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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934



For
the quarterly period ended June 30, 2003



Commission File
Number 000-26819



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WATCHGUARD TECHNOLOGIES, INC.

(Exact
Name of Registrant as Specified in Its Charter)



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



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

(Address of Principal Executive Offices) (Zip Code)



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



Not Applicable

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



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



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



32,867,173 shares of WatchGuard common stock were outstanding as of July 31, 2003.



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##### Table of Contents

WATCHGUARD TECHNOLOGIES, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2003



TABLE OF CONTENTS



|PART I.    FINANCIAL INFORMATION |  | 3                                                                                    
|-------------------------------- |  | -------------------------------------------------------------------------------------
|                                 |  |                                                                                      
|ITEM 1.                          |  | FINANCIAL STATEMENTS                                                                 
|                                 |  |                                                                                      
|                                 |  | -                                                                                    
|                                 |  |                                                                                      
|                                 |  | -                                                                                    
|                                 |  |                                                                                      
|                                 |  | -                                                                                    
|                                 |  |                                                                                      
|                                 |  | -                                                                                    
|                                 |  |                                                                                      
|ITEM 2.                          |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
|                                 |  |                                                                                      
|ITEM 3.                          |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                           
|                                 |  |                                                                                      
|ITEM 4.                          |  | CONTROLS AND PROCEDURES                                                              
|                                 | 
|PART II.    OTHER INFORMATION    |  | 37                                                                                   
|                                 |  |                                                                                      
|ITEM 4.                          |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                  
|                                 |  |                                                                                      
|ITEM 6.                          |  | EXHIBITS AND REPORTS ON FORM 8-K                                                     



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##### Table of Contents

PART I. FINANCIAL INFORMATION



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



WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

(unaudited)



|                                                                                               |  | December 31, 2002 |          |   | June 30, 2003 |  
|---------------------------------------------------------------------------------------------- |  | ----------------- | -------- | - | ------------- | -
|ASSETS                                                                                         |  |                   |          |   |               |  
|                                                                                               |  |                  
|Current assets:                                                                                |  |                   |          |   |               |  
|Cash and cash equivalents                                                                      |  | $                 | 8,890    |   |               | $
|Short-term investments                                                                         |  |                   | 80,412   |   |               |  
|Trade accounts receivable, net                                                                 |  |                   | 8,813    |   |               |  
|Inventories, net                                                                               |  |                   | 4,442    |   |               |  
|Prepaid expenses and other                                                                     |  |                   | 4,435    |   |               |  
|                                                                                               |  |                   |          |   |               |  
|Total current assets                                                                           |  |                   | 106,992  |   |               |  
|Property and equipment, net                                                                    |  |                   | 6,467    |   |               |  
|Goodwill                                                                                       |  |                   | 66,605   |   |               |  
|Other intangibles, net and other assets                                                        |  |                   | 9,234    |   |               |  
|                                                                                               |  |                   |          |   |               |  
|Total assets                                                                                   |  | $                 | 189,298  |   |               | $
|                                                                                               |  |                   |          |   |               |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                           |  |                   |          |   |               |  
|                                                                                               |  |                  
|Current liabilities:                                                                           |  |                   |          |   |               |  
|Accounts payable                                                                               |  | $                 | 4,905    |   |               | $
|Accrued expenses and other liabilities                                                         |  |                   | 5,143    |   |               |  
|Accrued restructuring and acquisition costs                                                    |  |                   | 9,035    |   |               |  
|Deferred revenues                                                                              |  |                   | 18,451   |   |               |  
|                                                                                               |  |                   |          |   |               |  
|Total current liabilities                                                                      |  |                   | 37,534   |   |               |  
|                                                                                               |  |                  
|Stockholders equity:                                                                          |  |                   |          |   |               |  
|Preferred stock, $0.001 par value:                                                             |  |                   |          |   |               |  
|Authorized shares: 10,000,000                                                                  |  |                   |          |   |               |  
|No shares issued and outstanding                                                               |  |                   |         |   |               |  
|Common stock, $0.001 par value:                                                                |  |                   |          |   |               |  
|Authorized shares: 80,000,000                                                                  |  |                   |          |   |               |  
|Shares issued and outstanding: 32,655,404 at December 31, 2002 and 32,860,089 at June 30, 2003 |  |                   | 33       |   |               |  
|Additional paid-in capital                                                                     |  |                   | 265,932  |   |               |  
|Deferred stock-based compensation                                                              |  |                   | (254     | ) |               |  
|Accumulated other comprehensive income                                                         |  |                   | 229      |   |               |  
|Accumulated deficit                                                                            |  |                   | (114,176 | ) |               |  
|                                                                                               |  |                   |          |   |               |  
|Total stockholders equity                                                                     |  |                   | 151,764  |   |               |  
|                                                                                               |  |                   |          |   |               |  
|Total liabilities and stockholders equity                                                     |  | $                 | 189,298  |   |               | $
|                                                                                               |  |                   |          |   |               |  



See
accompanying notes.



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##### Table of Contents

WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(unaudited)



|                                                                                    |  | Three Months Ended June 30, |         |   | Six Months Ended June 30, |  
|----------------------------------------------------------------------------------- |  | --------------------------- | ------- | - | ------------------------- | -
|                                                                                    |  | 2002                        |         |   | 2003                      |  
|Revenues:                                                                           |  |                             |         |   |                           |  
|Product                                                                             |  | $                           | 12,500  |   |                           | $
|Service                                                                             |  |                             | 5,348   |   |                           |  
|                                                                                    |  |                             |         |   |                           |  
|Total revenues                                                                      |  |                             | 17,848  |   |                           |  
|                                                                                    |  |                             |         |  
|Cost of revenues:                                                                   |  |                             |         |   |                           |  
|Product                                                                             |  |                             | 4,870   |   |                           |  
|Service                                                                             |  |                             | 1,551   |   |                           |  
|                                                                                    |  |                             |         |   |                           |  
|Total cost of revenues                                                              |  |                             | 6,421   |   |                           |  
|                                                                                    |  |                             |         |   |                           |  
|Gross margin                                                                        |  |                             | 11,427  |   |                           |  
|                                                                                    |  |                             |         |  
|Operating expenses:                                                                 |  |                             |         |   |                           |  
|Sales and marketing                                                                 |  |                             | 8,763   |   |                           |  
|Research and development                                                            |  |                             | 6,015   |   |                           |  
|General and administrative                                                          |  |                             | 2,031   |   |                           |  
|Stock-based compensation (1)                                                        |  |                             | 401     |   |                           |  
|Amortization of other intangible assets acquired                                    |  |                             | 1,219   |   |                           |  
|Acquired in-process technology                                                      |  |                             | 1,179   |   |                           |  
|Restructuring charges                                                               |  |                             | 4,272   |   |                           |  
|                                                                                    |  |                             |         |   |                           |  
|Total operating expenses                                                            |  |                             | 23,880  |   |                           |  
|                                                                                    |  |                             |         |   |                           |  
|Operating loss                                                                      |  |                             | (12,453 | ) |                           |  
|Interest income, net                                                                |  |                             | 766     |   |                           |  
|                                                                                    |  |                             |         |   |                           |  
|Loss before income taxes                                                            |  |                             | (11,687 | ) |                           |  
|Provision for income taxes                                                          |  |                             | 16      |   |                           |  
|                                                                                    |  |                             |         |   |                           |  
|Net loss                                                                            |  | $                           | (11,703 | ) |                           | $
|                                                                                    |  |                             |         |   |                           |  
|Basic and diluted net loss per share                                                |  | $                           | (0.36   | ) |                           | $
|                                                                                    |  |                             |         |   |                           |  
|Shares used in calculation of basic and diluted net loss per share                  |  |                             | 32,095  |   |                           |  
|                                                                                    |  |                             |         |   |                           |  
|(1)    Stock-based compensation charges relate to the following expense categories:
|Sales and marketing                                                                 |  | $                           | 27      |   |                           | $
|Research and development                                                            |  |                             | 328     |   |                           |  
|General and administrative                                                          |  |                             | 46      |   |                           |  
|                                                                                    |  |                             |         |   |                           |  
|Total                                                                               |  | $                           | 401     |   |                           | $
|                                                                                    |  |                             |         |   |                           |  



See
accompanying notes.



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##### Table of Contents

WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)



|                                                                                                                         |  | Six Months Ended June 30, |        
|------------------------------------------------------------------------------------------------------------------------ |  | ------------------------- | -------
|                                                                                                                         |  | 2002                      |        
|OPERATING ACTIVITIES:                                                                                                    |  |                           |        
|Net loss                                                                                                                 |  | $                         | (16,337
|Adjustments to reconcile net loss to net cash used in operating activities:                                              |  |                           |        
|Noncash expenses:                                                                                                        |  |                           |        
|Depreciation and amortization of property and equipment                                                                  |  |                           | 1,351  
|Amortization of other intangible assets acquired                                                                         |  |                           | 1,944  
|Amortization of stock-based compensation                                                                                 |  |                           | 1,014  
|Acquired in-process technology                                                                                           |  |                           | 1,179  
|Changes in operating assets and liabilities:                                                                             |  |                           |        
|Trade accounts receivable, net                                                                                           |  |                           | (2,546 
|Inventories, net                                                                                                         |  |                           | 2,170  
|Prepaid expenses and other                                                                                               |  |                           | 347    
|Other intangibles, net and other assets                                                                                  |  |                           | 3      
|Accounts payable                                                                                                         |  |                           | 411    
|Accrued expenses and other liabilities                                                                                   |  |                           | 1,533  
|Accrued restructuring and acquisition costs                                                                              |  |                           | 3,129  
|Deferred revenues                                                                                                        |  |                           | 1,544  
|                                                                                                                         |  |                           |        
|NET CASH USED IN OPERATING ACTIVITIES                                                                                    |  |                           | (4,258 
|                                                                                                                         |  |                          
|INVESTING ACTIVITIES:                                                                                                    |  |                           |        
|Purchases of property and equipment                                                                                      |  |                           | (78    
|Proceeds from maturity of marketable securities                                                                          |  |                           | 37,360 
|Proceeds from sale of marketable securities                                                                              |  |                           | 30,839 
|Purchases of marketable securities                                                                                       |  |                           | (41,389
|Net cash paid in connection with the acquisition of RapidStream                                                          |  |                           | (16,793
|                                                                                                                         |  |                           |        
|NET CASH PROVIDED BY INVESTING ACTIVITIES                                                                                |  |                           | 9,939  
|                                                                                                                         |  |                          
|FINANCING ACTIVITIES:                                                                                                    |  |                           |        
|Proceeds from the exercise of common stock options and the sale of common stock through the employee stock purchase
plan |  |                           | 546    
|                                                                                                                         |  |                           |        
|NET CASH PROVIDED BY FINANCING ACTIVITIES                                                                                |  |                           | 546    
|                                                                                                                         |  |                           |        
|NET INCREASE IN CASH AND CASH EQUIVALENTS                                                                                |  |                           | 6,227  
|                                                                                                                         |  |                          
|CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                                                                         |  |                           | 13,958 
|                                                                                                                         |  |                           |        
|CASH AND CASH EQUIVALENTS AT END OF PERIOD                                                                               |  | $                         | 20,185 
|                                                                                                                         |  |                           |        



See
accompanying notes.



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##### Table of Contents

WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



NOTE 1  DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION



Description of Business



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



Interim Financial Information



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



NOTE 2  SUMMARY OF
SIGNIFICANT ACCOUNTING POLICIES



Revenue Recognition



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



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



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



WatchGuard provides allowances for
estimated returns 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.



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



The promotional rebates vary by type and term and are earned by customers in accordance with various
conditions. WatchGuard accounts for promotional rebates given to customers in accordance with the Emerging Issues Task Force (EITF) Issue 01-09, Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendors
Product, which requires that sales incentives given to customers or resellers be accounted for as a reduction of revenue unless a vendor receives a benefit that is identifiable and can be reasonably estimated. WatchGuard accrues the maximum
amount possible unless historical trends indicate a lower rate of accrual is adequate.



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



Principles of Consolidation



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



Net Loss Per Share



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



Comprehensive Loss



WatchGuards investments consist of corporate and government debt securities, are considered available-for-sale, and are stated at fair value, with
unrealized gains and losses included as a component of stockholders equity. During the three- and six-month periods ended June 30, 2002 and June 30, 2003, there were no material realized gains or losses on securities available-for-sale. All
such investments mature within two years, with the weighted average life of the investment portfolio being approximately one year. The following table sets forth the components of comprehensive loss (in thousands):



|                                      |  | Three Months Ended June 30, |         |   | Six Months Ended June 30, |  
|------------------------------------- |  | --------------------------- | ------- | - | ------------------------- | -
|                                      |  | 2002                        |         |   | 2003                      |  
|Net loss                              |  | $                           | (11,703 | ) |                           | $
|Unrealized gain (loss) on investments |  |                             | 61      |   |                           |  
|                                      |  |                             |         |   |                           |  
|Comprehensive loss                    |  | $                           | (11,642 | ) |                           | $
|                                      |  |                             |         |   |                           |  



Recent
Accounting Pronouncements



At the November 21, 2002
meeting, the EITF of the Financial Accounting Standards Board (FASB) reached a consensus on EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables, which addresses revenue recognition for arrangements that may involve the
delivery or performance of multiple products, services and/or rights to use assets. The final consensus will be applicable to agreements entered into in fiscal periods beginning after June 15, 2003, with early adoption permitted. To the extent that
an arrangement is within the scope of other existing higher-level authoritative literature that provides guidance regarding whether or how to separate multiple-deliverable arrangements into separate units of accounting, such as SOP 97-2, the
arrangement should be accounted for in accordance with that literature. As WatchGuard accounts for the multiple-elements revenue arrangements in accordance with SOP 97-2, it does not believe the adoption of EITF Issue 00-21 will have a material
impact on its financial position or results of operation.



In
May 2003, SFAS 150, Accounting for Certain Instruments with Characteristics of Both Liabilities and Equity was issued. The standard establishes how an issuer classifies and measures certain freestanding financial instruments with
characteristics of liabilities and equity and requires that such instruments be classified as liabilities. The standard is effective for financial instruments entered into or modified after May 31, 2003 and is otherwise effective at the beginning of
the first interim period beginning after June 15, 2003. Adoption of the standard is not expected to have a material impact on the Companys consolidated financial position, results of operations or cash flows.



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



Reclassifications



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



NOTE 3  BALANCE SHEET ACCOUNT DETAIL



Trade Accounts Receivable, Net



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



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



Inventories, Net



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



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



Accrued Expenses
and Other Liabilities



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



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



Accrued
Restructuring and Acquisition Costs



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



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



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



NOTE 4  BUSINESS RESTRUCTURINGS



During 2001 and 2002, WatchGuard recorded restructuring charges of $3.7 million and $8.1 million, respectively. At June 30,
2003, the remaining balance of the restructuring liabilities was $5.5 million. No adjustments to the remaining liabilities were required in the six-month period ended June 30, 2003.



2001 Restructuring



In the second quarter of 2001, WatchGuard announced a restructuring plan designed to streamline operations and reduce operating costs. All costs
related to this restructuring have been paid or settled, except for certain liabilities related to abandoned facilities which are as follows (in thousands):



|                                                    |  | December 31, 2002 Accrued Restructuring Balance |       | Amounts Paid or Charged |   |      | June 30, 2003 Accrued Restructuring Balance
|--------------------------------------------------- |  | ----------------------------------------------- | ----- | ----------------------- | - | ---- | -------------------------------------------
|Accrued liabilities related to abandoned facilities |  | $                                               | 2,035 |                         | $ | (343 | )                                          
|                                                    |  |                                                 |       |                         |   |      |                                            



2002
Restructuring



In the second quarter of 2002,
WatchGuard implemented a restructuring plan primarily designed to eliminate redundancies and excess headcount resulting from the acquisition of RapidStream, Inc., which included a reduction in workforce, consolidation of excess facilities and
elimination of technology-related contracts that are no longer required or part of WatchGuards strategy. As a result of this restructuring, WatchGuard recorded a $6.7 million restructuring charge in 2002.



As part of this reorganization, WatchGuard implemented a workforce reduction
of 36 employees, which represented approximately 10% of WatchGuards post-acquisition employee base and included employees from all of WatchGuards functional areas. All such employees were terminated prior to June 30, 2002. Other costs
associated with the reorganization consist of contract terminations and the consolidation of excess facilities. Costs that related to ongoing operations were not included as restructuring charges. Restructuring charges for severance and termination
benefits were paid by December 31, 2002, while accrued amounts relating to losses for the lease buyout or sublease of abandoned facilities of approximately $3.8 million at June 30, 2003 are expected to be realized through 2010. Contract termination
costs were paid during the quarter ended March 31, 2003.



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



|                                                              |  | December 31, 2002 Accrued Restructuring Balance |       | Amounts Paid or Charged |   |        | June 30, 2003 Accrued Restructuring Balance
|------------------------------------------------------------- |  | ----------------------------------------------- | ----- | ----------------------- | - | ------ | -------------------------------------------
|Costs related to cancellation of technology-related contracts |  | $                                               | 580   |                         | $ | (580   | )                                          
|Abandoned facilities and other                                |  |                                                 | 4,792 |                         |   | (984   | )                                          
|                                                              |  |                                                 |       |                         |   |        |                                            
|Total                                                         |  | $                                               | 5,372 |                         | $ | (1,564 | )                                          
|                                                              |  |                                                 |       |                         |   |        |                                            



NOTE 5  STOCK-BASED
COMPENSATION



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



9



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##### Table of Contents

WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



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



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



|                                                                          |  | Three Months Ended June 30, |         |   | Six Months Ended June 30, |  
|------------------------------------------------------------------------- |  | --------------------------- | ------- | - | ------------------------- | -
|                                                                          |  | 2002                        |         |   | 2003                      |  
|Net lossas reported                                                      |  | $                           | (11,703 | ) |                           | $
|Add: stock-based compensation, as reported                                |  |                             | 401     |   |                           |  
|Deduct: stock-based compensation determined under fair-value-based method |  |                             | (9,129  | ) |                           |  
|                                                                          |  |                             |         |   |                           |  
|Net losspro forma                                                        |  | $                           | (20,431 | ) |                           | $
|                                                                          |  |                             |         |   |                           |  
|Net loss per shareas reported                                            |  | $                           | (0.36   | ) |                           | $
|Net loss per sharepro forma                                              |  | $                           | (0.64   | ) |                           | $



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##### Table of Contents

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



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



Forward-Looking Statements



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



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



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



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



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



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



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



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



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



Overview



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



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



Our
core market spans the small- to medium-sized enterprise, or SME, market, from companies at the lower end where ease-of-use is a key requirement, to companies at the high end, including those with high-speed connections supporting virtual private
networks, or VPNs, between the corporate headquarters and geographically dispersed branch offices, where performance, scalability and networking features are key requirements. In addition, through our partnership with Check Point Software
Technologies Ltd., or Check Point, and with the introduction of our RapidStream line of Secured by Check Point appliances, we also have the opportunity to leverage the established presence of Check Point in the large enterprise market.



11



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##### Table of Contents

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



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



| |  |  | In April 2002, we acquired RapidStream, Inc., a privately held provider of high-performance, ASIC (application-specific integrated circuit)-based firewall and VPN appliances.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In April 2002, we entered into a partnership with Check Point to deliver a RapidStream Secured by Check Point line of high-performance security firewall and VPN
appliances based on our custom-designed security ASIC technology and integrating Check Point Next Generation software, which is targeted at the Global 1000 and large enterprise market. In June 2002, we introduced this RapidStream line.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In the second quarter of 2002, we introduced high-performance Firebox Vclass VPN and firewall appliances, which are based on custom-designed security ASIC processors and are
designed to address the performance and flexibility needs of a wide range of customers, including those in the higher end of the SME market that are running large distributed networks and data center environments.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



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



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



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



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



Critical Accounting Policies



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



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



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



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



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



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



| |  |  | analysis of impairment of goodwill and intangible assets.
| | - |  | ---------------------------------------------------------



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##### Table of Contents

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



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



Revenue Recognition



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



We generate revenues through:



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



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



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



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



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



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



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



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



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



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



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



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



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##### Table of Contents

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



Bad Debts



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



Inventory Valuation



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



Restructuring



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



Business Combinations Purchase Price Allocation



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



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



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



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



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



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



Accounting for Goodwill and Other Intangibles



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 assets acquired, as well as capitalized technology and other definite-lived intangible assets.



14



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



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



Results of Operations for the Three and Six Month Periods Ended June 30, 2002 and 2003



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



|                                                 |  | Three Months Ended June 30, |    |  | Six Months Ended June 30, |   
|------------------------------------------------ |  | --------------------------- | -- |  | ------------------------- | --
|                                                 |  | 2002                        |    |  | 2003                      |   
|Revenues:                                        |  |                             |    |  |                           |   
|Product                                          |  | 70.0                        | %  |  | 65.6                      | % 
|Service                                          |  | 30.0                        |    |  | 34.4                      |   
|                                                 |  |                             |    |  |                           |   
|Total revenues                                   |  | 100.0                       |    |  | 100.0                     |   
|Cost of revenues:                                |  |                             |    |  |                           |   
|Product                                          |  | 27.3                        |    |  | 30.3                      |   
|Service                                          |  | 8.7                         |    |  | 7.8                       |   
|                                                 |  |                             |    |  |                           |   
|Total cost of revenues                           |  | 36.0                        |    |  | 38.1                      |   
|                                                 |  |                             |    |  |                           |   
|Gross margin                                     |  | 64.0                        |    |  | 61.9                      |   
|Operating expenses:                              |  |                             |    |  |                           |   
|Sales and marketing                              |  | 49.1                        |    |  | 41.0                      |   
|Research and development                         |  | 33.7                        |    |  | 26.6                      |   
|General and administrative                       |  | 11.4                        |    |  | 10.1                      |   
|Stock-based compensation                         |  | 2.2                         |    |  | 0.3                       |   
|Amortization of other intangible assets acquired |  | 6.8                         |    |  | 2.8                       |   
|Acquired in-process technology                   |  | 6.6                         |    |  |                          |   
|Restructuring charges                            |  | 23.9                        |    |  |                          |   
|                                                 |  |                             |    |  |                           |   
|Total operating expenses                         |  | 133.7                       |    |  | 80.8                      |   
|                                                 |  |                             |    |  |                           |   
|Operating loss                                   |  | (69.7                       | )  |  | (18.9                     | ) 
|Interest income, net                             |  | 4.3                         |    |  | 0.9                       |   
|                                                 |  |                             |    |  |                           |   
|Loss before income taxes                         |  | (65.4                       | )  |  | (18.0                     | ) 
|Provision for income taxes                       |  | 0.1                         |    |  | 0.0                       |   
|                                                 |  |                             |    |  |                           |   
|Net loss                                         |  | (65.5                       | )% |  | (18.0                     | )%
|                                                 |  |                             |    |  |                           |   



15



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##### Table of Contents

Revenues



|                                   |  | Three Months Ended June 30, |        |   | Percent Increase |   |        | Six Months Ended June 30, |      |    | Percent Increase |     
|---------------------------------- |  | --------------------------- | ------ | - | ---------------- | - | ------ | ------------------------- | ---- | -- | ---------------- | ----
|                                   |  | 2002                        |        |   | 2003             |   |        |                           | 2002 |    |                  | 2003
|Revenues (in thousands):           |  |                             |        |   |                  |   |        |                           |      |    |                  |     
|Product                            |  | $                           | 12,500 |   |                  | $ | 13,132 |                           |      | 5  | %                |     
|Service                            |  |                             | 5,348  |   |                  |   | 6,888  |                           |      | 29 | %                |     
|                                   |  |                             |        |   |                  |   |        |                           |      |    |                  |     
|Total                              |  | $                           | 17,848 |   |                  | $ | 20,020 |                           |      | 12 | %                |     
|                                   |  |                             |        |   |                  |   |        |                           |      |    |                  |     
|Revenues (as % of total revenues): |  |                             |        |   |                  |   |        |                           |      |    |                  |     
|Product                            |  |                             | 70     | % |                  |   | 66     | %                         |      |    |                  |     
|Service                            |  |                             | 30     | % |                  |   | 34     | %                         |      |    |                  |     
|                                   |  |                             |        |   |                  |   |        |                           |      |    |                  |     
|Total                              |  |                             | 100    | % |                  |   | 100    | %                         |      |    |                  |     
|                                   |  |                             |        |   |                  |   |        |                           |      |    |                  |     



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



|          |  | Three Months EndedJune 30, |        |   | PercentIncrease(Decrease) |   |        | Six Months EndedJune 30, |      |     | Percent Increase (Decrease) |     
|--------- |  | -------------------------- | ------ | - | ------------------------- | - | ------ | ------------------------ | ---- | --- | --------------------------- | ----
|          |  | 2002                       |        |   | 2003                      |   |        |                          | 2002 |     |                             | 2003
|Revenues: |  |                            |        |   |                           |   |        |                          |      |     |                             |     
|Americas  |  | $                          | 7,909  |   |                           | $ | 10,077 |                          |      | 27  | %                           |     
|EMEA      |  |                            | 6,100  |   |                           |   | 7,361  |                          |      | 21  | %                           |     
|APAC      |  |                            | 3,839  |   |                           |   | 2,582  |                          |      | (33 | )%                          |     
|          |  |                            |        |   |                           |   |        |                          |      |     |                             |     
|Total     |  | $                          | 17,848 |   |                           | $ | 20,020 |                          |      | 12  | %                           |     
|          |  |                            |        |   |                           |   |        |                          |      |     |                             |     
|Revenues: |  |                            |        |   |                           |   |        |                          |      |     |                             |     
|Americas  |  |                            | 44     | % |                           |   | 50     | %                        |      |     |                             |     
|EMEA      |  |                            | 34     | % |                           |   | 37     | %                        |      |     |                             |     
|APAC      |  |                            | 22     | % |                           |   | 13     | %                        |      |     |                             |     
|          |  |                            |        |   |                           |   |        |                          |      |     |                             |     
|Total     |  |                            | 100    | % |                           |   | 100    | %                        |      |     |                             |     
|          |  |                            |        |   |                           |   |        |                          |      |     |                             |     



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



|             |  | Three Months EndedJune 30, |       |   | PercentIncrease |   |       | Six Months Ended June 30, |      |     | Percent Increase |     
|------------ |  | -------------------------- | ----- | - | --------------- | - | ----- | ------------------------- | ---- | --- | ---------------- | ----
|             |  | 2002                       |       |   | 2003            |   |       |                           | 2002 |     |                  | 2003
|Revenues:    |  |                            |       |   |                 |   |       |                           |      |     |                  |     
|Tech Data    |  | $                          | 2,676 |   |                 | $ | 3,236 |                           |      | 21  | %                |     
|Ingram Micro |  |                            | 2,284 |   |                 |   | 3,121 |                           |      | 37  | %                |     
|CDW          |  |                            | 2,230 |   |                 |   | *     |                           |      | N/A |                  |     
|Revenues:    |  |                            |       |   |                 |   |       |                           |      |     |                  |     
|Tech Data    |  |                            | 15    | % |                 |   | 16    | %                         |      |     |                  |     
|Ingram Micro |  |                            | 13    | % |                 |   | 16    | %                         |      |     |                  |     
|CDW          |  |                            | 12    | % |                 |   | *     |                           |      |     |                  |     

---

|* |  | Less than 10%
|- |  | -------------



16



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##### Table of Contents

The product revenues dollar increase in the three- and six-month periods ended June 30, 2003 as compared
to the same periods of 2002 was primarily due to an increase in unit volumes for all major product lines, in connection with new product introductions, such as Firebox Vclass products in the second quarter of 2002 and SOHO 6 products in the third
quarter of 2002 and, to a lesser extent, in connection with further additions of new products to the Firebox Vclass and Firebox III lines in the first quarter of 2003. The increase in unit volume in the three- and six-month periods ended June 30,
2003, as compared to the same periods of 2002 was partially offset by the following factors:



| |  |  | competitive pricing pressure in the Firebox III product line;
| | - |  | -------------------------------------------------------------



| |  |  | the launch of new promotional programs intended to drive future demand;
| | - |  | -----------------------------------------------------------------------



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



| |  |  | the introduction of the lower priced products in the Firebox Vclass and Firebox III product lines.
| | - |  | --------------------------------------------------------------------------------------------------



From a regional standpoint, the increase in revenue in the three- and six-month periods ended June 30, 2003 as compared to
the same periods of 2002 was mostly achieved in Americas and EMEA regions, due primarily to the improved sales channel performance in those regions. The growth of international revenues was partially slowed by the decrease in sales in APAC,
specifically in Japan, in both the three- and six-month periods ended June 30, 2003, as compared to the same periods of 2002. In the first quarter of 2003 we were in the early stages of the realignment of our APAC business focused on improving the
performance of our sales channels and localization of some of our products, and we continued this process in the second quarter of 2003.



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



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



The increase in service revenues in the six-month period ended June 30, 2003
as compared to the same period of 2002 is also attributable to service revenue of $600,000 in the first quarter of 2003 and $20,000 in the second quarter of 2003 that was generated from LiveSecurity services that were provided through certain
managed security customers to their end-users in prior periods, but were identified by WatchGuard through a license compliance initiative as being previously unreported to WatchGuard by those customers.



Service revenue is related to the product shipments in the immediately
preceding quarters, because a substantial portion of the service revenue results from the amortization of the initial service fee bundled with the original product purchase. Our product volume declined for the first two quarters of 2003 as compared
to the last quarter of 2002. As a result of this decline in product volume negatively affecting the growth of initial service subscriptions, combined with the increasing installed customer base renewing services support, it is difficult to predict
the growth rate of service revenues through the remainder of 2003, but we believe that the rate of service revenue growth will be lower than in the first six months of 2003.



The provision for estimated sales returns, price protection rights and promotional rebates was $1.3 million, or 7% of total
revenues before the provision in the three-month period ended June 30, 2002, and $1.9 million, or 9% of total revenues before the provision in the same period of 2003. The higher provision in absolute dollars in the three-month period ended June 30,
2003 as compared to the same period of 2002 corresponds to higher product sales. The higher provision as a percentage of revenue in the three-month period ended June 30, 2003 as compared to the same period of 2002 relates to the introduction of new
promotional campaigns in 2003.



The provision for estimated
sales returns, price protection rights and promotional rebates was $2.4 million, or 7% of total revenues before the provision in the six-month period ended June 30, 2002, and $3.7 million, or 8% of total revenues before the provision in the same
period of 2003. The higher provision in absolute dollars in the six-month period ended June 30, 2003 as compared to the same period of 2002 corresponds to higher product sales. The higher provision as a percentage of revenue in the first six months
of 2003 as compared to the same period of 2002 relates to the introduction of new promotional campaigns in 2003.



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



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##### Table of Contents

Cost of Revenues and Gross Margin



|                                                      |  | Three Months Ended June 30, |        |   | Percent Increase (Decrease) |   |        | Six Months EndedJune 30, |      |    | Percent Increase (Decrease) |     
|----------------------------------------------------- |  | --------------------------- | ------ | - | --------------------------- | - | ------ | ------------------------ | ---- | -- | --------------------------- | ----
|                                                      |  | 2002                        |        |   | 2003                        |   |        |                          | 2002 |    |                             | 2003
|Cost of revenues (in thousands):                      |  |                             |        |   |                             |   |        |                          |      |    |                             |     
|Product                                               |  | $                           | 4,870  |   |                             | $ | 6,066  |                          |      | 25 | %                           |     
|Service                                               |  |                             | 1,551  |   |                             |   | 1,556  |                          |      | 0  | %                           |     
|                                                      |  |                             |        |   |                             |   |        |                          |      |    |                             |     
|Total                                                 |  | $                           | 6,421  |   |                             | $ | 7,622  |                          |      | 19 | %                           |     
|                                                      |  |                             |        |   |                             |   |        |                          |      |    |                             |     
|Cost of revenues (as % of total revenues):            |  |                             |        |   |                             |   |        |                          |      |    |                             |     
|Product                                               |  |                             | 27     | % |                             |   | 30     | %                        |      |    |                             |     
|Service                                               |  |                             | 9      | % |                             |   | 8      | %                        |      |    |                             |     
|                                                      |  |                             |        |   |                             |   |        |                          |      |    |                             |     
|Total                                                 |  |                             | 36     | % |                             |   | 38     | %                        |      |    |                             |     
|                                                      |  |                             |        |   |                             |   |        |                          |      |    |                             |     
|Cost of revenues (as % of related revenue component): |  |                             |        |   |                             |   |        |                          |      |    |                             |     
|Product (as % of product revenues)                    |  |                             | 39     | % |                             |   | 46     | %                        |      |    |                             |     
|Service (as % of service revenues)                    |  |                             | 29     | % |                             |   | 23     | %                        |      |    |                             |     
|                                                      |  |                             |        |   |                             |  
|Gross margin (in thousands):                          |  |                             |        |   |                             |   |        |                          |      |    |                             |     
|Product                                               |  | $                           | 7,630  |   |                             | $ | 7,066  |                          |      | (7 | )%                          |     
|Service                                               |  |                             | 3,797  |   |                             |   | 5,332  |                          |      | 40 | %                           |     
|                                                      |  |                             |        |   |                             |   |        |                          |      |    |                             |     
|Total                                                 |  | $                           | 11,427 |   |                             | $ | 12,398 |                          |      | 8  | %                           |     
|                                                      |  |                             |        |   |                             |   |        |                          |      |    |                             |     
|Gross margin (as % of related revenue component):     |  |                             |        |   |                             |   |        |                          |      |    |                             |     
|Product (as % of product revenues)                    |  |                             | 61     | % |                             |   | 54     | %                        |      |    |                             |     
|Service (as % of service revenues)                    |  |                             | 71     | % |                             |   | 77     | %                        |      |    |                             |     
|Total (as % of total revenues)                        |  |                             | 64     | % |                             |   | 62     | %                        |      |    |                             |     



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



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



The dollar increase in cost of product revenues in the three-month period
ended June 30, 2003 as compared to the same period of 2002 was primarily due to an approximate $900,000 increase in the provision for inventory reserves, as well as due to the increase in units shipped. For this same period, gross margins decreased,
in dollars and as a percent of revenue, primarily as a result of the increase in provision for inventory reserves mentioned above. If the provision for inventory reserves were excluded from the calculation of product margin, the product gross margin
as a percentage of product revenue would have been approximately 63% for both the three-month period ended June 30, 2002 and the same period of 2003. Quantities of shipments of our products have been below our expectations for the past two quarters.
Our cautionary projections for future quarters in combination with our product life cycle planning process resulted in us recording the additional provision for inventory reserves mentioned above for certain of our products, including our
RapidStream Secured by Check Point brand product. This brand is a subset of the products and technology obtained as a result of our April 2002 acquisition of RapidStream, Inc. Additional inventory reserves may be required if RapidStream
Secured by Check Point brand revenue continues to fall below our expectations.



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The dollar increase in cost of product revenues in the six-month period ended June 30, 2003 as compared
to the same period of 2002 was primarily due to the increase in unit volume, the provision for inventory reserves and cost of manufacturing. The downward effect of the increased inventory reserves described above on product margin as a percentage of
related revenue was offset by a favorable shift in the product mix, associated with the introduction of new products in the second and third quarter of 2002 with higher unit margins, therefore product margins as a percentage of related revenue
remained the same for both six-month periods ended June 30, 2002 and June 30, 2003.



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



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



Cost of service revenues remained relatively similar in absolute dollars and declined as a percentage of related revenue, with the corresponding increase
in dollar and percentage service margin in the three- and six-month periods ended June 30, 2003 as compared to the same periods of 2002, due to operational and cost efficiencies we have realized at the same time that we have expanded our customer
base. The larger percentage increase in service margins in comparative six-month periods than in the comparative three-month periods is also partially attributable to service revenue of $600,000 generated in the first quarter of 2003 and $20,000
generated in the second quarter of 2003, without significant additional costs, from our license compliance initiative mentioned above in the discussion of our service revenues.



We expect service costs to increase in absolute dollar amount as our user base expands in the remainder of 2003. In the
longer term, as revenues from LiveSecurity Service subscriptions are expected to grow, we expect our service margins to increase on an absolute dollar basis.



Operating Expenses



Sales and Marketing



|                                                      |  | Three Months Ended June 30, |       |   | Percent (Decrease) |   |       | Six Months Ended June 30, |      |    | Percent Increase |     
|----------------------------------------------------- |  | --------------------------- | ----- | - | ------------------ | - | ----- | ------------------------- | ---- | -- | ---------------- | ----
|                                                      |  | 2002                        |       |   | 2003               |   |       |                           | 2002 |    |                  | 2003
|Sales and marketing expenses (in thousands)           |  | $                           | 8,763 |   |                    | $ | 8,204 |                           |      | (6 | )%               |     
|                                                      |  |                             |       |   |                    |  
|Sales and marketing expenses (as % of total revenues) |  |                             | 49    | % |                    |   | 41    | %                         |      |    |                  |     



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



The dollar and percentage decline in sales and marketing expenses in the
three-month period ended June 30, 2003 as compared to the same period of 2002 was primarily due to decreases in marketing programs. Costs of marketing programs declined from $3.0 million in the three-month period ended June 30, 2002 to $2.5 million
in the same period of 2003. The decline in these costs is primarily related to the reduction in certain promotional costs, as we attempt to balance those activities with increases in sales discounts and other promotional programs.



The dollar increase in sales and marketing expenses in the six-month period
ended June 30, 2003 as compared to the same period of 2002 was primarily due to the increase of salaries, recruiting and consulting costs and other headcount related expenses associated with the expansion of our product lines, such as the addition
of the Firebox Vclass line in the second quarter of 2002, and the additions of new products to the Firebox III and Firebox Vclass lines in the first quarter of 2003. This increase in headcount related expenses was somewhat offset by a decrease of
approximately $500,000 in certain promotional costs. Sales and marketing expenses declined as a percentage of revenue as we focused on improving the productivity of our sales channels and the efficiency of our marketing campaigns.



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We expect to continue investing in key areas of our sales and marketing organizations. At the same time
we are targeting a reduction in our overall costs of sales and marketing for the remainder of 2003 as compared to the first six months of 2003.



Research and Development



|                                                           |  | Three Months Ended June 30, |       |   | Percent (Decrease) |   |       | Six Months Ended June 30, |      |     | Percent (Decrease) |     
|---------------------------------------------------------- |  | --------------------------- | ----- | - | ------------------ | - | ----- | ------------------------- | ---- | --- | ------------------ | ----
|                                                           |  | 2002                        |       |   | 2003               |   |       |                           | 2002 |     |                    | 2003
|Research and development expenses (in thousands)           |  | $                           | 6,015 |   |                    | $ | 5,337 |                           |      | (11 | )%                 |     
|                                                           |  |                             |       |   |                    |  
|Research and development expenses (as % of total revenues) |  |                             | 34    | % |                    |   | 27    | %                         |      |     |                    |     



Research and
development expenses include salaries, costs of noncapitalized equipment and software tools, depreciation of capital equipment and software, costs associated with our security appliance prototypes and payments to designers and contractors.



Research and development expenses declined in both absolute
dollars and as a percentage of revenue in the three- and six-month periods ended June 30, 2003 as compared to the same periods of 2002. This decline is primarily related to the decline in salaries and benefits, associated with the reduction in
research and development personnel. Headcount related compensation costs and other research and development costs increased substantially in the second quarter of 2002 as a result of the RapidStream acquisition and due to the product integration
efforts to accelerate the rollout of new Vclass products based on the RapidStream technology. Headcount was gradually brought down to the pre-acquisition levels by the end of the second quarter of 2003, as duplicate functions were eliminated. In the
six-month period ended June 30, 2003 as compared to the same period of 2002, the compensation costs decline was partially offset by the increased costs of outsourced development connected to the broadening of the existing product lines, as well as
directed towards new generations of products.



We
believe that technological leadership is critical to our success, and we intend to continue to fund our research and development efforts in order to meet the changing requirements of our customers, to provide for continued introduction of new
products as technology advances, and to enhance and expand our current product offerings. We expect to continue investments in key areas aimed at the development of new generations of our products, further extension of our existing product lines and
the development of the new generation of underlying silicon technology for our proprietary ASIC chips. At the same time, for the remainder of 2003, we expect to maintain or reduce the overall cost of research and development expenses as compared to
the first six months of 2003.



General and Administrative



|                                                             |  | Three Months Ended June 30, |       |   | Percent (Decrease) |   |       | Six Months Ended June 30, |      |    | Percent (Decrease) |     
|------------------------------------------------------------ |  | --------------------------- | ----- | - | ------------------ | - | ----- | ------------------------- | ---- | -- | ------------------ | ----
|                                                             |  | 2002                        |       |   | 2003               |   |       |                           | 2002 |    |                    | 2003
|General and administrative expenses (in thousands)           |  | $                           | 2,031 |   |                    | $ | 2,016 |                           |      | (1 | )%                 |     
|                                                             |  |                             |       |   |                    |  
|General and administrative expenses (as % of total revenues) |  |                             | 11    | % |                    |   | 10    | %                         |      |    |                    |     



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



General and administrative expenses declined in both absolute
dollars and as a percentage of revenue in the three- and six-month periods ended June 30, 2003 as compared to the same periods of 2002. The dollar and percentage decrease in general and administrative expenses reflects relatively stable headcount
and related personnel costs coupled with a slight reduction in travel costs. The travel costs decrease in the three-month period ended June 30, 2003 as compared to the same period of 2002 was partially offset by the increase in legal and accounting
fees as a result of enhanced corporate governance requirements.



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##### Table of Contents

For the remainder of 2003, we expect general and administrative expenses, in terms of absolute dollars,
to increase from the levels incurred in the first six months of 2003. We may incur additional expenses in connection with enhanced regulatory and corporate governance requirements relating to additional internal controls and procedures pursuant to
Section 404 of the Sarbanes-Oxley Act of 2002, and cost increases relating to directors and officers insurance.



Stock-Based Compensation



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



|                                               |  | Three Months Ended June 30, |     | Percent Increase |   |    | Six Months Ended June 30, |     |    | Percent Increase |  
|---------------------------------------------- |  | --------------------------- | --- | ---------------- | - | -- | ------------------------- | --- | -- | ---------------- | -
|                                               |  | 2002                        |     | 2003             |   |    | 2002                      |     |    | 2003             |  
|Sales and marketing                            |  | $                           | 27  |                  | $ | 5  |                           | (81 | )% |                  | $
|Research and development                       |  |                             | 328 |                  |   | 47 |                           | (86 | )% |                  |  
|General and administrative                     |  |                             | 46  |                  |   | 10 |                           | (78 | )% |                  |  
|                                               |  |                             |     |                  |   |    |                           |     |    |                  |  
|Total amortization of stock-based compensation |  | $                           | 401 |                  | $ | 62 |                           | (85 | )% |                  | $
|                                               |  |                             |     |                  |   |    |                           |     |    |                  |  



Deferred stock-based
compensation is recorded as a component of stockholders equity as the difference between the exercise price of options and the fair value of our common stock on the date of grant, and for the value of common stock subject to repurchase that we
issued in connection with our October 2000 acquisition of Qiave and our April 2002 acquisition of RapidStream. In addition, deferred stock-based compensation is recorded for the fair value of stock options granted to consultants.



Amortization of Other Intangible Assets Acquired



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



Amortization of other intangible assets
acquired was $1.2 million in the three-month period ended June 30, 2002 and $554,000 in the same period of 2003.



Amortization of other intangible assets acquired was $1.9 million in the six-month period ended June 30, 2002 and $1.1 million in the same period of 2003.



The decrease in amortization of other intangible assets
acquired in the three- and six-month periods ended June 2003 as compared to the same periods of 2002 resulted primarily from the following major factors:



| |  |  | During the fourth quarter of 2002, we developed a business plan that, because of limited resources, de-emphasized further development and integration of the technology we acquired
in connection with our acquisition of Qiave Technologies Corporation in October 2000. Separately, we continued to realize lower than expected revenue from products based on the Qiave technology. As a result, the expected future cash flows were
determined to be insufficient to support the carrying value of the Qiave capitalized technology. We therefore recorded an impairment charge of $6.7 million in the last quarter of 2002 of capitalized technology related to the acquisition of Qiave.
This impairment charge reduced the remaining amortization basis of the Qiave technology, which resulted in the decrease of quarterly amortization expense of approximately $700,000 in the three-month period ended June 30, 2003 as compared to the same
period of 2002 and the decrease of approximately $1.4 million in the six-month amortization expense for the six-month period ended June 30, 2003 as compared to the same period of 2002.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | As a result of the acquisition of RapidStream in April of 2002, the amortization expense increased in the six-month period ended June 30, 2003 as compared to the same period of
2002, by approximately $500,000 due to the amortization of intangible technology related to this acquisition. The amortization of this intangible asset was comparable in the three-month periods ended June 30, 2003 and 2002.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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We periodically review the carrying value of other intangible assets acquired for existence of facts and
circumstances, both internal and external, which may suggest potential impairment. Revenues from the RapidStream Secured by Check Point brand products based on the acquired RapidStream technology have thus far failed to meet our
expectations. A key factor for success of this brand is the willingness of Check Point to devote adequate resources to this relationship. If revenues from this brand fail to meet our expectations then an impairment charge may be indicated in the
future.



Acquired In-process Technology



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



Restructuring Charge



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



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



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



Interest Income, Net



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



Interest income decreased from $766,000 in the three-month period ended June 30, 2002 to $183,000 in the same period of
2003. The decrease is caused by both a decrease in the average balance invested and a decline in the average rates of return. Additionally, the decline in net interest revenue was caused by the increase of approximately $100,000 in financing costs
from term discounts taken by our customers, as the decline in market interest rates makes early payment terms more attractive.



Interest income decreased from $1.9 million in the six-month period ended June 30, 2002 to $446,000 in the same period of 2003. These decreases resulted
from all three factors mentioned above. The decline in the invested balance in the six-month period ended June 30, 2003 was primarily due to cash used for the acquisition of RapidStream in April of 2002. Approximately $200,000 decline in net
interest income is due to the increase in financing costs from term discounts.



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



Income Taxes



Income tax expense was $16,000 in the three-month period ended June 30, 2002 and $8,000 in the same period of 2003. Income tax expense was $29,000 in the six-month period ended June 30, 2002 and $14,000 in the same period of 2003. Income
tax primarily relates to our provision for foreign income taxes associated with our international operations. We have experienced losses since inception, resulting in a net operating loss carry forward position for federal income tax purposes of
approximately $189.0 million as of June 30, 2003. These carry forwards, if not utilized, will begin to expire in 2011, and may be subject to limitations under Section 382 of the Internal Revenue Code of 1986, as amended. In addition, approximately
$103.0 million of the net operating losses generated for federal income tax purposes are not available to reduce income tax expense for financial reporting purposes because the tax effects of tax deductions for employee stock options in excess of
the related financial reporting compensation expense are recognized through equity. A valuation allowance has been established to reflect the uncertainty of generating future taxable income necessary to utilize available tax loss carry forwards.



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##### Table of Contents

Quarterly Results of Operations



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



|                                                                   |  | Three Months Ended                    |        
|------------------------------------------------------------------ |  | ------------------------------------- | -------
|                                                                   |  | June 30, 2002                         |        
|                                                                   |  | (In thousands, except per share data) |        
|Consolidated Statement of Operations Data:                         |  |                                       |        
|                                                                   |  |                                       |        
|Revenues:                                                          |  |                                       |        
|Product                                                            |  | $                                     | 12,500 
|Service                                                            |  |                                       | 5,348  
|                                                                   |  |                                       |        
|Total revenues                                                     |  |                                       | 17,848 
|Cost of revenues:                                                  |  |                                       |        
|Product                                                            |  |                                       | 4,870  
|Service                                                            |  |                                       | 1,551  
|                                                                   |  |                                       |        
|Total cost of revenues                                             |  |                                       | 6,421  
|                                                                   |  |                                       |        
|Gross margin                                                       |  |                                       | 11,427 
|Operating expenses:                                                |  |                                       |        
|Sales and marketing                                                |  |                                       | 8,763  
|Research and development                                           |  |                                       | 6,015  
|General and administrative                                         |  |                                       | 2,031  
|Stock-based compensation                                           |  |                                       | 401    
|Amortization of other intangible assets acquired                   |  |                                       | 1,219  
|Acquired in-process technology                                     |  |                                       | 1,179  
|Restructuring charges                                              |  |                                       | 4,272  
|                                                                   |  |                                       |        
|Total operating expenses                                           |  |                                       | 23,880 
|                                                                   |  |                                       |        
|Operating loss                                                     |  |                                       | (12,453
|Interest income, net                                               |  |                                       | 766    
|                                                                   |  |                                       |        
|Loss before income taxes                                           |  |                                       | (11,687
|Provision for income taxes                                         |  |                                       | 16     
|                                                                   |  |                                       |        
|Net loss                                                           |  | $                                     | (11,703
|                                                                   |  |                                       |        
|Basic and diluted net loss per share                               |  | $                                     | (0.36  
|                                                                   |  |                                       |        
|Shares used in calculation of basic and diluted net loss per share |  |                                       | 32,095 
|                                                                   |  |                                       |        



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|                                                 |  | Three Months Ended |   
|------------------------------------------------ |  | ------------------ | --
|                                                 |  | June 30,2002       |   
|Consolidated Statement of Operations Data:       |  |                    |   
|                                                 |  |                    |   
|Revenues:                                        |  |                    |   
|Product                                          |  | 70.0               | % 
|Service                                          |  | 30.0               |   
|                                                 |  |                    |   
|Total revenues                                   |  | 100.0              |   
|Cost of revenues:                                |  |                    |   
|Product                                          |  | 27.3               |   
|Service                                          |  | 8.7                |   
|                                                 |  |                    |   
|Total cost of revenues                           |  | 36.0               |   
|                                                 |  |                    |   
|Gross margin                                     |  | 64.0               |   
|                                                 |  |                    |   
|Operating expenses:                              |  |                    |   
|Sales and marketing                              |  | 49.1               |   
|Research and development                         |  | 33.7               |   
|General and administrative                       |  | 11.4               |   
|Stock-based compensation                         |  | 2.2                |   
|Amortization of other intangible assets acquired |  | 6.8                |   
|Acquired in-process technology                   |  | 6.6                |   
|Restructuring charges                            |  | 23.9               |   
|                                                 |  |                    |   
|Total operating expenses                         |  | 133.7              |   
|                                                 |  |                    |   
|Operating loss                                   |  | (69.7              | ) 
|                                                 |  |                    |   
|Interest income, net                             |  | 4.3                |   
|                                                 |  |                    |   
|Loss before income taxes                         |  | (65.4              | ) 
|                                                 |  |                    |   
|Provision for income taxes                       |  | 0.1                |   
|                                                 |  |                    |   
|Net loss                                         |  | (65.5              | )%
|                                                 |  |                    |   



During 2002 and the
first six months of 2003, global economic, political and other uncertainties, as well as constrained corporate information technology spending, appeared to slow the demand for our products and services. Like most companies in the technology sector,
we are experiencing a downturn in the growth rate of revenues that began in the fourth quarter of 2000 and continues through the first six months of 2003. We believe that both our revenues and our operating results for the five-quarter period
presented above were negatively affected by the worldwide economic conditions and an overall reduction in capital spending by businesses.



As a result of realigning of our sales and marketing organization and refocusing our distribution and channel partner strategy in late 2001, we achieved
growth in revenues in all quarters of 2002. The sequential decline in revenues in the first and second quarters of 2003 was primarily driven by overall economic conditions, the realignment of our APAC sales organization and channel strategy and by
the competitive pressure on selling prices for some of our products. The decline in APAC regional revenue began in the last quarter of 2002 and continued into the first quarter of 2003. In response to the declining APAC revenues, we focused on
rebuilding our regional operation, including strengthening our sales channels and support infrastructure, as well as localizing some of our products. In the second quarter of 2003, APAC revenues continued to decline due to the revenues shortfall in
Japan although revenues in other countries of the region have stabilized. We are continuing our realignment efforts in Japan in the remainder of 2003. These efforts, however, may not be successful as soon as expected or at all.



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



Overall, our total operating expenses have fluctuated, both in dollar amount and as a percentage of revenues, in the five-quarter period ended June 30,
2003, due primarily to the acquisition of RapidStream and business restructuring in 2002.



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



| |  |  | Sales and marketing expenses increased sequentially from the second to the third quarter of 2002, declined by $230,000 in the fourth quarter of 2002 and remained relatively
comparable to prior levels in the first quarter of 2003 and declined by $470,000 in the second quarter of 2003. The increase in sales and marketing expenses in 2002 reflects changes in our sales and marketing organizations, realignment of our
distribution and channel partner strategy, increased sales commissions associated with increased revenues and enhanced marketing effort to support the introduction of new product lines and the broadening of existing lines. A small decline in the
fourth quarter of 2002 is due to achievement of stability in our sales and marketing efforts. The achieved level on investment in sales and marketing in 2002 continued in the first quarter of 2003, as we continued to broaden our product offerings.
The decline in the second quarter of 2003 is primarily due to the decrease in incentive compensation tied to revenue goals and partially due to the reduction in certain promotional costs, as we attempt to balance those activities with the increase
in the sales discounts and other promotional programs.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Research and development expenses increased sharply in the second quarter of 2002 as a result of the RapidStream acquisition, reflecting additional personnel and general development
costs, and returned to the pre-acquisition levels by the fourth quarter of 2002, as a result of eliminating duplicate resources during our restructuring in the second quarter of 2002. Our research and development expenses increased sequentially by
$350,000 in the first quarter of 2003 and by $120,000 in the second quarter of 2003 compared to the prior quarter, as we devoted more internal and outsourced resources for new product initiatives and development of new generation technologies.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



| |  |  | Amortization of other intangible assets acquired increased in the fourth quarter of 2002 as we recognized a $6.7 million impairment charge of the capitalized technology related to
the acquisition of Qiave, as we revised downwards our estimate of future cash flow streams from products based on this technology. The amortization expense recorded in the first quarter of 2003 reflects primarily the amortization of the RapidStream
technology.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Acquired in-progress technology expense was recorded as a one-time cost in the second quarter of 2002 in connection with the acquisition of RapidStream.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------



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





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Liquidity and Capital Resources



As of June 30, 2003, we had $84.9 million in cash, cash equivalents and short-term investments. The cash equivalents and
short-term investments were invested primarily in high-quality money market accounts and marketable securities. We believe that the market risk arising from our holdings of these financial instruments is not material. We currently have outstanding a
$3.0 million unconditional letter of credit that we issued in September 2000 to our landlord in conjunction with the building lease for our corporate headquarters. Currently, our letter of credit is collateralized by short-term investments with our
bank. Our working capital as of June 30, 2003 was $67.1 million.



Operating Activities

Our operating activities resulted in net cash outflows of $4.3 million in the six-month period
ended June 30, 2002, and $3.7 million in the same period of 2003. The operating cash outflows during these periods primarily resulted from significant investments in sales and marketing and research and development, all of which led to operating
losses.



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):



|                                                            |  | Six Months Ended June 30, |        
|----------------------------------------------------------- |  | ------------------------- | -------
|                                                            |  | 2002                      |        
|Net loss                                                    |  | $                         | (16,337
|Add: noncash expenses                                       |  |                           | 5,488  
|Add (Subtract): changes in operating assets and liabilities |  |                           | 6,591  
|                                                            |  |                           |        
|Net cash used in operating activities                       |  | $                         | (4,258 
|                                                            |  |                           |        



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



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



| | a) |  | Trade Accounts Receivable, Netincreased from $8.8 million at December 31, 2002 to $9.3 million at June 30, 2003, primarily reflecting the timing of revenues during the
quarters ended December 31, 2002 and June 30, 2003. Days sales outstanding, or DSOs, calculated on a quarterly basis, increased from 36 days at December 31, 2002 to 42 days at June 30, 2003. DSOs are affected by the payment terms contained in our
customer contracts, including term discounts taken by our customers, risks associated with the uncertain economy, 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), and the amount of deferred revenue contained in the receivable balance that has not been recognized as revenue. Based on our current sales mix, the linearity of revenues in past and future quarters,
timing differences arising from the varying payment terms in our customer agreements and the growth of deferred revenue, we expect our DSOs to generally range from 50 to 60 days in the future. Any change in these factors, however, could negatively
affect expected DSO results.
| | -- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | Net Inventoriesincreased from $4.4 million at December 31, 2002 to $5.6 million at June 30, 2003. The increase of inventories was due to an expansion of product offerings
resulting from the RapidStream acquisition and introduction of new products in 2002 and 2003, as well as minimum required purchases of key components.
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | c) |  | Accrued Expenses and Other Liabilities increased from $5.1 million at December 31, 2002 to $6.1 million at June 30, 2003. The increase resulted primarily from customer
payments received in advance of revenue recognized.
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | d) |  | Accrued Restructuring and Acquisition Costsdecreased from $9.0 million at December 31, 2002 to $6.7 million at June 30, 2003, due to settlements of an abandoned lease and a
technology-related contract, as well as to the ongoing payment of rents on excess facilities.
| | -- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | e) |  | Deferred Revenuedecreased from $18.5 million at December 31, 2002 to $17.6 million at June 30, 2003. The decrease of deferred revenue balance is related to the decrease in
the number of initial service subscriptions bundled with the original product purchases, as the product shipments sequentially declined in the first and second quarters of 2003 compared to shipments in the last quarter of 2002.
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Investing Activities



Cash provided by investing activities was $9.9 million in the six-month period ended June 30, 2002 and $5.4 million in the
same period of 2003. In the six month period ended June 30, 2003, these activities primarily relate to short-term investment of the proceeds received from our public offerings, offset by capital expenditures for equipment and furniture. In the six
month period ended June 30, 2002, the investing activities also included the net cash consideration paid in connection with the acquisition of RapidStream.



Financing Activities



Cash provided by financing activities totaled $546,000 in the six month period ended June 30, 2002 and $805,000 in the same period of 2003. Cash provided
by financing activities in both periods reflects the exercise of employee stock options and the purchase of common stock through our employee stock purchase plan.



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



Contractual Obligations and Contingencies



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



Our contractual commitments at June 30, 2003 associated with
lease obligations and purchase obligations, net of future minimum rental income from subleases of $2.1 million, are as follows (in thousands):



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



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



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



We have incurred losses in the past and may not achieve or sustain
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 June 30, 2003, we had an accumulated deficit of approximately $119.0 million. Although our revenues have
increased each year since we began operations, we may not be able to continue to grow our revenues as expected, and even if we are able to grow our revenues, we do not believe that the historical percentage growth rate of our revenues will be
sustainable as our revenue base increases and we may not achieve or sustain profitability in future periods. We expect that over time we will have to increase our operating expenses in connection with



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



| |  |  | bad debt;
| | - |  | ---------



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



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



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



We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, as provided in
our discussion and analysis of financial condition and results of operations in this quarterly report, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from
other sources. Examples of such estimates include, but are not limited to, those associated with the costs of our 2001 and 2002 restructurings, and impairment analysis of our Rapid Stream intangible assets, as well as goodwill relating to our
acquisitions. Although we do not anticipate further significant adjustments to our 2002 restructuring, the actual costs related to the restructuring may differ from estimates if it takes us longer than expected to find suitable tenants or if there
are further changes in the real estate market where excess facilities are located. We periodically review the carrying value of other intangible assets acquired for existence of facts and circumstances, both internal and external, which may suggest
potential impairment. Revenues from the RapidStream Secured by Check Point brand products based on the acquired RapidStream technology have thus far to meet our expectations. A key factor for success of this brand is the willingness of
Check Point to devote adequate resources to this relationship. If revenues from this brand fail to meet our expectations then an impairment charge to our operating expenses may be indicated in the future, which could have an adverse effect on our
results of operations. Actual results may differ from these and other estimates if our assumptions change or if actual circumstances differ from those in our assumptions, which could cause our operating results to fall below the expectations of
securities analysts and investors, resulting in a decline in our stock price.



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



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



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



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



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



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



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



We currently expect that future revenues will be primarily generated through sales of our Firebox products and the related LiveSecurity Service, including
subscription fees, and we cannot succeed if the market does not accept these products and services. Our success depends on our ability and the ability of our distribution network, which includes distributors, value-added resellers and Internet
service providers and other managed service providers, to obtain and retain customers. Some of our Firebox products, particularly the Firebox Vclass products based on the RapidStream technology we acquired in the second quarter of 2002, however, are
relatively new and unproven. The Firebox Vclass products were launched in May 2002 and delivered in June 2002. The Firebox Vclass products are also directed at a new class of customer for us, one that requires a high-performance security solution
with enterprise-level networking functionality and VPN scalability, and we may be unsuccessful in marketing and selling to this class of customer.



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



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



Following our acquisition of RapidStream in the second quarter of 2002, we entered into a relationship with Check Point under which we market a line of products that includes Check Point security software. These
products, which are sold under the RapidStream brand as Secured by Check Point, are relatively new and unproven, have not achieved market acceptance and may not achieve market acceptance in the future. In addition, Check Point is a
competitor of ours in the Internet security industry, and our relationship with Check Point is terminable by either party at will. If Check Point discontinues its relationship with us or fails to devote sufficient resources and attention to the
marketing of our RapidStream products, we may not realize any benefits from our relationship with Check Point and may not generate significant revenues from the sale of the RapidStream line of products.



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



We sell most of our products and services
through our distribution network, and we expect our success to continue to depend in large part on the performance of this network. Our channel customers have the ability to sell products and services that are competitive with ours, to devote more
resources to those competitive products or to cease selling our products and services altogether. In addition, our channel partners are subject to the economic and competitive pressures unique to their respective regions, which may adversely affect
their ability to sell our products and services. Two of our channel customers, Ingram Micro and Tech Data, together accounted for 32% of our revenues in the quarter ended June 30, 2003. The loss of one of these distributors, a reduction in their
sales, a reduction in our share of their sales of Internet security products, or a loss or reduction in sales involving one or more other channel customers, particularly if the reduction results in increased sales of competitive products, could harm
our business. In addition, we are in the process of realigning our channel by reducing the number of channel customers with whom we have a direct contract, in some areas and expanding the number in others while expanding our programs for our
indirect partners to improve overall performance and efficiencies. While we have made progress in the Americas and EMEA regions, and some initial progress in the APAC region outside of Japan, we have not been successful in making material progress
in Japan. The channel reorganization in the APAC region also includes identifying and hiring additional personnel to assist us in managing the channel. If the realignment and reorganization causes disruption in any region, or we continue to be
unsuccessful in making progress on the realignment and reorganization in Japan, we could experience a loss or reduction in sales involving one or more of our channel customers. In addition, the aftermath or a renewed spread of severe acute
respiratory syndrome (SARS) in the APAC region may also result in a loss or reduction in sales from our channel customers in that region.



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



We provide most of our channel customers with product return rights for
stock rotation and price protection rights for their inventories, which they may exercise if we lower our prices for those products. We also provide promotional rebates to some of our channel customers. We may experience significant returns, price
adjustments and rebate costs for which we may not have adequate allowances. The short life cycles of our products and the difficulty of predicting future sales increase the risk that new product introductions, notification of the end-of-life of
existing products or price reductions by us or our competitors could result in significant product returns or price adjustments. When we introduced the Firebox II, and then later the Firebox III, security appliances, we experienced an increase in
returns of previous products and product versions. Provisions for estimated sales returns, price protection rights and promotional rebates were $1.9 million in 2000, $6.9 million in 2001 and $4.6 million in 2002 or 3%, 10% and 6% of total revenues
before the provisions. The provision for estimated sales returns, price protection rights and promotional rebates was $1.9 million, or 9% of revenues, before the provision, in the quarter ended June 30, 2003, and $3.7 million or 8% of total
revenues, before the provision, in the six-month period ended June 30, 2003. While we review and adjust our provision for returns and allowances in order to properly reflect the potential for promotional rebate costs, increased returns and pricing
adjustments associated with new products, including new products resulting from our acquisition of RapidStream, or notification of the end-of-life of existing products, the provision may still be inadequate.



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



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



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



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



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



We may be unable to adequately expand our operational systems to accommodate growth, which could harm our ability to deliver our products and services.



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



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



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



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



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



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.



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



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



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



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



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



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



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



If we fail to obtain and maintain patent protection for our technology, we may be unable to compete effectively. We have one issued patent and 20 patents
pending, but our patent applications may not result in issued patents. Even if we secure a patent, the patent may not provide meaningful protection. In addition, we rely on unpatented proprietary technology. Because this proprietary technology does
not have patent protection, we may be unable to meaningfully protect this technology from unauthorized use or misappropriation by a third party. In addition, our competitors may independently develop similar or superior technologies or duplicate any
unpatented technologies that we have developed, which could significantly reduce the value of our proprietary technology or threaten our market position.



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



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



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



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



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

| |  |  | redesign products or services that incorporate infringing technology.
| | - |  | ---------------------------------------------------------------------



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



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



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



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



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



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



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



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



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



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



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



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 50% and 51% of our revenues in the three- and six-month periods ended June 30, 2003 respectively. The failure of our channel customers
to sell our products internationally would limit our ability to increase our revenues. In addition, our international sales are subject to the risks inherent in international business activities, including



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



| |  |  | export and import restrictions, such as those affecting encryption commodities and software or those requiring local content;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------



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



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



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



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Our international sales currently are U.S. dollar-denominated. As a result, an increase in the value of
the U.S. dollar relative to foreign currencies has made and may continue to make our products less competitive in international markets.



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



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



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



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



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



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



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



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



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



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



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



Our stock price is volatile.



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



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



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



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



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



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



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



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



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



Interest Rate Risk



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



Foreign Currency Risk



All of our sales and the majority of our expenses are currently denominated
in U.S. dollars. As a result, we have not experienced significant foreign exchange gains and losses. While we incurred some expenses in foreign currencies during the six-month period ended June 30, 2003 and expect to continue to do so in the future,
we do not anticipate that foreign exchange gains or losses will be material to us. Although we have not engaged in foreign currency hedging to date, we may do so in the future.



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



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



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



There were no significant changes to our internal controls or in other
factors that have materially affected, or are reasonably likely to materially affect, our internal controls subsequent to the end of the period covered by this quarterly report.



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PART II. OTHER INFORMATION



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



At our annual meeting of
stockholders held on June 5, 2003, stockholders representing a total of 28,565,701 shares of common stock entitled to vote at the meeting, constituting a quorum, voted to:



| | (1) |  | Elect two Class 3 directors, each to hold office until the third annual meeting of stockholders following his or her election and until his or her successor is elected and
qualified.
| | --- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                 |  | For        |  | Withheld
|---------------- |  | ---------- |  | --------
|Ellen M. Hancock |  | 28,333,476 |  | 232,225 
|Steven N. Moore  |  | 28,460,356 |  | 105,345 



| | (2) |  | Reapprove our 1996 Stock Incentive Compensation Plan, as amended and restated solely to impose limits on the number of shares that may be granted under the plan to any single
employee in any single fiscal year.
| | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|For     |  | 19,328,415
|------- |  | ----------
|Against |  | 8,730,941 
|Abstain |  | 506,345   



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



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



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



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



| | 10.1 |  | Amended and Restated 1996 Stock Incentive Compensation Plan.
| | ---- |  | ------------------------------------------------------------



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



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



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



|(b) |  | Reports on Form 8-K
|--- |  | -------------------



We did not file any current reports on Form-K with the SEC during the three-month period ended June 30, 2003. We furnished a current report on Form 8-K to
the SEC on April 24, 2003 announcing our financial results for the three-month period ended March 31, 2003.



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SIGNATURES



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



August
12, 2003



WATCHGUARD TECHNOLOGIES, INC.By:

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




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WATCHGUARD TECHNOLOGIES, INC.



INDEX TO EXHIBITS



|Exhibit |  | Description                                                                                                                                                                                                       
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|        | 
|3.1     |  | Restated Certificate of Incorporation of WatchGuard Technologies, Inc. (incorporated by reference to Exhibit 3.1 to WatchGuards Registration Statement on Form S-1 (file
number 333-78813), filed July 30, 1999).
|        | 
|3.2     |  | Restated Bylaws of WatchGuard Technologies, Inc. (incorporated by reference to Exhibit 3.2 to WatchGuards Registration Statement on Form S-1 (file number 333-78813), filed
July 30, 1999).                      
|        | 
|10.1    |  | Amended and Restated 1996 Stock Incentive Compensation Plan.                                                                                                                                                      
|        | 
|31.1    |  | Certification of Chief Executive required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.                                                                                 
|        | 
|31.2    |  | Certification of Chief Financial Officer required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.                                                                         
|        | 
|32.1    |  | Certifications of Chief Executive Officer and Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934, as amended, and 18
U.S.C. Section 1350.                





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