | % |  |       |   
|Service                                               |  |                             | 6.6    | % |                               |   | 8.8    | % |  |       |   
|                                                      |  |                             |        |   |                               |   |        |   |  |       |   
|Total                                                 |  |                             | 38.3   | % |                               |   | 33.4   | % |  |       |   
|                                                      |  |                             |        |   |                               |   |        |   |  |       |   
|Cost of revenues (as % of related revenue component): |  |                             |        |   |                               |   |        |   |  |       |   
|Product (as % of product revenues)                    |  |                             | 46.9   | % |                               |   | 44.7   | % |  |       |   
|Service (as % of service revenues)                    |  |                             | 20.5   | % |                               |   | 19.7   | % |  |       |   
|                                                      |  |                             |       
|Gross margin (in thousands):                          |  |                             |        |   |                               |   |        |   |  |       |   
|Product                                               |  | $                           | 7,247  |   |                               | $ | 5,048  |   |  | (30.3 | )%
|Service                                               |  |                             | 5,218  |   |                               |   | 6,013  |   |  | 15.2  | % 
|                                                      |  |                             |        |   |                               |   |        |   |  |       |   
|Total                                                 |  | $                           | 12,465 |   |                               | $ | 11,061 |   |  | (11.3 | )%
|                                                      |  |                             |        |   |                               |   |        |   |  |       |   
|Gross margin (as % of related revenue component):     |  |                             |        |   |                               |   |        |   |  |       |   
|Product (as % of product revenues)                    |  |                             | 53.1   | % |                               |   | 55.3   | % |  |       |   
|Service (as % of service revenues)                    |  |                             | 79.5   | % |                               |   | 80.3   | % |  |       |   
|Total (as % of total revenues)                        |  |                             | 61.7   | % |                               |   | 66.6   | % |  |       |   



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



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



The decrease in cost of product revenues, in absolute dollars,
for the three months ended March 31, 2005, as compared to the three months ended March 31, 2004, was primarily due to an overall decrease in product volumes and the conversion of certain channel customers from the sell in method to the sell through
method. The decrease also reflects a reduction in the costs of excess and obsolete inventory caused by product life cycle considerations and new product introductions.



Product gross margins, in absolute dollars, were negatively affected for the three months ended March 31, 2005, as compared
to the three months ended March 31, 2004, by an overall decrease in product volumes as noted above.



Product gross margins increased as a percentage of revenues for the three months ended March 31, 2005, as compared to the three months ended March 31,
2004, primarily due to reduced discounts on our product offerings during the current period and a reduction in the costs of our excess and obsolete inventory.



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##### Table of Contents

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



Cost of service
revenues increased in absolute dollars for the three months ended March 31, 2005, as compared to the three months ended March 31, 2004. The increase in service costs primarily reflects the effect of a partial refund of customer support software
received in the 2004 first quarter.



Service gross margins
increased in both absolute dollars and as a percentage of service revenues for the three months ended March 31, 2005, as compared to the three months ended March 31, 2004, primarily due to growth of our installed customer base and initial purchases
of new subscription-based services as noted above.



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



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



Operating Expenses



Sales and Marketing



|                                                      |  |                             |       |   |                     |   |       |   |  |      |   
|----------------------------------------------------- |  | --------------------------- | ----- | - | ------------------- | - | ----- | - |  | ---- | --
|                                                      |  | Three Months EndedMarch 31, |       |   | Percentage Decrease |  
|                                                      |  | 2004                        |       |   | 2005                |   |      
|Sales and marketing expenses (in thousands)           |  | $                           | 8,395 |   |                     | $ | 7,946 |   |  | (5.3 | )%
|Sales and marketing expenses (as % of total revenues) |  |                             | 41.5  | % |                     |   | 47.8  | % |  |      |   



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 shows, advertising expenses, direct marketing
and costs of demo units.



The reduction in sales and marketing
expenses, in absolute dollars, for the three months ended March 31, 2005, as compared to the three months ended March 31, 2004, was primarily due to lower variable spending on marketing-related activities in 2005, largely advertising and market
development costs. The decrease is primarily due to significant costs incurred in the 2004 first quarter in support of our Firebox X product launch in February 2004. We did not have any significant product launches in the first quarter of 2005.



Sales and marketing expenses increased, as a percentage of
revenues, for the three months ended March 31, 2005, as compared to the three months ended March 31, 2004, primarily due to a reduction in product revenue during the first quarter of 2005 for the reasons noted above.



We expect our sales and marketing expenses will increase during the second
quarter of 2005 as we incur marketing-related costs associated with the introduction of our Firebox X Peak product line. Our actual sales and marketing expenses could differ materially from those anticipated, which could have an adverse effect on
our operating results.



Research and Development



|                                                           |  |                             |       |   |                     |   |       |   |  |      |   
|---------------------------------------------------------- |  | --------------------------- | ----- | - | ------------------- | - | ----- | - |  | ---- | --
|                                                           |  | Three Months EndedMarch 31, |       |   | Percentage Decrease |  
|                                                           |  | 2004                        |       |   | 2005                |   |      
|Research and development expenses (in thousands)           |  | $                           | 4,539 |   |                     | $ | 4,443 |   |  | (2.1 | )%
|Research and development expenses (as % of total revenues) |  |                             | 22.5  | % |                     |   | 26.7  | % |  |      |   



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



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##### Table of Contents

Research and development expenses decreased, in absolute dollars, for the three months ended March 31,
2005 as compared to the three months ended March 31, 2004, primarily due to the following:



| |  |  | Lower spending on compensation and benefits in 2005 reflecting a reduction in headcount.
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | Lower depreciation expense and costs of information technology in support of research and development in 2005, primarily due to cost containment for research and development capital
expenditures and the expiration of depreciation on earlier purchases.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



These decreases were partially offset by an increase in outsourced development and certification costs, reflecting higher costs incurred in those areas in the first quarter of 2005.



Research and development expenses increased, as a percentage of revenues, for
the three months ended March 31, 2005 as compared to the three months ended March 31, 2004 primarily due to a reduction in product revenue during the first quarter of 2005 for the reasons noted above.



For the second quarter of 2005, we anticipate an increase in our research and
development expenses, in absolute dollars, in comparison to levels incurred in the 2005 first quarter. We intend to continue to fund our research and development efforts and hire the necessary personnel in order to attempt to meet the changing
requirements of our customers, to provide for continued introduction of new products as technology advances and to enhance and expand our current product offerings. Research and development expenses may vary significantly from quarter to quarter due
to inherent uncertainties in the timing of certain development costs. We expect to continue to invest in key areas aimed at the development of new generations of our products, the further extension of our existing product lines and the development
of future technologies. Our actual research and development expenses could differ materially from those anticipated, which could have an adverse effect on our operating results.



General and Administrative



|                                                             |  |                             |       |   |                     |   |       |   |  |      |  
|------------------------------------------------------------ |  | --------------------------- | ----- | - | ------------------- | - | ----- | - |  | ---- | -
|                                                             |  | Three Months EndedMarch 31, |       |   | Percentage Increase |  
|                                                             |  | 2004                        |       |   | 2005                |   |      
|General and administrative expenses (in thousands)           |  | $                           | 2,263 |   |                     | $ | 2,756 |   |  | 21.8 | %
|General and administrative expenses (as % of total revenues) |  |                             | 11.2  | % |                     |   | 16.6  | % |  |      |  



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



General and administrative expenses increased, both in absolute dollars
and as a percentage of revenues, for the three months ended March 31, 2005 as compared to the three months ended March 31, 2004. The dollar and percentage increase in general and administrative expenses is primarily due to the following:



| |  |  | A substantial increase in accounting fees in the first quarter of 2005, in comparison to the first quarter of 2004, primarily due to incremental annual audit fees.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Increased contract labor and consulting costs in 2005, primarily due to WatchGuards sell through revenue automation initiative.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------



| |  |  | Higher legal expenses in 2005 reflecting costs associated with regulatory compliance, analysis of, and revisions to, our compensation plans, and ongoing litigation.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------



The increase in general and administrative
expenses, as a percentage of revenues, for the three months ended March 31, 2005 as compared to the three months ended March 31, 2004 also reflects a reduction in product revenue during the first quarter of 2005 as noted above.



For the second quarter of 2005, we expect general and administrative expenses
to be comparable to levels incurred in the 2005 first quarter. Our actual general and administrative expenses could differ materially from those anticipated, which could have an adverse effect on our operating results.



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##### Table of Contents

Stock-Based Compensation



Stock-based compensation expenses arise primarily from amortization of previously deferred stock-based compensation over the
vesting periods of common stock subject to repurchase and to stock options. Stock-based compensation expenses were not material in 2004 or during the first quarter of 2005.



Deferred stock-based compensation is initially recorded as a component of stockholders equity in the amount of the
excess of the fair value of our common stock on the date of grant over the exercise price of options and also in the amount of the fair value of temporarily restricted common stock that we issued in connection with our April 2002 acquisition of
RapidStream, Inc. that is subject to repurchase. Deferred stock-based compensation is amortized into expense over the relevant vesting periods using the accelerated method.



For the remainder of 2005, we could potentially experience significant fluctuations in stock-based compensation expense as a
direct result of our stock option exchange program which we expect will be completed in May 2005. Under existing accounting rules, to the extent stock awards have been subject to an exchange offer, other modifications, or performance criteria, such
awards are subject to variable accounting treatment. Variable accounting treatment could result in unpredictable and potentially significant charges or credits recorded to stock-based compensation expense, dependent upon fluctuations in the quoted
market prices of our common stock subsequent to implementation of the stock option exchange program.



Amortization of Other Intangible Assets



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



Amortization of other intangible assets was $244,000 for both the three months ended March 31, 2004 and the three months
ended March 31, 2005.



Interest and Other Income, Net



Interest income, net, is primarily comprised of
interest income generated from our short-term available-for-sale investments. Interest income was $266,000 for three months ended March 31, 2004, compared to $452,000 for the three months ended March 31, 2005. This increase is primarily due to
higher interest rates on invested balances in 2005.



Provision for Income Taxes



Income tax
expense of $14,000 for the three months ended March 31, 2004 and $42,000 for the three months ended March 31, 2005 primarily relates to our provision for foreign income taxes associated with our international operations.



Liquidity and Capital Resources



At March 31, 2005, we had $73.6 million in cash, cash equivalents and
short-term and available for sale investments, which were invested primarily in high-quality money market accounts and marketable securities. We believe that the market risk arising from our holdings of these financial instruments is not material.
Our working capital at March 31, 2005 was $57.8 million.



Operating Activities



Our operating
activities resulted in net cash outflows of $2.0 million for the three month ended March 31, 2004 and $3.4 million for the three months ended March 31, 2005. Operating cash outflows during these periods resulted primarily from our net 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):



|                                            |  |                             |        |   |      |   |        |  
|------------------------------------------- |  | --------------------------- | ------ | - | ---- | - | ------ | -
|                                            |  | Three Months EndedMarch 31, |       
|                                            |  | 2004                        |        |   | 2005 |  
|Net loss                                    |  | $                           | (2,724 | ) |      | $ | (3,918 | )
|Noncash expenses                            |  |                             | 1,017  |   |      |   | 900    |  
|Changes in operating assets and liabilities |  |                             | (298   | ) |      |   | (358   | )
|                                            |  |                             |        |   |      |   |        |  
|Net cash used in operating activities       |  | $                           | (2,005 | ) |      | $ | (3,376 | )
|                                            |  |                             |        |   |      |   |        |  



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



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



Trade Accounts Receivable, Net decreased from $7.3 million at December 31, 2004 to $6.8 million at March 31, 2005, primarily due to lower total revenues in the first quarter of 2005 as compared to the fourth quarter of 2004. Days
sales outstanding, or DSOs, calculated on a quarterly basis, was 34 days at December 31, 2004 and 37 days at March 31, 2005. DSOs are affected by:



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



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



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



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



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



Based on our current sales mix, the linearity of
revenues in past and future quarters and timing differences arising from the varying payment terms in our customer agreements, we expect our DSOs to generally range from 35 to 40 days in the future. Any change in these factors, however, could
negatively affect expected DSO results.



Net Inventories
increased from $3.1 million at December 31, 2004 to $4.8 million at March 31, 2005. Higher inventory levels primarily reflect costs associated with the anticipated product launch of the new Firebox X Peak product line in the second quarter of 2005,
a lower volume of shipments during the 2005 first quarter and an increase in inventories held by customers on the sell through basis during the first quarter of 2005.



Accounts Payable decreased from $3.2 million at December 31, 2004 to $2.9 million at March 31, 2005, primarily due to
timing of payment of accounts payable.



Accrued Expenses,
Other Liabilities and Deferred Rentincreased from $7.6 million at December 31, 2004 to $9.5 million at March 31, 2005, primarily due to an increase in payments by customers on the sell through method in advance of the sell through of underlying
inventory.



Total Accrued Restructuring Costs decreased
from $4.9 million at December 31, 2004 to $4.6 million at March 31, 2005, reflecting the ongoing payment of rents on abandoned facilities.



Total Deferred Revenuesdecreased from $19.2 million at December 31, 2004 to $18.9 million at March 31, 2005. The reduction in deferred revenues is
primarily due to implementation of our sell through initiative during the first quarter of 2005 as well as lower units shipped in comparison to the quarter ended December 31, 2004, partially offset by LiveSecurity Service subscription renewals on a
growing installed customer base.



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Investing Activities



Cash provided by investing activities was $1.4 million for the three months ended March 31, 2004 and $6.4 million for the
three months ended March 31, 2005. In both periods, these amounts primarily reflect proceeds from the maturity of our investment securities net of amounts reinvested, partially offset by capital expenditures for property and equipment.



Financing Activities



Cash provided by financing activities totaled $1.4 million for the three
months ended March 31, 2004 and $346,000 for the three months ended March 31, 2005. Cash provided by financing activities in both periods reflects the exercise of employee stock options and the purchase of common stock through our employee stock
purchase plan.



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



Contractual Obligations and Contingencies



We lease office space and some computer equipment under operating leases
that are noncancelable. Our facilities commitments include a lease for our corporate headquarters in Seattle, Washington, which expires in September 2010, with an option to extend this lease for an additional five-year term. We lease a product
fulfillment and distribution warehouse in Seattle with a lease term through April 2006. We also lease facilities in Aliso Viejo, San Jose and Tustin, California and Waltham, Massachusetts under operating leases that expire between 2005 and 2007, in
addition to leases for other sales offices under operating leases or other lease obligations that expire over various terms. Our excess facilities at our corporate headquarters in Seattle, and in Aliso Viejo and Waltham, are partially subleased to
tenants, with sublease terms that expire between 2005 and 2010. We also have several operating leases for computer equipment. We are a party to several noncancelable and nonrefundable agreements to purchase inventory.



Our contractual commitments at March 31, 2005 associated with lease
obligations and purchase obligations, net of future minimum rental income from subleases of $1.8 million, are presented below (in thousands). This future rental income from subleases may be adversely affected if the financial condition of our
tenants were to deteriorate, resulting in an impairment of their ability to make lease payments.



|                               |  |                       |        |                  |   |                        |  |                  |       |  |   |       |  |   |      
|------------------------------ |  | --------------------- | ------ | ---------------- | - | ---------------------- |  | ---------------- | ----- |  | - | ----- |  | - | -----
|                               |  | Payment due by period
|                               |  |                       |        | Before           |   | After December 31,2008
|                               |  | Total                 |        | December 31,2005 |   | December 31,2006       |  | December 31,2008 |      
|Operating lease obligations    |  | $                     | 16,172 |                  | $ | 2,461                  |  | $                | 5,747 |  | $ | 5,931 |  | $ | 2,033
|Inventory purchase obligations |  |                       | 3,135  |                  |   | 3,135                  |  |                  |      |  |   |      |  |   |     
|                               |  |                       |        |                  |   |                        |  |                  |       |  |   |       |  |   |      
|Total                          |  | $                     | 19,307 |                  | $ | 5,596                  |  | $                | 5,747 |  | $ | 5,931 |  | $ | 2,033
|                               |  |                       |        |                  |   |                        |  |                  |       |  |   |       |  |   |      



In addition, we have
contractual agreements with some of our distributors to reimburse them for advertising and other marketing activities that they may incur to promote our products, contingent on performance of those activities in the future. At March 31, 2005, the
total amount of those agreements was $571,000.



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



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



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



Since inception, we have incurred net losses and
experienced negative cash flows from operations in each quarter, except that we had net income and a positive cash flow from operations in the third quarter of 2000 and a positive cash flow from operations in the third quarter of 2001. As of March
31, 2005, we had an accumulated deficit of approximately $141.9 million. Although our revenues have increased each year since we began operations, we may not be able to continue to grow our revenue in the future, and even if we do, the historical
percentage growth rate of our revenues may not be sustainable as our revenue base increases. In addition, irrespective of our revenue, we may not achieve or sustain profitability in future periods as a result of our operating expenses. We expect
that over time we will have to increase our operating expenses in connection with:



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



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



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



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



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



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



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



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



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



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



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



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



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



The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We base our estimates on historical experience and on various
other assumptions that we believe to be reasonable under the circumstances, as provided in our 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



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liabilities that are not readily apparent from other sources. Our results may be adversely affected 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.



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



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



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



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



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



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



Examples of estimates we have made include, but are not limited to, those associated with the costs of excess and obsolete inventory, costs of our 2001
and 2002 restructuring, impairment analysis of the intangible assets obtained in our 2002 acquisition of RapidStream Inc., as well as goodwill relating to the acquisitions of BeadleNet LLC, Qiave Technologies Corporation and RapidStream. The
estimates may prove to be inaccurate. For example, the costs of excess and obsolete inventory may increase above current estimates if our revenues fall below our sales forecasts. Although we do not anticipate further significant adjustments to our
2001 and 2002 restructuring in addition to the $1 million charge we recorded in the fourth quarter of 2003 and the $400,000 charge we recorded in the third quarter of 2004, the actual costs related to the restructuring may differ from our estimate
if it takes us longer than expected to find suitable tenants for our excess facilities or if there are further changes in the real estate market where excess facilities are located.



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



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



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



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If we are unable to compete successfully in the highly competitive market for Internet security products and
services for any reason, including because current or potential competitors gain competitive advantage through partnering or acquisition, our business will fail.



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



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



We rely on third-party channel customers to generate most of our revenues, and if they fail to perform, our ability to sell our products and services will be limited.



We sell most of our products and services through our distribution network,
and we expect our success to continue to depend in large part on the performance of this network. To the extent our channel customers are unsuccessful selling our products, or we are unable to partner with and retain a sufficient number of channel
customers in each of the regions in which we sell products, our ability to sell our products and services will be limited. Our channel customers also have the ability to sell products and services that are competitive with ours, to devote more
resources to those competitive products or to cease selling our products and services altogether. The loss of one or more of these channel customers, a reduction in their sales or a reduction in our share of their sales of Internet security
products, particularly if any such changes result in increased sales of competitive products, could harm our business. In addition, we are still in the process of reorganizing our channel in the Asia Pacific region and, particularly, Japan. If this
reorganization causes disruption, we could experience a loss or reduction in sales involving one or more of our channel customers.



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



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Implementation of changes in our revenue policies related to third-party channel customers could negatively affect
revenues in 2005.



We recognize revenue from a
majority of our channel customers when we sell product to them (the sell in method). Where the customer is a distributor with unlimited stock returns and rotation rights, product revenues are not recognized until the distributors sell
the products to their customers (the sell through method). During the first quarter of 2005, we negotiated changes in contractual obligations with certain channel customers in North America, Australia and New Zealand which provided such
customers with unlimited return rights. The changes were triggered by the need to offer promotional programs to give us the flexibility in the respective markets to be more competitive, responsive and effective. As a result, we converted these
customers to a sell through method beginning in the first quarter of 2005. When a channel customer is converted from the sell in method to the sell through method of revenue recognition, revenue can no longer be recognized when product is sold to
the channel customer, while revenue from products already in that channel customers inventory was already recognized in the prior periods. Therefore, revenue on individual inventory items sold subsequent to the conversion can only be
recognized after the converted channel customer has disposed of their inventories predating the conversion. As of December 31, 2004, the converted customers held inventories, the revenues from which were $2.3 million and were recognized by us during
2004. During the first quarter of 2005, these customers sold through approximately $2.0 million of these inventories with approximately $0.3 million carried over to later quarters. While the contractual changes and the resulting conversion of these
customers from a sell in method to a sell through method of revenue recognition resulted in a reduction of revenues during the first quarter of 2005, the effect of this reduction cannot be measured reliably due to a change in customer buying pattern
upon conversion to the sell-through method. As a result of this transition, we expect that business conducted on a sell through method beginning in the second quarter of 2005 will generate approximately 50% to 60% of our total worldwide revenues.



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



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



We provide most of our channel customers with product return rights for stock rotation and price protection rights for their inventories, which they may
exercise if we lower our prices for those products. We also provide promotional rebates to some of our channel customers. We may experience significant returns, price adjustments and rebate costs for which we may not have adequate allowances,
particularly with the recent introduction of our Firebox X line of products, which replaced our Firebox III line of products. The short life cycles of our products and the difficulty of predicting future sales increase the risk that new product
introductions or price reductions by us or our competitors could result in significant product returns or price adjustments. When we introduced the Firebox II, the Firebox III and then later the Firebox X Core and Firebox X Edge security appliances,
we experienced an increase in returns of previous products and product versions. While we review and adjust our provision for returns and allowances in order to properly reflect the potential for promotional rebate costs, increased returns and
pricing adjustments associated with the introduction of new products, such as the Firebox X product lines, including the expected release of the Firebox X Peak product line in the first half of 2005, the provision may still be inadequate. An
increase in the provision for returns and allowances will result in the reduction of revenues.



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



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



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



Releasing new
or improved products and services, or updates to products or services, prematurely may result in quality problems, and releasing them late may result in loss of customer confidence and market share. In the past, we have experienced delays in the
scheduled or expected introduction of new, improved and updated products and services, and in the future we may experience delays, or be unable to introduce an expected new, improved or updated product or service at all. When we do introduce new or
enhanced products and services, we may be unable to successfully manage the transition from the older products and services to minimize disruption in customer-ordering patterns, avoid excessive inventories of older products and deliver enough new
products and services to meet customer demand. In the past, when we have introduced new or improved products or services, we have experienced issues with the transition, which had an adverse effect on our operating results. These have included, but
were not limited to, issues such as excess inventories of products that were replaced that we had difficulty selling as customer demand for those product decreased, shortages of new product due to manufacturing and delivery issues that prevented us
from delivering enough new product to meet demand and lower-than-expected initial sales of new or improved products as our sales personnel and channels adapted to selling the new or improved products or services.



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



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



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



We obtain the component parts for our hardware from a variety of manufacturers. Companies in the electronics industry
regularly experience lower-than-required component allocations, and the industry is subject to frequent component shortfalls. We have experienced such component shortfalls recently, with memory and flash component manufacturers providing these
components on a limited allocation basis only. Although we have found additional or replacement sources for hardware components in the past, it is possible that we might not be able to find additional or replacement sources for our hardware
components to address future shortfalls. Even if we find replacement sources, our operations could be disrupted or negatively affected if we have to add or switch to a replacement vendor, if our component supply is interrupted for an extended period
or if the costs of the components increase due to shortages, which could result in loss of customer orders and revenue.



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



We rely on third-party contract manufacturers for the
assembly of all of our security appliance hardware platforms and for the design of certain of our security appliance hardware platforms. If a third-party manufacturer fails to or inadequately performs its obligations, we may be required to find a
replacement, possibly on relatively short notice. Moreover, our contract manufacturers may not be able to react quickly if our forecasts exceed or fall short of our predictions. Even if we are able to find a replacement source for these finished
products on a timely basis, our operations could be disrupted if we have to add or switch to a replacement manufacturer, particularly if we were required to replace or redesign a hardware platform, or if our finished goods supply is interrupted for
an extended period, which could result in loss of customer orders and revenue.



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



Our success will depend in part on our continued ability to license
technology that is important for the functionality of our products and for the delivery of new products based on third-party technology. A significant interruption in the supply of



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



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



Our future success will depend largely on the efforts and abilities of our senior management and our key development, technical, operations, information systems, customer support and sales and marketing personnel, and on our ability to
retain them. These employees are not obligated to continue their employment with us and may leave us at any time. In addition, there have been changes to our management team recently, including the addition of a new chief executive officer and
interim chief financial officer in 2004 and a new vice president of North American sales and a new chief financial officer in 2005. If these changes have a negative effect on our operations, our business and operating results could be adversely
affected.



Because many potential customers do not fully understand or
remain unaware of the need for comprehensive and up-to-date Internet security, may perceive it as costly and difficult to implement, or may not understand the components of comprehensive Internet security well enough to effectively compare
competitive offerings, our products and services may not achieve market acceptance.



We believe that many potential customers, particularly SMEs, do not fully understand or are not aware of the need for comprehensive and up-to-date Internet security products and services, and also may not fully
understand the components of comprehensive Internet security well enough to effectively compare competitive offerings. Any inability to effectively compare competitive offerings may give companies with greater resources or more recognizable brands a
competitive advantage over us. In addition, historically, only enterprises having substantial resources have developed or purchased comprehensive Internet security solutions and kept such security up to date. Also, there is a perception that
comprehensive Internet security is costly and difficult to implement. We will therefore not succeed unless the market understands the need for comprehensive and up-to-date Internet security and we can convince our potential customers of our ability
to provide this security in an integrated, cost-effective and administratively feasible manner. Although we have spent, and will continue to spend, considerable resources educating potential customers about the need for comprehensive and up-to-date
Internet security and the benefits of our products and services, our efforts may be unsuccessful.



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



Our operational systems
have not been tested at the customer volumes that may be required in the future. In addition, our operational systems required for the delivery of products and services through license-key activation were not originally designed for the combination
of the number of product and service offerings and customer volumes that may be required in the future, and we will have to update and expand our operational systems to accommodate this activity. We may be unable to update and expand our operational
systems in a timely fashion or without disruption to our business, and we may encounter performance difficulties when operating with a substantially greater number of customers or a substantially greater number of products and services offered
through license-key activation or a combination of the two. These difficulties could harm our ability to deliver our products and services. An inability to add software and hardware or to develop and upgrade existing technology or operational
systems to handle increased traffic or increased number of products and services offered through license-key activation may cause unanticipated system disruptions, slower response times and poor customer service, including problems filling customer
orders.



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



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



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



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



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



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



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



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



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



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



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



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



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



Despite our efforts
to protect our proprietary rights, unauthorized parties may misappropriate or infringe on our patents, trade secrets, copyrights, trademarks, service marks and similar proprietary rights. For example, our former Vice President of America Sales
recently joined our competitor SonicWALL as its Vice President of Channel Sales. We filed a complaint in federal court against this former employee and SonicWALL to prevent the misappropriation of our trade secrets and to enjoin the acts of unfair
competition by this former employee and SonicWALL. We may, however, be unsuccessful in protecting our



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trade secrets or, even if successful, any required litigation may be costly and time consuming, which could harm our business. Moreover, we face additional
risk when conducting business in countries that have poorly developed or inadequately enforced intellectual property laws. While we are unable to determine the extent to which piracy of our software products exists, we expect piracy to be a
continuing concern, particularly in international markets and as a result of the growing use of the Internet.



If we fail to obtain and maintain patent protection for our technology, we may be unable to compete effectively. We have 12 issued patents and 16 patents
pending, but our patent applications may not result in issued patents. Even if we secure a patent, the patent may not provide meaningful protection. In addition, we rely on unpatented proprietary technology. Because this proprietary technology does
not have patent protection, we may be unable to meaningfully protect this technology from unauthorized use or misappropriation by a third party. In addition, our competitors may independently develop similar or superior technologies or duplicate any
unpatented technologies that we have developed, which could significantly reduce the value of our proprietary technology or threaten our market position.



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



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



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



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



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



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



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



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



Our ability to grow will depend in part
on the expansion of our international sales and operations, which are expected to continue to account for a significant portion of our revenues. Sales to customers outside of the United States accounted for approximately 56% of our revenues in both
2003 and 2004. The failure of our channel customers to sell our products internationally would limit our ability to increase our revenues. In addition, our international sales are subject to the risks inherent in international business activities,
including:



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



| |  |  | export and import restrictions, such as those affecting encryption commodities and software 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, any increase in the value of the U.S. dollar relative to foreign currencies
makes our products less competitive in international markets. Because of this, we may be required to denominate our sales in foreign currencies at some point in the future to remain competitive.



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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.



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



We believe
that our existing available cash, cash equivalents and investments will be sufficient to meet our operating expenses, working capital needs and capital expenditure requirements for at least the next 12 months. Our capital requirements will depend on
several factors, however, including:



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



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



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



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



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



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



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



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



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



Our stock price is volatile.



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



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



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



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



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



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



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



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



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



On April 8, 2005, a holder of our common stock, on behalf of himself and purportedly on behalf of a class of our stockholders, filed an action in the United States District Court for the Western District of Washington
against WatchGuard and some of our current and former officers, alleging violations of the federal securities laws arising out of, among other things, our announcement on March 15, 2005 that we were restating some of our financial results for
interim periods of 2004; related actions have been subsequently filed, which together with the April 8, 2005 action are referred to as the Action. Pursuant to Delaware law, we are obligated to indemnify our officers in connection with the Action,
and have insurance for such individuals, to the extent of the limits of the applicable insurance policies and subject to potential reservations of rights. We intend to vigorously defend against the Action. We are unable, however, to predict the
ultimate outcome of the Action. We cannot assure that we will be successful in defending against the Action and if we are unsuccessful we may be subject to significant damages which could have a material adverse effect on our operating results and
financial position. Even if we are successful, defending against the Action is likely to be expensive and may divert managements attention from other business concerns and harm our business.



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



Interest Rate Risk.



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



Foreign Currency Risk.



All of our sales and the majority of our expenses are currently denominated
in U.S. dollars. As a result, we have not experienced significant foreign exchange gains and losses. While we incurred some expenses in foreign currencies during the three months ended March 31, 2005 and expect to continue to do so in the future, we
do not anticipate that foreign exchange gains or losses will be material to us. Although we have not engaged in foreign currency hedging to date, we may do so in the future. In addition, we may be required to denominate our sales in foreign
currencies at some point in the future to remain competitive.



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



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



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Changes in internal controls. During the first quarter of 2005 we implemented new control
processes which we believe to be effective as of March 31, 2005, over the material weakness reported in our 2004 annual report on Form 10-K pertaining to insufficient controls over the initial identification and processing of deferred revenue
elements of software and services sales and the accurate recording of customer obligations. These new controls were developed through investigation and review of the processes and activities surrounding the material weakness, and include changes to
these processes and the development of test and review programs designed to prevent or detect similar occurrences.



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PART II. OTHER INFORMATION



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



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



Litigation Against Terminated Employee



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



Class-Action Securities Litigation



On April 8, 2005, a holder of our common stock, on behalf of himself and
purportedly on behalf of a class of our stockholders, filed an action in the United States District Court for the Western District of Washington against WatchGuard and some of our current and former officers, alleging violations of the federal
securities laws arising out of, among other things, our announcement on March 15, 2005 that we were restating some of our financial results for interim periods of 2004; related actions have been subsequently filed, which together with the April 8,
2005 action are referred to as the Action. Pursuant to Delaware law, we are obligated to indemnify our officers in connection with the Action, and have insurance for such individuals, to the extent of the limits of the applicable insurance policies
and subject to potential reservations of rights. We intend to vigorously defend against the Action. We are unable, however, to predict the ultimate outcome of the Action. We cannot assure that we will be successful in defending against the Action
and if we are unsuccessful we may be subject to significant damages which could have a material adverse effect on our operating results and financial position. Even if we are successful, defending against the Action is likely to be expensive and may
divert managements attention from other business concerns and harm our business.



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



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



|     |  |                                                                                                                                            
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------
|10.1 |  | Director and Section 16 Officer Stock Ownership Program                                                                                    
|     | 
|10.2 |  | CEO & Executive Bonus Program - 205 (exhibit 10.1)(a)                                                                                      
|     | 
|31.1 |  | Section 302 Certification of Edward J. Borey                                                                                               
|     | 
|31.2 |  | Section 302 Certification of Bradley E. Sparks                                                                                             
|     | 
|32.1 |  | Certification of Edward J. Borey pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  
|     | 
|32.2 |  | Certification of Bradley E. Sparks pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

---

|(a) | Incorporated by reference to the designated exhibit to the registrants Current Report on Form 8-K (No. 0-26819)
|--- | ----------------------------------------------------------------------------------------------------------------



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SIGNATURES



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



Date: May 10, 2005



WATCHGUARD TECHNOLOGIES, INC.By:

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




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WATCHGUARD TECHNOLOGIES, INC.



INDEX TO EXHIBITS



|        |  |                                                                                                                                            
|------- |  | -------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  | Description                                                                                                                                
|10.1    |  | Director and Section 16 Officer Stock Ownership Program                                                                                    
|        | 
|10.2    |  | CEO & Executive Bonus Program - 2005 (exhibit 10.1)(a)                                                                                     
|        | 
|31.1    |  | Section 302 Certification of Edward J. Borey                                                                                               
|        | 
|31.2    |  | Section 302 Certification of Bradley E. Sparks                                                                                             
|        | 
|32.1    |  | Certification of Edward J. Borey pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  
|        | 
|32.2    |  | Certification of Bradley E. Sparks pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

---

|(a) | Incorporated by reference to the designated exhibit to the registrants Current Report on Form 8-K (No. 0-26819) filed on April 6, 2005.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------