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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 March 31, 2003 |  | Commission File Number 000-26819
|--------------------------------------------- |  | --------------------------------





WATCHGUARD TECHNOLOGIES, INC.

(Exact Name of
Registrant as Specified in Its Charter)





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





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

(Address of Principal Executive Offices) (Zip Code)





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





Not Applicable

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





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





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





32,843,029 shares of WatchGuard common stock were outstanding as of May 6, 2003.





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##### Table of Contents

WATCHGUARD TECHNOLOGIES, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER
ENDED MARCH 31, 2003



TABLE OF CONTENTS



|PART I.  |  | FINANCIAL INFORMATION                                                                         |  |   
|-------- |  | --------------------------------------------------------------------------------------------- |  | --
|        
|ITEM 1.  |  | FINANCIAL STATEMENTS                                                                          |  | 3 
|        
|         |  |     Consolidated Balance Sheets as of December 31, 2002 and March 31, 2003                   |  | 3 
|        
|         |  |     Consolidated Statements of Operations for the three months ended March 31, 2002 and 2003 |  | 4 
|        
|         |  |     Consolidated Statements of Cash Flows for the three months ended March 31, 2002 and 2003 |  | 5 
|        
|         |  |     Notes to Consolidated Financial Statements                                               |  | 6 
|        
|ITEM 2.  |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS         |  | 12
|        
|ITEM 3.  |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                    |  | 36
|        
|ITEM 4.  |  | CONTROLS AND PROCEDURES                                                                       |  | 36
|        
|PART II. |  | OTHER INFORMATION                                                                             |  |   
|        
|ITEM 6.  |  | EXHIBITS AND REPORTS ON FORM 8-K                                                              |  | 37



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PART I.    FINANCIAL INFORMATION



ITEM 1.    FINANCIAL STATEMENTS



WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

(unaudited)



|                                                                                               |  | December 31, 2002 |          |   | March 31, 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 and32,833,039 at
March 31, 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  |   |                | $
|                                                                                               |  |                   |          |   |                |  

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See accompanying notes.



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WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(unaudited)



|                                                                  |  | Three Months Ended March 31, |       
|----------------------------------------------------------------- |  | ---------------------------- | ------
|                                                                  |  | 2002                         |       
|                                                                 
|Revenues:                                                         |  |                              |       
|Product                                                           |  | $                            | 10,558
|Service                                                           |  |                              | 4,954 
|                                                                  |  |                              |       
|Total revenues                                                    |  |                              | 15,512
|                                                                 
|Cost of revenues:                                                 |  |                              |       
|Product                                                           |  |                              | 4,297 
|Service                                                           |  |                              | 1,516 
|                                                                  |  |                              |       
|Total cost of revenues                                            |  |                              | 5,813 
|                                                                  |  |                              |       
|Gross margin                                                      |  |                              | 9,699 
|                                                                 
|Operating expenses:                                               |  |                              |       
|Sales and marketing (1)                                           |  |                              | 7,438 
|Research and development (2)                                      |  |                              | 4,668 
|General and administrative (3)                                    |  |                              | 2,000 
|Stock-based compensation                                          |  |                              | 613   
|Amortization of other intangible assets acquired                  |  |                              | 721   
|                                                                  |  |                              |       
|Total operating expenses                                          |  |                              | 15,440
|                                                                  |  |                              |       
|Operating loss                                                    |  |                              | (5,741
|Interest income, net                                              |  |                              | 1,120 
|                                                                  |  |                              |       
|Loss before income taxes                                          |  |                              | (4,621
|Provision for income taxes                                        |  |                              | 13    
|                                                                  |  |                              |       
|Net loss                                                          |  | $                            | (4,634
|                                                                  |  |                              |       
|                                                                 
|Basic and diluted net loss per share                              |  | $                            | (0.17 
|                                                                  |  |                              |       
|                                                                 
|Shares used in calculation of basic and dilutednet loss per share |  |                              | 27,117
|                                                                  |  |                              |       

---

|(1) |  | Sales and marketing expenses exclude amortization of stock-based compensation of $12 and $13 for the three months ended March 31, 2002 and 2003, respectively.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | Research and development expenses exclude amortization of stock-based compensation of $596 and $94 for the three months ended March 31, 2002 and 2003, respectively.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) |  | General and administrative expenses exclude amortization of stock-based compensation of $5 and $14 for the three months ended March 31, 2002 and 2003, respectively.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------



See accompanying notes.



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WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)



|                                                                                                                        |  | Three Months Ended March 31, |        
|----------------------------------------------------------------------------------------------------------------------- |  | ---------------------------- | -------
|                                                                                                                        |  | 2002                         |        
|                                                                                                                       
|OPERATING ACTIVITIES:                                                                                                   |  |                              |        
|Net loss                                                                                                                |  | $                            | (4,634 
|Adjustments to reconcile net loss to net cash used in operating
activities:                                             |  |                              |        
|Noncash expenses:                                                                                                       |  |                              |        
|Depreciation and amortization of property and equipment                                                                 |  |                              | 623    
|Amortization of other intangible assets acquired                                                                        |  |                              | 723    
|Amortization of stock-based compensation                                                                                |  |                              | 613    
|Changes in operating assets and liabilities:                                                                            |  |                              |        
|Trade accounts receivable, net                                                                                          |  |                              | (2,581 
|Inventories, net                                                                                                        |  |                              | 1,448  
|Prepaid expenses and other                                                                                              |  |                              | 875    
|Other intangibles, net and other assets                                                                                 |  |                              | 5      
|Accounts payable                                                                                                        |  |                              | (2,113 
|Accrued expenses and other liabilities                                                                                  |  |                              | 1,283  
|Accrued restructuring and acquisition costs                                                                             |  |                              | (329   
|Deferred revenues                                                                                                       |  |                              | 893    
|                                                                                                                        |  |                              |        
|NET CASH USED IN OPERATING ACTIVITIES                                                                                   |  |                              | (3,194 
|                                                                                                                       
|INVESTING ACTIVITIES:                                                                                                   |  |                              |        
|Purchases of property and equipment                                                                                     |  |                              | (19    
|Proceeds from maturity of marketable securities                                                                         |  |                              | 17,845 
|Proceeds from sale of marketable securities                                                                             |  |                              | 17,336 
|Purchases of marketable securities                                                                                      |  |                              | (32,775
|                                                                                                                        |  |                              |        
|NET CASH PROVIDED BY INVESTING ACTIVITIES                                                                               |  |                              | 2,387  
|                                                                                                                       
|FINANCING ACTIVITIES:                                                                                                   |  |                              |        
|Proceeds from the exercise of common stock options and the saleof common stock
through the employee stock purchase plan |  |                              | 370    
|                                                                                                                        |  |                              |        
|NET CASH PROVIDED BY FINANCING ACTIVITIES                                                                               |  |                              | 370    
|                                                                                                                        |  |                              |        
|NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                                                    |  |                              | (437   
|CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                                                                        |  |                              | 13,958 
|                                                                                                                        |  |                              |        
|CASH AND CASH EQUIVALENTS AT END OF PERIOD                                                                              |  | $                            | 13,521 
|                                                                                                                        |  |                              |        

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See accompanying notes.



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WATCHGUARD
TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



NOTE 1DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION



Description of Business



WatchGuard Technologies, Inc.
(WatchGuard) is a leading provider of Internet security solutions designed to protect 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 period ended March 31, 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 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.



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.



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 contract, 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-month periods ended March 31, 2002 and March 31, 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 March 31, |       
|------------------------------ |  | ---------------------------- | ------
|                               |  | 2002                         |       
|                              
|Net loss                       |  | $                            | (4,634
|Unrealized loss on investments |  |                              | (513  
|                               |  |                              |       
|Comprehensive loss             |  | $                            | (5,147
|                               |  |                              |       



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



Recent
Accounting Pronouncements



In June 2002,
the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS 146 addresses financial accounting and reporting for
costs associated with exit or disposal activities and nullifies EITF Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).
SFAS 146 generally requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred rather than at the date of an entitys commitment to an exit plan. As the provisions of SFAS 146
are effective for exit and disposal activities initiated after December 31, 2003, and WatchGuard did not undertake these activities in the three months ended March 31, 2003, SFAS 146 did not have a material impact on WatchGuards consolidated
financial statements.



At the November 21, 2002
meeting, the EITF of the 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.



Reclassifications



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



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



NOTE 3BALANCE SHEET
ACCOUNT DETAIL



Trade Accounts
Receivable, Net



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



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



Accrued Expenses and Other Liabilities



Accrued expenses consisted of the following (in thousands):



|                                    |  | December 31, 2002 |       | March 31, 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 |       | March 31, 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 March 31, 2003, the remaining balance of the restructuring liabilities was $6.0 million. No adjustments to the remaining liabilities were required in the three-month period ended March 31,
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 |   |      | March 31, 2003 Accrued Restructuring Balance
|--------------------------------------------------- |  | ----------------------------------------------- | ----- | ----------------------- | - | ---- | --------------------------------------------
|                                                   
|Accrued liabilities related to abandoned facilities |  | $                                               | 2,035 |                         | $ | (149 | )                                           
|                                                    |  |                                                 |       |                         |   |      |                                             



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 related to losses for the lease buyout or sublease of abandoned facilities of approximately $4.1 million at March 31, 2003 are
expected to be realized through 2010. Contract termination costs were paid during the quarter ended March 31, 2003, except for certain legal fees that will be paid by June 30, 2003.



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



|                                                              |  | December 31, 2002 Accrued Restructuring Balance |       | Amounts Paid or Charged |   |        | March 31, 2003 Accrued Restructuring Balance
|------------------------------------------------------------- |  | ----------------------------------------------- | ----- | ----------------------- | - | ------ | --------------------------------------------
|                                                             
|Costs related to cancellation of technology-related contracts |  | $                                               | 580   |                         | $ | (559   | )                                           
|Abandoned facilities and other                                |  |                                                 | 4,792 |                         |   | (667   | )                                           
|                                                              |  |                                                 |       |                         |   |        |                                             
|Total                                                         |  | $                                               | 5,372 |                         | $ | (1,226 | )                                           
|                                                              |  |                                                 |       |                         |   |        |                                             



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WATCHGUARD
TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



NOTE 5STOCK-BASED COMPENSATION



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



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



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



|                                                                          |  | Three Months Ended March 31, |        
|------------------------------------------------------------------------- |  | ---------------------------- | -------
|                                                                          |  | 2002                         |        
|                                                                         
|Net lossas reported                                                      |  | $                            | (4,634 
|Add: stock-based compensation, as reported                                |  |                              | 613    
|Deduct: stock-based compensation determined under fair-value-based
method |  |                              | (9,655 
|                                                                          |  |                              |        
|Net losspro forma                                                        |  |                              | (13,676
|                                                                          |  |                              |        
|Net loss per shareas reported                                            |  | $                            | (0.17  
|Net loss per sharepro forma                                              |  | $                            | (0.50  





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



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



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, 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 Software
Technologies Ltd., or Check Point, in the large enterprise market.



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



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



| |  |  | In 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 Check Points 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.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Critical Accounting Policies



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



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



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



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



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



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



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



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



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



Revenue Recognition



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



We generate revenues through:



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



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



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



Product revenues 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 CheckPoint 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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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.



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. Variation in market trends, customer preferences and introduction of new products that replace existing products or technological advances
could, however, significantly affect these estimates and result in additional inventory write-downs.



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 had to adjust 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 as part of 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 had 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.



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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.



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 impairment adjustments.



Results of Operations



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



|                                                 |  | Three Months Ended March 31, |   
|------------------------------------------------ |  | ---------------------------- | --
|                                                 |  | 2002                         |   
|                                                
|Revenues:                                        |  |                              |   
|Product                                          |  | 68.1                         | % 
|Service                                          |  | 31.9                         |   
|                                                 |  |                              |   
|Total revenues                                   |  | 100.0                        |   
|                                                
|Cost of revenues:                                |  |                              |   
|Product                                          |  | 27.7                         |   
|Service                                          |  | 9.8                          |   
|                                                 |  |                              |   
|Total cost of revenues                           |  | 37.5                         |   
|                                                 |  |                              |   
|Gross margin                                     |  | 62.5                         |   
|                                                
|Operating expenses:                              |  |                              |   
|Sales and marketing                              |  | 47.9                         |   
|Research and development                         |  | 30.1                         |   
|General and administrative                       |  | 12.9                         |   
|Stock-based compensation                         |  | 4.0                          |   
|Amortization of other intangible assets acquired |  | 4.6                          |   
|                                                 |  |                              |   
|Total operating expenses                         |  | 99.5                         |   
|                                                 |  |                              |   
|                                                
|Operating loss                                   |  | (37.0                        | ) 
|                                                
|Interest income, net                             |  | 7.2                          |   
|                                                 |  |                              |   
|                                                
|Loss before income taxes                         |  | (29.8                        | ) 
|                                                
|Provision for income taxes                       |  | 0.1                          |   
|                                                 |  |                              |   
|                                                
|Net loss                                         |  | (29.9                        | )%
|                                                 |  |                              |   



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Three Months Ended March
31, 2002 and 2003



Revenues



|                                   |  | Three Months Ended March 31, |        |   | Percentage Increase |  
|---------------------------------- |  | ---------------------------- | ------ | - | ------------------- | -
|                                   |  | 2002                         |        |   | 2003                |  
|                                  
|Revenues (in thousands):           |  |                              |        |   |                     |  
|Product                            |  | $                            | 10,558 |   |                     | $
|Service                            |  |                              | 4,954  |   |                     |  
|                                   |  |                              |        |   |                     |  
|Total                              |  | $                            | 15,512 |   |                     | $
|                                   |  |                              |        |   |                     |  
|                                  
|Revenues (as % of total revenues): |  |                              |        |   |                     |  
|Product                            |  |                              | 68     | % |                     |  
|Service                            |  |                              | 32     | % |                     |  
|                                   |  |                              |        |   |                     |  
|Total                              |  |                              | 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 Ended March 31, |        |   | Percentage Increase (Decrease) |  
|--------- |  | ---------------------------- | ------ | - | ------------------------------ | -
|          |  | 2002                         |        |   | 2003                           |  
|         
|Revenues: |  |                              |        |   |                                |  
|Americas  |  | $                            | 6,182  |   |                                | $
|EMEA      |  |                              | 5,749  |   |                                |  
|APAC      |  |                              | 3,581  |   |                                |  
|          |  |                              |        |   |                                |  
|Total     |  | $                            | 15,512 |   |                                | $
|          |  |                              |        |   |                                |  
|         
|Revenues: |  |                              |        |   |                                |  
|Americas  |  |                              | 40     | % |                                |  
|EMEA      |  |                              | 37     | % |                                |  
|APAC      |  |                              | 23     | % |                                |  
|          |  |                              |        |   |                                |  
|Total     |  |                              | 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 Ended March 31, |       |   | Percentage Increase |  
|------------ |  | ---------------------------- | ----- | - | ------------------- | -
|             |  | 2002                         |       |   | 2003                |  
|            
|Revenues:    |  |                              |       |   |                     |  
|Tech Data    |  | $                            | 2,281 |   |                     | $
|Ingram Micro |  |                              | *     |   |                     |  
|            
|Revenues:    |  |                              |       |   |                     |  
|Tech Data    |  |                              | 15    | % |                     |  
|Ingram Micro |  |                              | *     |   |                     |  

---



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



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The product
revenues dollar increase was primarily due to larger unit volumes 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 lines in the first quarter of 2003. The dollar growth in product revenues is also attributed to the improved sales channel performance in the Americas and EMEA
markets. The growth of international revenues was partially slowed by the decrease in sales in the Asia-Pacific region in the first quarter of 2003, as compared to the first quarter 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. 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 remain depressed 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 or at the rate expected, and we may be unable to achieve similar results in future periods.



The dollar increase in service revenues 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 as a percentage of total revenues is primarily due to $600,000 of service revenue in the first 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.
Although we may realize additional service revenues as a result of our license compliance initiatives, we expect a slower growth rate of service revenues through the remainder of 2003 as compared to corresponding periods of 2002.



The provision for estimated sales returns, price protection
rights and promotional rebates was $1.1 million, or 7% of total revenues before the provision in the first quarter of 2002, and $1.7 million, or 7% of total revenues before the provision in the first quarter of 2003. The higher provision in absolute
dollars in the first three months of 2003 as compared to the same period of 2002 corresponds to higher product sales. 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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Cost of
Revenues and Gross Margin



|                                                      |  | Three Months Ended March 31, |       |   | Percentage Increase (Decrease) |  
|----------------------------------------------------- |  | ---------------------------- | ----- | - | ------------------------------ | -
|                                                      |  | 2002                         |       |   | 2003                           |  
|                                                     
|Cost of revenues (in thousands):                      |  |                              |       |   |                                |  
|Product                                               |  | $                            | 4,297 |   |                                | $
|Service                                               |  |                              | 1,516 |   |                                |  
|                                                      |  |                              |       |   |                                |  
|Total                                                 |  | $                            | 5,813 |   |                                | $
|                                                      |  |                              |       |   |                                |  
|                                                     
|Cost of revenues (as % of total revenues):            |  |                              |       |   |                                |  
|Product                                               |  |                              | 28    | % |                                |  
|Service                                               |  |                              | 10    | % |                                |  
|                                                      |  |                              |       |   |                                |  
|Total                                                 |  |                              | 38    | % |                                |  
|                                                      |  |                              |       |   |                                |  
|                                                     
|Cost of revenues (as % of related revenue component): |  |                              |       |   |                                |  
|Product (as % of product revenues)                    |  |                              | 41    | % |                                |  
|Service (as % of service revenues)                    |  |                              | 31    | % |                                |  
|                                                     
|Gross margin (in thousands):                          |  |                              |       |   |                                |  
|Product                                               |  | $                            | 6,261 |   |                                | $
|Service                                               |  |                              | 3,438 |   |                                |  
|                                                      |  |                              |       |   |                                |  
|Total                                                 |  | $                            | 9,699 |   |                                | $
|                                                      |  |                              |       |   |                                |  
|                                                     
|Gross margin (as % of related revenue component):     |  |                              |       |   |                                |  
|Product (as % of product revenues)                    |  |                              | 59    | % |                                |  
|Service (as % of service revenues)                    |  |                              | 69    | % |                                |  
|                                                      |  |                              |       |   |                                |  
|Total (as % of total revenues)                        |  |                              | 62    | % |                                |  
|                                                      |  |                              |       |   |                                |  



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Gross margins
are impacted by various factors, including the volume discount level contained in our channel partner agreements, the cost of our Firebox and RapidStream Secured by Check Point 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 and
third-party product licensing fees. The dollar increase in cost of product revenues was primarily due to the increase in units sold. The decrease in cost of product revenues as a percentage of total product revenues was primarily due to the
introduction of new products in the second and third quarters of 2002 with higher product margins and a lower provision for inventory reserves. We expect a dollar increase in cost of product revenues for the remainder of 2003 if we achieve the
expected increase in shipments. We expect product gross margins to increase in the future in dollar amount, primarily as a result of increased sales combined with a more favorable product mix aimed at a greater quantity of higher-margin products.
However, our gross margins may be adversely affected in the future by 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. The percentage and dollar decrease in cost of service revenues and the resulting improved gross margin reflect operational and cost efficiencies we have realized at the same time that we have expanded our customer base. The
percentage decrease in cost of service revenues in the first quarter of 2003 is also partially attributable to $600,000 of service revenue generated, without significant additional costs, from our license compliance initiative, discussed above. 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 grow, we expect our service margins to increase on an absolute
dollar basis.



Operating Expenses



Sales and Marketing



|                                                      |  | Three Months Ended March 31, |       |   | Percentage Increase
|----------------------------------------------------- |  | ---------------------------- | ----- | - | -------------------
|                                                      |  | 2002                         |       |   | 2003               
|                                                     
|Sales and marketing expenses (in thousands)           |  | $                            | 7,438 |   |                    
|Sales and marketing expenses (as % of total revenues) |  |                              | 48    | % |                    



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 and trade show expenses. The dollar and
percentage increases in sales and marketing expenses were primarily due to increases in headcount in our sales and marketing organizations and the expansion of marketing programs. Increases in both headcount and in marketing activities were
primarily required to support the expansion of our product lines, such as the addition of our Firebox Vclass line and our RapidStream Secured by CheckPoint line, which was developed as a result of our acquisition of RapidStream in the
second quarter of 2002. Specifically, major components of the increase were:



| |  |  | an increase in salaries, recruiting, consulting and related expenses from $4.1 million to $4.6 million;
| | - |  | -------------------------------------------------------------------------------------------------------



| |  |  | an increase in marketing programs, including advertising, trade shows, public relations and other expenses from $2.0 million to $2.4 million; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | an increase in travel costs from $410,000 to $570,000.
| | - |  | ------------------------------------------------------



We expect to continue to increase our sales and marketing expenses in dollar amount as we expand our international presence, especially in
the APAC markets. We believe we will incur additional expenses to introduce new products and increase the adoption rate for these products as we continue to broaden our product offerings. We expect sales and marketing expenses to decrease as a
percentage of revenues as we focus on improving depth and productivity of our existing channel partners.



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Research
and Development



|                                                           |  | Three Months Ended March 31, |       |   | Percentage Increase
|---------------------------------------------------------- |  | ---------------------------- | ----- | - | -------------------
|                                                           |  | 2002                         |       |   | 2003               
|                                                          
|Research and development expenses (in thousands)           |  | $                            | 4,668 |   |                    
|Research and development expenses (as % of total revenues) |  |                              | 30    | % |                    



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. The
dollar and percentage increases in research and development expenses primarily reflect the increases in headcount and corresponding employee-related costs, due to our acquisition of RapidStream in the second quarter of 2002. We also increased our
investment in outsourced development, integration and certification costs. We continued to invest in the further development of our new product lines introduced in the second quarter of 2002, such as our Firebox Vclass line and our RapidStream
Secured by CheckPoint line. In the first quarter of 2003, we also developed new additions to the Firebox Vclass and Firebox III lines, such as V60L, V200, Firebox S6 and Firebox 500. At the same time, we continued to integrate our
existing and acquired products. Specifically, major components of the increase were:



| |  |  | an increase in payroll and related expenses from $2.9 million to $3.3 million; and
| | - |  | ----------------------------------------------------------------------------------



| |  |  | an increase in security appliance prototype development, certification and consulting costs from $590,000 to $750,000.
| | - |  | ----------------------------------------------------------------------------------------------------------------------



We expect research and development expenses to increase in
dollar amount and decline as a percentage of revenues in the remainder of 2003. We believe that technological leadership is critical to our success and we are committed to continuing a high level of funding for our research and development effort in
order to meet the changing requirements of our customers, to ensure continued introduction of new products as technology advances, and to enhance and expand our current product offerings.



General and Administrative



|                                                             |  | Three Months Ended March 31, |       |   | Percentage Decrease
|------------------------------------------------------------ |  | ---------------------------- | ----- | - | -------------------
|                                                             |  | 2002                         |       |   | 2003               
|                                                            
|General and administrative expenses (in thousands)           |  | $                            | 2,000 |   |                    
|General and administrative expenses (as % of total revenues) |  |                              | 13    | % |                    



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. The dollar and percentage decrease in general and administrative expenses reflects relatively stable headcount and related personnel costs, coupled with a reduction in outside professional service fees. We expect general and administrative
expenses to increase in dollar amount and decline as a percentage of revenues in the remainder of 2003, as we incur additional costs related to the growth of our business and our operation as a public company, including new regulatory and corporate
governance requirements.



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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 March 31, |     | Percentage Increase (Decrease) |  
|---------------------------------------------- |  | ---------------------------- | --- | ------------------------------ | -
|                                               |  | 2002                         |     | 2003                           |  
|                                              
|Sales and marketing                            |  | $                            | 12  |                                | $
|Research and development                       |  |                              | 596 |                                |  
|General and administrative                     |  |                              | 5   |                                |  
|                                               |  |                              |     |                                |  
|Total amortization of stock-based compensation |  | $                            | 613 |                                | $



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 $721,000 in the three months ended March 31, 2002 and $518,000 in the three months ended March 31, 2003. The decrease in amortization of
other intangible assets acquired in the first quarter of 2003 as compared to the first quarter 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 $700,000 in the first quarter of 2003.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In the first quarter of 2003, we recorded $500,000 amortization of intangible assets related to the acquisition of RapidStream, which acquisition was completed in
the second quarter of 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. Interest income decreased from $1.1
million in the three months ended March 31, 2002 to $263,000 in the three months ended March 31, 2003. This decrease resulted from both a decrease in the average balance of invested funds primarily due to cash used for the acquisition of RapidStream
and from a decrease in the average rates of return.



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Income
Taxes



Income tax expense of $13,000 in
the three months ended March 31, 2002 and $6,000 in the three months ended March 31, 2003 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 $185 million as of March 31, 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 $104 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.



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 March 31, 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                    |       
|------------------------------------------------------------------ |  | ------------------------------------- | ------
|                                                                   |  | Mar. 31, 2002                         |       
|                                                                   |  | (In thousands, except per share data) |       
|                                                                  
|Consolidated Statement of Operations Data:                         |  |                                       |       
|                                                                  
|Revenues:                                                          |  |                                       |       
|Product                                                            |  | $                                     | 10,558
|Service                                                            |  |                                       | 4,954 
|                                                                   |  |                                       |       
|Total revenues                                                     |  |                                       | 15,512
|                                                                  
|Cost of revenues:                                                  |  |                                       |       
|Product                                                            |  |                                       | 4,297 
|Service                                                            |  |                                       | 1,516 
|                                                                   |  |                                       |       
|Total cost of revenues                                             |  |                                       | 5,813 
|                                                                   |  |                                       |       
|Gross margin                                                       |  |                                       | 9,699 
|                                                                  
|Operating expenses:                                                |  |                                       |       
|Sales and marketing                                                |  |                                       | 7,438 
|Research and development                                           |  |                                       | 4,668 
|General and administrative                                         |  |                                       | 2,000 
|Stock-based compensation                                           |  |                                       | 613   
|Amortization of other intangible assets acquired                   |  |                                       | 721   
|Acquired in-process technology                                     |  |                                       |      
|Restructuring charges                                              |  |                                       |      
|                                                                   |  |                                       |       
|Total operating expenses                                           |  |                                       | 15,440
|                                                                   |  |                                       |       
|Operating loss                                                     |  |                                       | (5,741
|Interest income, net                                               |  |                                       | 1,120 
|                                                                   |  |                                       |       
|Loss before income taxes                                           |  |                                       | (4,621
|Provision for income taxes                                         |  |                                       | 13    
|                                                                   |  |                                       |       
|Net loss                                                           |  | $                                     | (4,634
|                                                                   |  |                                       |       
|Basic and diluted net loss per share                               |  | $                                     | (0.17 
|                                                                   |  |                                       |       
|Shares used in calculation of basic and diluted net loss per share |  |                                       | 27,117
|                                                                   |  |                                       |       



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|                                                 |  | Three Months Ended |   
|------------------------------------------------ |  | ------------------ | --
|                                                 |  | Mar. 31, 2002      |   
|                                                
|Consolidated Statement of Operations Data:       |  |                    |   
|                                                
|Revenues:                                        |  |                    |   
|Product                                          |  | 68.1               | % 
|Service                                          |  | 31.9               |   
|                                                 |  |                    |   
|Total revenues                                   |  | 100.0              |   
|                                                
|Cost of revenues:                                |  |                    |   
|Product                                          |  | 27.7               |   
|Service                                          |  | 9.8                |   
|                                                 |  |                    |   
|Total cost of revenues                           |  | 37.5               |   
|                                                 |  |                    |   
|Gross margin                                     |  | 62.5               |   
|                                                
|Operating expenses:                              |  |                    |   
|Sales and marketing                              |  | 47.9               |   
|Research and development                         |  | 30.1               |   
|General and administrative                       |  | 12.9               |   
|Stock-based compensation                         |  | 4.0                |   
|Amortization of other intangible assets acquired |  | 4.6                |   
|Acquired in-process technology                   |  |                   |   
|Restructuring charges                            |  |                   |   
|                                                 |  |                    |   
|Total operating expenses                         |  | 99.5               |   
|                                                 |  |                    |   
|Operating loss                                   |  | (37.0              | ) 
|Interest income, net                             |  | 7.2                |   
|                                                 |  |                    |   
|Loss before income taxes                         |  | (29.8              | ) 
|Provision for income taxes                       |  | 0.1                |   
|                                                 |  |                    |   
|Net loss                                         |  | (29.9              | )%
|                                                 |  |                    |   



During
2002 and the first quarter 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 quarter 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 each of the four quarters of 2002. The sequential decline in revenues in the first quarter of 2003 was primarily driven by overall economic conditions and the realignment of our APAC sales organization and
channel strategy. The decline in APAC regional revenue began in the last quarter of 2002 and continued to a greater extent into the first quarter of 2003. In the first quarter of 2003, in an attempt to expand the APAC market penetration, we focused
on rebuilding our regional operation, including strengthening our sales channels and support infrastructure, as well as localizing some of our products. These efforts, however, may not be successful as soon as expected or at all.



Our gross margins, both in dollar amount and as a percentage
of total revenues, have increased sequentially in each of the five quarters presented. The gross margin improvements in 2002 were caused by sequential revenue growth and the introduction of 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 discussed above.



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Overall, our
total operating expenses have fluctuated, both in dollar amount and as a percentage of revenues, in the five-quarter period ended March 31, 2003, due primarily to the acquisition of RapidStream and business restructuring in 2002.



The components of the total operating expense fluctuation are
as follows:



| |  |  | Sales and marketing expenses increased sequentially in the first three quarters of 2002, declined by $230,000 in the fourth quarter of 2002 and remained relatively
flat in the first 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.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 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 level 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 $350,000 in the first quarter of 2003 compared to the prior quarter, as we devoted more internal and outsourced resources for new product initiatives.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | General and administrative expenses have been relatively stable for the five-quarter period ended March 31, 2003.
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | Stock-based compensation charges, associated primarily with the acquisition of Qiave in October 2000, have decreased sequentially for all quarters presented, due to
recognizing a much larger portion of the expense in the early quarters after an acquisition.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Amortization of other intangible assets acquired increased in the second quarter of 2002 by $500,000 as we capitalized technology acquired in connection with the
RapidStream acquisition. In the fourth quarter of 2002, we recorded 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.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Liquidity and Capital Resources



As of March 31, 2003, we had $88.2 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 March 31, 2003 was $70.1 million.



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Operating Activities



Our operating activities resulted in net cash outflows of $3.2 million in the three months ended March 31, 2002, and $1.1 million in the three months ended March 31, 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):



|                                                      |  | Three Months Ended March 31, |       
|----------------------------------------------------- |  | ---------------------------- | ------
|                                                      |  | 2002                         |       
|                                                     
|Net loss                                              |  | $                            | (4,634
|Add: noncash expenses                                 |  |                              | 1,959 
|Subtract: changes in operating assets and liabilities |  |                              | (519  
|                                                      |  |                              |       
|Net cash used in operating activities                 |  | $                            | (3,194
|                                                      |  |                              |       



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.



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 $10.2 million at March 31, 2003, primarily reflecting the timing of
revenues during the quarters ended December 31, 2002 and March 31, 2003. Days sales outstanding, or DSOs, calculated on a quarterly basis, increased from 36 days at December 31, 2002 to 42 days at March 31, 2003. DSOs are affected by the payment
terms contained in our customer contracts, 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 $6.3 million at March 31, 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 $6.8 million at March 31, 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 $7.4 million at March 31, 2003, due to settlements of an
abandoned lease and a technology-related contract, as well as to the payment of rents on excess facilities.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Investing Activities



Cash provided by investing activities was $2.4 million in the three months ended March 31, 2002 and $3.9 million in the three months ended
March 31, 2003. In both periods, these activities primarily relate to short-term investment of the proceeds received from our public offerings, offset by capital expenditures for equipment and furniture.



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Financing Activities



Cash provided by financing activities totaled $370,000 in the three months ended March 31, 2002 and $751,000 in the three months ended March 31, 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 March
31, 2003 associated with lease obligations and purchase obligations, net of future minimum rental income from subleases of $1.7 million, are as follows (in thousands):



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



We have
entered into employment and executive retention agreements with certain employees and executive officers that, among other things, include certain severance and change-of-control provisions.



From time to time, we are involved in litigation relating to
claims arising out of our operations in the normal course of business. We are not presently a party to any legal proceedings, the adverse outcome of which, in our opinion, would have a material adverse effect on our operating results or financial
position.



As permitted under Delaware law, we
have agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is, or was, serving at our request in such capacity. The term of the indemnification period is for the later of six years
after the date that the officer or director ceases to serve at our request in such capacity or the final termination of proceedings against the officer or director as outlined in the indemnification agreement. The maximum potential amount of future
payments we could be required to make under these indemnification agreements is unlimited; however, we have a director and officer insurance policy that limits our exposure and enables us to recover a portion of any future amounts paid.



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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 March 31, 2003, we had an accumulated deficit of approximately
$115 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 continue 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 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.



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



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



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



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



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



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



We base our estimates on historical experience and on various other assumptions that we believe to be
reasonable under the circumstances, as provided in our discussion and analysis of financial condition and results of operations in this quarterly report, the results of which form the basis for making judgments about the carrying values of assets
and liabilities that are not readily apparent from other sources. Examples of such estimates include, but are not limited to, those associated with the costs of our 2001 and 2002 restructuring and impairment analysis of our Qiave intangible asset,
as well as goodwill relating to our acquisitions of BeadleNet, Qiave and RapidStream. 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. 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.



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.





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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, and the broadcast portion of our LiveSecurity Service has been available only since February 1999. 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 new
and unproven and may not achieve market acceptance. 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.



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 may result in pricing reductions, reduced gross margins and
loss of market share. Currently, the primary competitors in our industry include Check Point, Cisco Systems, Inc., 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 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.
Two of our channel customers, Ingram Micro and Tech Data, together accounted for 35% of our revenues in the quarter ended March 31, 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 consolidating our channel by reducing the number of channel customers with whom we have a direct contract, 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, we are in an earlier stage of that process in the APAC region where, in addition to consolidation, a channel reorganization is required. The channel reorganization in the APAC region also includes identifying and hiring
additional personnel to assist us in managing the channel. If the consolidation and reorganization causes disruption, we could experience a loss or reduction in sales involving one or more of our channel customers. In addition, the spread of 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 returns and allowances 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 returns and allowances. The
provision for returns and allowances was 1.7 million, or 7% of revenues, before returns and allowances in the quarter ended March 31, 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.



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



We may be unable to adequately expand 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 third-party technology that is important for the functionality of our products.



Our success will depend in part on our continued ability to license technology that is important for the functionality of our products. A
significant interruption in the supply of a third-party technology 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. While we are unable to determine the extent to which piracy of our software products exists, we expect piracy to be a continuing
concern, particularly in international markets and as a result of the growing use of the Internet.



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



If we do not retain our key employees, 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 attempting to integrate the business and technology of any future acquisition, we could incur significant costs that may not be outweighed by any benefits of the acquisition.



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



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



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



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



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



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



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



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



Our ability to grow will depend in part on the expansion of our international sales and operations, which are expected to continue to
account for a significant portion of our revenues. Sales to customers outside of the United States accounted for approximately 57% of our revenues in the quarter ended March 31, 2003. The failure of our channel customers to sell our products
internationally would limit our ability to increase our revenues. In addition, our international sales are subject to the risks inherent in international business activities, including



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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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.



ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



Interest Rate Risk



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



Foreign Currency Risk



All of our sales and the majority of our expenses are
currently denominated in U.S. dollars. As a result, we have not experienced significant foreign exchange gains and losses. While we incurred some expenses in foreign currencies during the three months ended March 31, 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.



ITEM 4.    CONTROLS AND PROCEDURES



The term disclosure controls and procedures is defined in Rules 13a-14(c) and 15d-14(c) 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 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 Evaluation Date, which is a date within 90 days before the filing of this quarterly report, and they have concluded that, as of the Evaluation Date, our disclosure
controls and procedures were effective.



There
were no significant changes to our internal controls or in other factors that could significantly affect our internal controls subsequent to the Evaluation Date.



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PART
II.    OTHER INFORMATION



ITEM 6.    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).
| | --- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 99.1 |  | Certifications of Chief Executive Officer and Chief Financial Officer
| | ---- |  | ---------------------------------------------------------------------



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



None.



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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.



May 14, 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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CERTIFICATIONS



I, James A. Cady, certify that:



|1. |  | I have reviewed this quarterly report on Form 10-Q of WatchGuard Technologies, Inc. (WatchGuard);
|-- |  | ---------------------------------------------------------------------------------------------------



|2. |  | Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|3. |  | Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the
financial condition, results of operations and cash flows of WatchGuard as of, and for, the periods presented in this quarterly report;
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|4. |  | WatchGuards other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act
Rules 13a-14 and 15d-14) for WatchGuard and we have:
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | designed such disclosure controls and procedures to ensure that material information relating to WatchGuard, including its consolidated subsidiaries, is made known
to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
| | -- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | evaluated the effectiveness of WatchGuards disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report
(the Evaluation Date); and
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | c) |  | presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation
Date;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------



|5. |  | WatchGuards other certifying officer and I have disclosed, based on our most recent evaluation, to WatchGuards auditors and the audit committee of
WatchGuards board of directors (or persons performing the equivalent function):
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | all significant deficiencies in the design or operation of internal controls which could adversely affect WatchGuards ability to record, process, summarize and
report financial data and have identified for WatchGuards auditors any material weaknesses in internal controls; and
| | -- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | any fraud, whether or not material, that involves management or other employees who have a significant role in WatchGuards internal controls; and
| | -- |  | --------------------------------------------------------------------------------------------------------------------------------------------------



|6. |  | WatchGuards other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------





Date: May 14, 2003



/S/    JAMES A.
CADYJames A. Cady President, Chief Executive Officer and Chairman of the Board (Principal Executive
Officer)




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##### Table of Contents

I, Michael E. McConnell, certify that:



|1. |  | I have reviewed this quarterly report on Form 10-Q of WatchGuard Technologies, Inc. (WatchGuard);
|-- |  | ---------------------------------------------------------------------------------------------------



|2. |  | Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|3. |  | Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the
financial condition, results of operations and cash flows of WatchGuard as of, and for, the periods presented in this quarterly report;
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|4. |  | WatchGuards other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act
Rules 13a-14 and 15d-14) for WatchGuard and we have:
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | designed such disclosure controls and procedures to ensure that material information relating to WatchGuard, including its consolidated subsidiaries, is made known
to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
| | -- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | evaluated the effectiveness of WatchGuards disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report
(the Evaluation Date); and
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | c) |  | presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation
Date;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------



|5. |  | WatchGuards other certifying officer and I have disclosed, based on our most recent evaluation, to WatchGuards auditors and the audit committee of
WatchGuards board of directors (or persons performing the equivalent function):
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | all significant deficiencies in the design or operation of internal controls which could adversely affect WatchGuards ability to record, process, summarize and
report financial data and have identified for WatchGuards auditors any material weaknesses in internal controls; and
| | -- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | any fraud, whether or not material, that involves management or other employees who have a significant role in WatchGuards internal controls; and
| | -- |  | --------------------------------------------------------------------------------------------------------------------------------------------------



|6. |  | WatchGuards other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Date: May 14, 2003



/S/    MICHAEL E.
MCCONNELLMichael E. McConnell Senior Vice President, Chief Financial Officer and Treasurer (Principal Executive
Officer)




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##### Table of Contents

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).                      
|       
|99.1    |  | Certifications of Chief Executive Officer and Chief Financial Officer