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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934



For the quarterly period ended June 30, 2004



Commission File Number 000-26819



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WATCHGUARD TECHNOLOGIES, INC.

(Exact Name of Registrant as Specified in Its Charter)



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



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

(Address of Principal Executive Offices) (Zip Code)



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



Not Applicable

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



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



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



33,535,217 shares of WatchGuard common stock were outstanding as of July 30, 2004.



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WATCHGUARD TECHNOLOGIES, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2004



TABLE OF CONTENTS



|                                                                                           |  |                                                                                       |  |   
|------------------------------------------------------------------------------------------ |  | ------------------------------------------------------------------------------------- |  | --
|PART I. FINANCIAL INFORMATION                                                              |  | 3                                                                                    
|                                                                                           |  |                                                                                      
|ITEM 1.                                                                                    |  | FINANCIAL STATEMENTS                                                                  |  | 3 
|                                                                                           |  |                                                                                      
|ITEM 2.                                                                                    |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS |  | 10
|                                                                                           | 
|RESULTS OF OPERATIONS                                                                      |  | 14                                                                                   
|                                                                                           | 
|IMPORTANT FACTORS THAT MAY AFFECT OUR BUSINESS, OUR OPERATING RESULTS,
AND OUR STOCK PRICE |  | 24                                                                                   
|                                                                                           |  |                                                                                      
|ITEM 3.                                                                                    |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            |  | 32
|                                                                                           |  |                                                                                      
|ITEM 4.                                                                                    |  | CONTROLS AND PROCEDURES                                                               |  | 32
|                                                                                           | 
|PART II. OTHER INFORMATION                                                                 |  | 33                                                                                   
|                                                                                           |  |                                                                                      
|ITEM 4.                                                                                    |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                   |  | 33
|                                                                                           |  |                                                                                      
|ITEM 6.                                                                                    |  | EXHIBITS AND REPORTS ON FORM 8-K                                                      |  | 33



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PART I. FINANCIAL INFORMATION



ITEM 1. FINANCIAL STATEMENTS



WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)



|                                                                                                                              |  |                  |          |   |               |   |          |  
|----------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | -------- | - | ------------- | - | -------- | -
|                                                                                                                              |  | December 31,2003 |          |   | June 30, 2004 |  
|                                                                                                                              |  |                  |          |   | (unaudited)   |  
|ASSETS                                                                                                                        |  |                  |          |   |               |   |          |  
|Current assets:                                                                                                               |  |                  |          |   |               |   |          |  
|Cash and cash equivalents                                                                                                     |  | $                | 3,899    |   |               | $ | 4,284    |  
|Short-term investments                                                                                                        |  |                  | 74,890   |   |               |   | 73,005   |  
|Trade accounts receivable, net                                                                                                |  |                  | 6,700    |   |               |   | 8,093    |  
|Inventories, net                                                                                                              |  |                  | 3,068    |   |               |   | 4,540    |  
|Prepaid expenses and other current assets                                                                                     |  |                  | 3,924    |   |               |   | 3,721    |  
|                                                                                                                              |  |                  |          |   |               |   |          |  
|Total current assets                                                                                                          |  |                  | 92,481   |   |               |   | 93,643   |  
|Property and equipment, net                                                                                                   |  |                  | 5,471    |   |               |   | 4,873    |  
|Restricted cash                                                                                                               |  |                  | 3,000    |   |               |   | 3,000    |  
|Goodwill                                                                                                                      |  |                  | 66,605   |   |               |   | 66,605   |  
|Other intangibles, net and other assets                                                                                       |  |                  | 3,562    |   |               |   | 2,975    |  
|                                                                                                                              |  |                  |          |   |               |   |          |  
|Total assets                                                                                                                  |  | $                | 171,119  |   |               | $ | 171,096  |  
|                                                                                                                              |  |                  |          |   |               |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                          |  |                  |          |   |               |   |          |  
|Current liabilities:                                                                                                          |  |                  |          |   |               |   |          |  
|Accounts payable                                                                                                              |  | $                | 3,676    |   |               | $ | 4,210    |  
|Accrued expenses and other liabilities                                                                                        |  |                  | 6,819    |   |               |   | 6,212    |  
|Short-term accrued restructuring and acquisition costs                                                                        |  |                  | 2,271    |   |               |   | 1,703    |  
|Short-term deferred revenues                                                                                                  |  |                  | 15,675   |   |               |   | 16,551   |  
|                                                                                                                              |  |                  |          |   |               |   |          |  
|Total current liabilities                                                                                                     |  |                  | 28,441   |   |               |   | 28,676   |  
|Long-term accrued restructuring costs                                                                                         |  |                  | 4,268    |   |               |   | 3,820    |  
|Long-term deferred revenues                                                                                                   |  |                  | 1,072    |   |               |   | 1,254    |  
|                                                                                                                              |  |                  |          |   |               |   |          |  
|Total liabilities                                                                                                             |  |                  | 33,781   |   |               |   | 33,750   |  
|Stockholders equity:                                                                                                         |  |                  |          |   |               |   |          |  
|Preferred stock, $0.001 par value:                                                                                            |  |                  |          |   |               |   |          |  
|Authorized shares: 10,000,000; no shares issued and outstanding                                                               |  |                  |         |   |               |   |         |  
|Common stock, $0.001 par value:                                                                                               |  |                  |          |   |               |   |          |  
|Authorized shares: 80,000,000; shares issued and outstanding: 33,091,787 at December 31, 2003 and 33,534,047 at June 30, 2004 |  |                  | 33       |   |               |   | 34       |  
|Additional paid-in capital                                                                                                    |  |                  | 267,649  |   |               |   | 269,746  |  
|Deferred stock-based compensation                                                                                             |  |                  | (25      | ) |               |   | (14      | )
|Accumulated other comprehensive loss                                                                                          |  |                  | (41      | ) |               |   | (288     | )
|Accumulated deficit                                                                                                           |  |                  | (130,278 | ) |               |   | (132,132 | )
|                                                                                                                              |  |                  |          |   |               |   |          |  
|Total stockholders equity                                                                                                    |  |                  | 137,338  |   |               |   | 137,346  |  
|                                                                                                                              |  |                  |          |   |               |   |          |  
|Total liabilities and stockholders equity                                                                                    |  | $                | 171,119  |   |               | $ | 171,096  |  
|                                                                                                                              |  |                  |          |   |               |   |          |  



See accompanying
notes.



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WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(unaudited)



|                                                                                    |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|----------------------------------------------------------------------------------- |  | --------------------------- | ------ | - | ------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                    |  | Three Months Ended June 30, |        |   | Six Months Ended June 30, |  
|                                                                                    |  | 2003                        |        |   | 2004                      |   |        | 2003 |  |   | 2004   |  
|Revenues:                                                                           |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Product                                                                             |  | $                           | 13,132 |   |                           | $ | 16,074 |      |  | $ | 27,711 |   |  | $ | 31,068 |  
|Service                                                                             |  |                             | 6,888  |   |                           |   | 6,947  |      |  |   | 14,118 |   |  |   | 13,429 |  
|                                                                                    |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Total revenues                                                                      |  |                             | 20,020 |   |                           |   | 23,021 |      |  |   | 41,829 |   |  |   | 44,497 |  
|Cost of revenues:                                                                   |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Product                                                                             |  |                             | 6,066  |   |                           |   | 6,566  |      |  |   | 11,041 |   |  |   | 12,963 |  
|Service                                                                             |  |                             | 1,556  |   |                           |   | 1,431  |      |  |   | 3,031  |   |  |   | 2,775  |  
|                                                                                    |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Total cost of revenues                                                              |  |                             | 7,622  |   |                           |   | 7,997  |      |  |   | 14,072 |   |  |   | 15,738 |  
|                                                                                    |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Gross margin                                                                        |  |                             | 12,398 |   |                           |   | 15,024 |      |  |   | 27,757 |   |  |   | 28,759 |  
|Operating expenses:                                                                 |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Sales and marketing                                                                 |  |                             | 8,204  |   |                           |   | 8,300  |      |  |   | 16,877 |   |  |   | 16,695 |  
|Research and development                                                            |  |                             | 5,337  |   |                           |   | 4,708  |      |  |   | 10,556 |   |  |   | 9,247  |  
|General and administrative                                                          |  |                             | 2,016  |   |                           |   | 2,079  |      |  |   | 3,950  |   |  |   | 4,331  |  
|Stock-based compensation (1)                                                        |  |                             | 62     |   |                           |   | 7      |      |  |   | 183    |   |  |   | 18     |  
|Amortization of other intangible assets acquired                                    |  |                             | 554    |   |                           |   | 243    |      |  |   | 1,072  |   |  |   | 487    |  
|                                                                                    |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Total operating expenses                                                            |  |                             | 16,173 |   |                           |   | 15,337 |      |  |   | 32,638 |   |  |   | 30,778 |  
|                                                                                    |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Operating loss                                                                      |  |                             | (3,775 | ) |                           |   | (313   | )    |  |   | (4,881 | ) |  |   | (2,019 | )
|                                                                                    |  |                             |        |  
|Interest income, net:                                                               |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Interest income                                                                     |  |                             | 325    |   |                           |   | 298    |      |  |   | 738    |   |  |   | 572    |  
|Interest expense                                                                    |  |                             | (142   | ) |                           |   | (195   | )    |  |   | (292   | ) |  |   | (364   | )
|                                                                                    |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Total interest income, net                                                          |  |                             | 183    |   |                           |   | 103    |      |  |   | 446    |   |  |   | 208    |  
|                                                                                    |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Loss before income taxes                                                            |  |                             | (3,592 | ) |                           |   | (210   | )    |  |   | (4,435 | ) |  |   | (1,811 | )
|Provision for income taxes                                                          |  |                             | 8      |   |                           |   | 29     |      |  |   | 14     |   |  |   | 43     |  
|                                                                                    |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Net loss                                                                            |  | $                           | (3,600 | ) |                           | $ | (239   | )    |  | $ | (4,449 | ) |  | $ | (1,854 | )
|                                                                                    |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Basic and diluted net loss per share                                                |  | $                           | (0.11  | ) |                           | $ | (0.01  | )    |  | $ | (0.14  | ) |  | $ | (0.06  | )
|                                                                                    |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Shares used in calculation of basic and diluted net loss per share                  |  |                             | 32,842 |   |                           |   | 33,461 |      |  |   | 32,791 |   |  |   | 33,356 |  
|                                                                                    |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|                                                                                    |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|(1)    Stock-based compensation charges relate to the following expense categories: |  |                             |        |   |                           |   |        |      | 
|Sales and marketing                                                                 |  | $                           | 5      |   |                           | $ | 2      |      |  | $ | 17     |   |  | $ | 4      |  
|Research and development                                                            |  |                             | 47     |   |                           |   | 4      |      |  |   | 141    |   |  |   | 10     |  
|General and administrative                                                          |  |                             | 10     |   |                           |   | 1      |      |  |   | 25     |   |  |   | 4      |  
|                                                                                    |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Total                                                                               |  | $                           | 62     |   |                           | $ | 7      |      |  | $ | 183    |   |  | $ | 18     |  
|                                                                                    |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  



See accompanying notes.



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WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)



|                                                                                                          |  |                           |         |   |      |   |         |  
|--------------------------------------------------------------------------------------------------------- |  | ------------------------- | ------- | - | ---- | - | ------- | -
|                                                                                                          |  | Six Months Ended June 30, |        
|                                                                                                          |  | 2003                      |         |   | 2004 |  
|Operating activities:                                                                                     |  |                           |         |   |      |   |         |  
|                                                                                                          |  |                          
|Net loss                                                                                                  |  | $                         | (4,449  | ) |      | $ | (1,854  | )
|Adjustments to reconcile net loss to net cash used in operating activities:                               |  |                           |         |   |      |   |         |  
|Noncash expenses:                                                                                         |  |                           |         |   |      |   |         |  
|Depreciation and amortization of property and equipment                                                   |  |                           | 1,419   |   |      |   | 1,398   |  
|Amortization of other intangible assets acquired                                                          |  |                           | 1,072   |   |      |   | 487     |  
|Stock-based compensation                                                                                  |  |                           | 183     |   |      |   | 18      |  
|Changes in operating assets and liabilities:                                                              |  |                           |         |   |      |   |         |  
|Trade accounts receivable, net                                                                            |  |                           | (536    | ) |      |   | (1,393  | )
|Inventories, net                                                                                          |  |                           | (1,182  | ) |      |   | (1,472  | )
|Prepaid expenses and other current assets                                                                 |  |                           | 1,169   |   |      |   | 203     |  
|Other assets                                                                                              |  |                           | 126     |   |      |   | 100     |  
|Accounts payable                                                                                          |  |                           | 961     |   |      |   | 534     |  
|Accrued expenses and other liabilities                                                                    |  |                           | 773     |   |      |   | (607    | )
|Accrued restructuring and acquisition costs                                                               |  |                           | (2,336  | ) |      |   | (1,016  | )
|Deferred revenues                                                                                         |  |                           | (869    | ) |      |   | 1,058   |  
|                                                                                                          |  |                           |         |   |      |   |         |  
|Net cash used in operating activities                                                                     |  |                           | (3,669  | ) |      |   | (2,544  | )
|                                                                                                          |  |                          
|Investing activities:                                                                                     |  |                           |         |   |      |   |         |  
|Purchases of property and equipment                                                                       |  |                           | (1,390  | ) |      |   | (800    | )
|Proceeds from maturities of marketable securities                                                         |  |                           | 80,247  |   |      |   | 27,600  |  
|Purchases of marketable securities                                                                        |  |                           | (73,430 | ) |      |   | (25,962 | )
|                                                                                                          |  |                           |         |   |      |   |         |  
|Net cash provided by investing activities                                                                 |  |                           | 5,427   |   |      |   | 838     |  
|                                                                                                          |  |                          
|Financing activities:                                                                                     |  |                           |         |   |      |   |         |  
|Proceeds from stock option exercises and issuances of common stock under the employee stock purchase plan |  |                           | 805     |   |      |   | 2,091   |  
|                                                                                                          |  |                           |         |   |      |   |         |  
|Net cash provided by financing activities                                                                 |  |                           | 805     |   |      |   | 2,091   |  
|                                                                                                          |  |                           |         |   |      |   |         |  
|Net increase in cash and cash equivalents                                                                 |  |                           | 2,563   |   |      |   | 385     |  
|                                                                                                          |  |                          
|Cash and cash equivalents at beginning of period                                                          |  |                           | 8,890   |   |      |   | 3,899   |  
|                                                                                                          |  |                           |         |   |      |   |         |  
|Cash and cash equivalents at end of period                                                                |  | $                         | 11,453  |   |      | $ | 4,284   |  
|                                                                                                          |  |                           |         |   |      |   |         |  



See accompanying notes.



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



NOTE 1  DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION



Description of Business



WatchGuard Technologies, Inc. (WatchGuard) is a leading provider of Internet
security solutions designed to protect small- to medium-sized enterprises (or SMEs) 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, 2003 balance
sheet that was derived from audited consolidated financial statements, have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of
Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the unaudited financial statements include
all adjustments, consisting of normal recurring accruals, necessary for a fair presentation. Operating results for the three-month and six-month periods ended June 30, 2004 are not necessarily indicative of the results that may be expected for
future quarters or for the year ending December 31, 2004. The financial statements should be read in conjunction with the financial statements and related notes for the year ended December 31, 2003 included in WatchGuards annual report on Form
10-K, filed with the Securities and Exchange Commission (SEC) on March 15, 2004.



NOTE 2  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



Revenue Recognition



WatchGuard generates revenues through sales of its Firebox products, including licenses for related software options, and subscriptions for its LiveSecurity Service, which includes access to technical support, software updates (if and when
available), early-warning vulnerability alerts and expert instruction and training. Software license revenues are generated from licensing the rights to use WatchGuards products directly to end-users, from sublicense fees from resellers and
distributors and from sales of its managed security solution products to Internet service providers and other service providers that utilize WatchGuards products to provide managed security services to their customers.



WatchGuard recognizes revenue in accordance with accounting standards for
software companies, including Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-9, and related interpretations, including Technical Practice Aids and the SEC Topic 13 Revenue Recognition of
the codification of the Staff Accounting Bulletins. Topic 13 summarizes certain of the SECs views in applying generally accepted accounting principles to revenue recognition in financial statements. WatchGuard believes its current revenue
recognition policies and practices are consistent with the current accounting standards.



Revenues from software license agreements are generally recognized upon delivery of software if persuasive evidence of an arrangement exists, collection is probable, the fee is fixed or determinable, and
vendor-specific objective evidence of fair value for undelivered elements of the arrangement has been established. Vendor-specific objective evidence of fair value 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 of fair value 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.



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 No. 01-09, Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendors Product,



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##### Table of Contents

WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



which requires that sales incentives given to customers or resellers be accounted for as a
reduction of revenue unless a vendor receives a benefit that is identifiable and can be reasonably estimated. WatchGuard accrues allowances for rebates to the potential maximum amount possible unless there are sufficient historical trends which
would indicate a lower rate of accrual is appropriate.



Revenues from some distribution arrangements where the distributor has unlimited stock returns and rotation rights are not recognized until the distributors sell the products to their customers.



Revenues from LiveSecurity Service subscriptions are recognized ratably over
the term of the subscription, typically 90 days to two years. WatchGuards payment terms typically range from 30 to 60 days.



Principles of Consolidation



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



Net Loss Per Share



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



Comprehensive Loss



WatchGuards investments consist of corporate and government debt
securities, are considered available-for-sale, and are stated at fair value, with unrealized gains and losses included as a component of stockholders equity. During the three- and six-month periods ended June 30, 2003 and June 30, 2004, 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 EndedJune 30, |        |   | Six Months EndedJune 30, |  
|                               |  | 2003                       |        |   | 2004                     |   |      | 2003 |  |   | 2004   |  
|Net loss                       |  | $                          | (3,600 | ) |                          | $ | (239 | )    |  | $ | (4,449 | ) |  | $ | (1,854 | )
|Unrealized loss on investments |  |                            | (148   | ) |                          |   | (348 | )    |  |   | (158   | ) |  |   | (247   | )
|                               |  |                            |        |   |                          |   |      |      |  |   |        |   |  |   |        |  
|Comprehensive loss             |  | $                          | (3,748 | ) |                          | $ | (587 | )    |  | $ | (4,607 | ) |  | $ | (2,101 | )
|                               |  |                            |        |   |                          |   |      |      |  |   |        |   |  |   |        |  



Stock-based Compensation



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



Pro Forma Disclosures Under SFAS 123



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



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



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



|                                                                          |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |        |  
|------------------------------------------------------------------------- |  | -------------------------- | ------ | - | ------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                                                          |  | Three Months EndedJune 30, |        |   | Six Months EndedJune 30, |  
|                                                                          |  | 2003                       |        |   | 2004                     |   |        | 2003 |  |   | 2004    |  
|Net loss  as reported                                                    |  | $                          | (3,600 | ) |                          | $ | (239   | )    |  | $ | (4,449  | ) |  | $ | (1,854 | )
|Add: stock-based compensation, as reported                                |  |                            | 62     |   |                          |   | 7      |      |  |   | 183     |   |  |   | 18     |  
|Deduct: stock-based compensation determined under fair-value-based method |  |                            | (4,441 | ) |                          |   | (3,426 | )    |  |   | (10,290 | ) |  |   | (6,278 | )
|                                                                          |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |        |  
|Net loss  pro forma                                                      |  | $                          | (7,979 | ) |                          | $ | (3,658 | )    |  | $ | (14,556 | ) |  | $ | (8,114 | )
|                                                                          |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |        |  
|Net loss per share  as reported                                          |  | $                          | (0.11  | ) |                          | $ | (0.01  | )    |  | $ | (0.14   | ) |  | $ | (0.06  | )
|Net loss per share  pro forma                                            |  | $                          | (0.24  | ) |                          | $ | (0.11  | )    |  | $ | (0.44   | ) |  | $ | (0.24  | )



Reclassifications



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



NOTE 3  BALANCE SHEET ACCOUNT DETAIL



Trade Accounts Receivable, Net



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



|                                     |  |                   |        |   |               |   |        |  
|------------------------------------ |  | ----------------- | ------ | - | ------------- | - | ------ | -
|                                     |  | December 31, 2003 |        |   | June 30, 2004 |  
|                                     |  |                  
|Trade accounts receivable            |  | $                 | 9,231  |   |               | $ | 10,677 |  
|Reserve for returns and allowances   |  |                   | (2,283 | ) |               |   | (2,276 | )
|Allowance for uncollectible accounts |  |                   | (248   | ) |               |   | (308   | )
|                                     |  |                   |        |   |               |   |        |  
|                                     |  | $                 | 6,700  |   |               | $ | 8,093  |  
|                                     |  |                   |        |   |               |   |        |  



Inventories, Net



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



|                    |  |                   |        |   |               |   |        |  
|------------------- |  | ----------------- | ------ | - | ------------- | - | ------ | -
|                    |  | December 31, 2003 |        |   | June 30, 2004 |  
|                    |  |                  
|Finished goods      |  | $                 | 2,638  |   |               | $ | 3,088  |  
|Components          |  |                   | 1,868  |   |               |   | 2,566  |  
|                    |  |                   |        |   |               |   |        |  
|                    |  |                   | 4,506  |   |               |   | 5,654  |  
|Inventory allowance |  |                   | (1,438 | ) |               |   | (1,114 | )
|                    |  |                   |        |   |               |   |        |  
|                    |  | $                 | 3,068  |   |               | $ | 4,540  |  
|                    |  |                   |        |   |               |   |        |  



Accrued Expenses and Other Liabilities



Accrued expenses consisted of the following (in thousands):



|                                    |  |                   |       |               |   |      
|----------------------------------- |  | ----------------- | ----- | ------------- | - | -----
|                                    |  | December 31, 2003 |       | June 30, 2004
|                                    |  |                  
|Accrued payroll-related liabilities |  | $                 | 2,225 |               | $ | 2,658
|Other accrued liabilities           |  |                   | 4,594 |               |   | 3,554
|                                    |  |                   |       |               |   |      
|                                    |  | $                 | 6,819 |               | $ | 6,212
|                                    |  |                   |       |               |   |      



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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



NOTE 4  GUARANTEES



WatchGuards operating lease for its corporate headquarters includes a
collateral restriction that requires WatchGuard to maintain an irrevocable standby letter of credit issued to WatchGuards landlord and secured by restricted cash. At December 31, 2003 and at June 30, 2004, WatchGuards restricted cash
balance was $3 million in conjunction with this facilities lease.



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



WatchGuards estimated product warranty liability was $197,000 and $198,000 at December 31, 2003 and at June 30, 2004, respectively.



NOTE 5  BUSINESS RESTRUCTURINGS



During 2001 and 2002 WatchGuard implemented two restructuring plans. The costs of those restructuring plans are accounted for under EITF Issue No. 94-3,
Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity as they pertain to the restructuring plans initiated in 2001 and 2002.



In July 2002, the Financial Accounting Standards Board issued SFAS 146, Accounting for Costs Associated with Exit or
Disposal Activities. This pronouncement nullified EITF Issue No. 94-3, and 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; however, the provisions of SFAS 146 are effective for exit and disposal activities initiated after December 31, 2002, and therefore are not applicable to WatchGuards restructuring plans initiated in
2001 and 2002.



At June 30, 2004, the remaining balance of the
restructuring liabilities, including short-term and long-term portions, was $5.1 million. No adjustments to the remaining liabilities were required in the six-month period ended June 30, 2004.



2001 Restructuring



In the second quarter of 2001, WatchGuard announced a restructuring plan
designed to streamline operations and reduce operating costs. All costs related to this restructuring have been paid or settled, except for accrued amounts related to losses for the lease commitments, net of estimated proceeds from subleases of
abandoned facilities, which are expected to be paid through 2010. The accrued liabilities relating to this restructuring at December 31, 2003 and at June 30, 2004 and activity recorded through June 30, 2004 are as follows (in thousands):



|                                                    |  |                                                |       |                        |   |      |                                            |  |   |      
|--------------------------------------------------- |  | ---------------------------------------------- | ----- | ---------------------- | - | ---- | ------------------------------------------ |  | - | -----
|                                                    |  | December 31, 2003 Accrued RestructuringBalance |       | Amounts Paidor Charged |   |      | June 30, 2004 Accrued RestructuringBalance
|Accrued liabilities related to abandoned facilities |  | $                                              | 1,714 |                        | $ | (221 | )                                          |  | $ | 1,493
|                                                    |  |                                                |       |                        |   |      |                                            |  |   |      



2002
Restructuring



In the second quarter of 2002,
WatchGuard implemented a restructuring plan primarily designed to eliminate redundancies and excess headcount resulting from the acquisition of RapidStream, Inc. in April 2002, which included a reduction in workforce, consolidation of excess
facilities and elimination of technology-related contracts that are no longer required or part of WatchGuards strategy. All costs related to this restructuring have been paid or settled, except for accrued amounts related to losses for the
lease commitments, net of estimated proceeds from subleases of abandoned facilities, which are expected to be paid through 2010. The accrued liabilities relating to this restructuring at December 31, 2003 and at June 30, 2004, and activity recorded
through June 30, 2004 are as follows (in thousands):



|                                                    |  |                                                |       |                        |   |      |                                            |  |   |      
|--------------------------------------------------- |  | ---------------------------------------------- | ----- | ---------------------- | - | ---- | ------------------------------------------ |  | - | -----
|                                                    |  | December 31, 2003 Accrued RestructuringBalance |       | Amounts Paidor Charged |   |      | June 30, 2004 Accrued RestructuringBalance
|Accrued liabilities related to abandoned facilities |  | $                                              | 4,021 |                        | $ | (399 | )                                          |  | $ | 3,622
|                                                    |  |                                                |       |                        |   |      |                                            |  |   |      



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



The following discussion and analysis provides information that we believe is relevant to an assessment and understanding of WatchGuards financial condition and results of operations. The discussion should be
read in conjunction with the consolidated financial statements and the notes thereto. References to we, our and us in this quarterly report refer to WatchGuard Technologies, Inc. and 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 statements that are not historical facts.
| | - | -----------------------------------------------



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



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



Overview



WatchGuard is a leading provider of Internet security solutions designed to protect small- to medium-sized enterprises, or
SMEs, that use the Internet for electronic commerce and secure communications.



Our products and services include our integrated, expandable Firebox security solutions that offer firewall protection and intrusion prevention technology for access control, virtual private networking for secure
communications, content and spam filtering, anti-virus protection and vulnerability assessment services. Our innovative subscription-based LiveSecurity Service provides our customers with access to expert guidance and support so they can protect
their data and communications in a continuously changing environment.



Our market spans the SME market, from smaller-sized companies for which ease-of-use is a primary requirement, to medium-sized companies, including those with high-speed connections supporting virtual private networks, or VPNs, between the
corporate headquarters and geographically dispersed branch offices, for which performance, scalability and networking features are key requirements. Our security solutions also give enterprises a security management choice. An enterprise can manage
its own Internet security with our product offerings or outsource its security management to an Internet service provider, or ISP, or other managed service provider implementing our managed security solutions.



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##### Table of Contents

We sell our Internet security solutions indirectly to end-users through a network that includes thousands
of distributors and resellers and we have 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 2003, we have continued to invest heavily in the development of
our products as follows:



| |  | In March 2003, we introduced the Firebox S6 and Firebox S6tcVPN firewall and VPN network security appliances for small businesses, remote offices and telecommuters, which were fully
localized for the Japanese market.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In March 2003, we introduced the Firebox V60L, an addition to our line of Firebox Vclass security appliances. 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. The new product is designed to eliminate the need for
multiple appliances in environments requiring multi-gigabit throughput, thereby providing a cost-effective, easy-to-implement solution for distributed enterprises and service providers.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



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



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
consolidated financial statements, including those related to:



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



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



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



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



| |  | analysis for impairment of goodwill and 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 to our service provider customers at volume pricing rates; and
| | - | ----------------------------------------------------------------------------------------------------------



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



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



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



| |  | revenues from license sales of software options, such as user expansion and software management modules; 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 from some distribution arrangements where the distributor has unlimited stock returns and rotation rights are not recognized until the distributors sell the products to their customers.



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



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



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



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Provision for Doubtful Accounts



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



Inventory Valuation



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



Restructuring



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



Accounting for Goodwill and Other Intangible Long-Lived Assets



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



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



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



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##### Table of Contents

Results of Operations



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



|                                                 |  |                             |    |  |                           |    |  |       |    |  |       |   
|------------------------------------------------ |  | --------------------------- | -- |  | ------------------------- | -- |  | ----- | -- |  | ----- | --
|                                                 |  | Three Months Ended June 30, |    |  | Six Months Ended June 30, |   
|                                                 |  | 2003                        |    |  | 2004                      |    |  | 2003  |    |  | 2004  |   
|Revenues:                                        |  |                             |    |  |                           |    |  |       |    |  |       |   
|Product                                          |  | 65.6                        | %  |  | 69.8                      | %  |  | 66.2  | %  |  | 69.8  | % 
|Service                                          |  | 34.4                        |    |  | 30.2                      |    |  | 33.8  |    |  | 30.2  |   
|                                                 |  |                             |    |  |                           |    |  |       |    |  |       |   
|Total revenues                                   |  | 100.0                       |    |  | 100.0                     |    |  | 100.0 |    |  | 100.0 |   
|Cost of revenues:                                |  |                             |    |  |                           |    |  |       |    |  |       |   
|Product                                          |  | 30.3                        |    |  | 28.5                      |    |  | 26.4  |    |  | 29.1  |   
|Service                                          |  | 7.8                         |    |  | 6.2                       |    |  | 7.2   |    |  | 6.3   |   
|                                                 |  |                             |    |  |                           |    |  |       |    |  |       |   
|Total cost of revenues                           |  | 38.1                        |    |  | 34.7                      |    |  | 33.6  |    |  | 35.4  |   
|                                                 |  |                             |    |  |                           |    |  |       |    |  |       |   
|Gross margin                                     |  | 61.9                        |    |  | 65.3                      |    |  | 66.4  |    |  | 64.6  |   
|Operating expenses:                              |  |                             |    |  |                           |    |  |       |    |  |       |   
|Sales and marketing                              |  | 41.0                        |    |  | 36.1                      |    |  | 40.4  |    |  | 37.5  |   
|Research and development                         |  | 26.6                        |    |  | 20.5                      |    |  | 25.2  |    |  | 20.8  |   
|General and administrative                       |  | 10.1                        |    |  | 9.0                       |    |  | 9.5   |    |  | 9.7   |   
|Stock-based compensation                         |  | 0.3                         |    |  | 0.0                       |    |  | 0.4   |    |  | 0.1   |   
|Amortization of other intangible assets acquired |  | 2.8                         |    |  | 1.1                       |    |  | 2.6   |    |  | 1.1   |   
|                                                 |  |                             |    |  |                           |    |  |       |    |  |       |   
|Total operating expenses                         |  | 80.8                        |    |  | 66.7                      |    |  | 78.1  |    |  | 69.2  |   
|                                                 |  |                             |    |  |                           |    |  |       |    |  |       |   
|Operating loss                                   |  | (18.9                       | )  |  | (1.4                      | )  |  | (11.7 | )  |  | (4.6  | ) 
|Interest income, net:                            |  |                             |    |  |                           |    |  |       |    |  |       |   
|Interest income                                  |  | 1.6                         |    |  | 1.3                       |    |  | 1.8   |    |  | 1.3   |   
|Interest expense                                 |  | (0.7                        | )  |  | (0.8                      | )  |  | (0.7  | )  |  | (0.8  | ) 
|                                                 |  |                             |    |  |                           |    |  |       |    |  |       |   
|Total interest income, net                       |  | 0.9                         |    |  | 0.5                       |    |  | 1.1   |    |  | 0.5   |   
|                                                 |  |                             |    |  |                           |    |  |       |    |  |       |   
|Loss before income taxes                         |  | (18.0                       | )  |  | (0.9                      | )  |  | (10.6 | )  |  | (4.1  | ) 
|Provision for income taxes                       |  | 0.0                         |    |  | 0.1                       |    |  | 0.0   |    |  | 0.1   |   
|                                                 |  |                             |    |  |                           |    |  |       |    |  |       |   
|Net loss                                         |  | (18.0                       | )% |  | (1.0                      | )% |  | (10.6 | )% |  | (4.2  | )%
|                                                 |  |                             |    |  |                           |    |  |       |    |  |       |   



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##### Table of Contents

Revenues



|                                   |  |                             |        |   |                  |   |        |                           |      |      |                            |      |   |        |   |  |   |        |   |  |      |   
|---------------------------------- |  | --------------------------- | ------ | - | ---------------- | - | ------ | ------------------------- | ---- | ---- | -------------------------- | ---- | - | ------ | - |  | - | ------ | - |  | ---- | --
|                                   |  | Three Months Ended June 30, |        |   | Percent Increase |   |        | Six Months Ended June 30, |      |      | Percent Increase(Decrease) |     
|                                   |  | 2003                        |        |   | 2004             |   |        |                           | 2003 |      |                            | 2004 |   |       
|Revenues (in thousands):           | 
|Product                            |  | $                           | 13,132 |   |                  | $ | 16,074 |                           |      | 22.4 | %                          |      | $ | 27,711 |   |  | $ | 31,068 |   |  | 12.1 | % 
|Service                            |  |                             | 6,888  |   |                  |   | 6,947  |                           |      | 0.9  | %                          |      |   | 14,118 |   |  |   | 13,429 |   |  | (4.9 | )%
|                                   |  |                             |        |   |                  |   |        |                           |      |      |                            |      |   |        |   |  |   |        |   |  |      |   
|Total                              |  | $                           | 20,020 |   |                  | $ | 23,021 |                           |      | 15.0 | %                          |      | $ | 41,829 |   |  | $ | 44,497 |   |  | 6.4  | % 
|                                   |  |                             |        |   |                  |   |        |                           |      |      |                            |      |   |        |   |  |   |        |   |  |      |   
|Revenues (as % of total revenues): | 
|Product                            |  |                             | 65.6   | % |                  |   | 69.8   | %                         |      |      |                            |      |   | 66.2   | % |  |   | 69.8   | % |  |      |   
|Service                            |  |                             | 34.4   | % |                  |   | 30.2   | %                         |      |      |                            |      |   | 33.8   | % |  |   | 30.2   | % |  |      |   
|                                   |  |                             |        |   |                  |   |        |                           |      |      |                            |      |   |        |   |  |   |        |   |  |      |   
|Total                              |  |                             | 100.0  | % |                  |   | 100.0  | %                         |      |      |                            |      |   | 100.0  | % |  |   | 100.0  | % |  |      |   
|                                   |  |                             |        |   |                  |   |        |                           |      |      |                            |      |   |        |   |  |   |        |   |  |      |   



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



|                                   |  |                            |        |   |                 |   |        |                          |      |      |                 |      |   |        |   |  |   |        |   |  |     |  
|---------------------------------- |  | -------------------------- | ------ | - | --------------- | - | ------ | ------------------------ | ---- | ---- | --------------- | ---- | - | ------ | - |  | - | ------ | - |  | --- | -
|                                   |  | Three Months EndedJune 30, |        |   | PercentIncrease |   |        | Six Months EndedJune 30, |      |      | PercentIncrease |     
|                                   |  | 2003                       |        |   | 2004            |   |        |                          | 2003 |      |                 | 2004 |   |       
|Revenues (in thousands):           | 
|Americas                           |  | $                          | 10,077 |   |                 | $ | 11,178 |                          |      | 10.9 | %               |      | $ | 20,240 |   |  | $ | 22,190 |   |  | 9.6 | %
|EMEA                               |  |                            | 7,361  |   |                 |   | 8,411  |                          |      | 14.3 | %               |      |   | 15,611 |   |  |   | 16,134 |   |  | 3.4 | %
|APAC                               |  |                            | 2,582  |   |                 |   | 3,432  |                          |      | 32.9 | %               |      |   | 5,978  |   |  |   | 6,173  |   |  | 3.3 | %
|                                   |  |                            |        |   |                 |   |        |                          |      |      |                 |      |   |        |   |  |   |        |   |  |     |  
|Total                              |  | $                          | 20,020 |   |                 | $ | 23,021 |                          |      | 15.0 | %               |      | $ | 41,829 |   |  | $ | 44,497 |   |  | 6.4 | %
|                                   |  |                            |        |   |                 |   |        |                          |      |      |                 |      |   |        |   |  |   |        |   |  |     |  
|Revenues (as % of total revenues): | 
|Americas                           |  |                            | 50.3   | % |                 |   | 48.6   | %                        |      |      |                 |      |   | 48.4   | % |  |   | 49.9   | % |  |     |  
|EMEA                               |  |                            | 36.8   | % |                 |   | 36.5   | %                        |      |      |                 |      |   | 37.3   | % |  |   | 36.2   | % |  |     |  
|APAC                               |  |                            | 12.9   | % |                 |   | 14.9   | %                        |      |      |                 |      |   | 14.3   | % |  |   | 13.9   | % |  |     |  
|                                   |  |                            |        |   |                 |   |        |                          |      |      |                 |      |   |        |   |  |   |        |   |  |     |  
|Total                              |  |                            | 100.0  | % |                 |   | 100.0  | %                        |      |      |                 |      |   | 100.0  | % |  |   | 100.0  | % |  |     |  
|                                   |  |                            |        |   |                 |   |        |                          |      |      |                 |      |   |        |   |  |   |        |   |  |     |  



The dollar and
percentage increase in product revenues for both the three and six months ended June 30, 2004, as compared to the corresponding periods of 2003, was primarily due to an increase in unit shipments. The shipments increased for all major product lines.
The largest impact on revenues was caused by the increase in shipments in the Firebox product line. This increase is primarily related to the introduction of Firebox X products in February 2004. The net increase in shipments for the total Firebox
line included a decrease in shipments of Firebox III products, as these products are being replaced by comparable new Firebox X products.



The increase in product revenues for both three and six months ended June 30, 2004 was partially offset by the reductions in selling prices and higher
discounts for most of our products. The unfavorable pricing changes are the result of aggressive sales promotions and discounts that were introduced in the second half of 2003 and continued through the first half of 2004 in response to product
life-cycle considerations combined with competitive pricing pressure in the mid-tier of our market. In the fourth quarter of 2003, promotional offers were extended on small-business appliances (SOHO) for competitive reasons. These offers were
continued in the first half of 2004.



From a regional
standpoint, in the three and six months ended June 30, 2004, as compared to the corresponding periods of 2003, revenues increased for both the Americas market and the international markets. For the six months ended June 30, 2004, as compared to the
same period of 2003, total revenues from the Americas grew at a higher rate than revenues from the EMEA and APAC markets. For the three months ended June 30, 2004, as compared to the same period of 2003, total APAC revenues grew faster than other
regions. APAC revenues were at depressed levels in the first half of 2003, as we were in the early stages of the realignment of our APAC business. APAC revenues grew consecutively for the first two quarters of 2004.



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It is too early to determine if recent signs of gradual improvement in information technology spending by
businesses and positive sentiment on the economic outlook in the first half of 2004 will continue in the future and can translate into continued increased demand for our products. Given the continuing economic and geopolitical uncertainty and
constrained corporate information technology spending, it is difficult to predict revenue levels in future quarters, which may decline or fluctuate more than they have historically.



For the three months ended June 30, 2004, as compared to the same period of 2003, service revenues remained at a comparable
level in absolute dollars. For the six months ended June 30, 2004, as compared to the same period of 2003, service revenues declined in absolute dollars. For both the three and six month periods ended June 30, 2004, as compared to the corresponding
periods of 2003, service revenues declined as a percentage of total revenues.



The decrease in service revenues of approximately $690,000 for the six months ended June 30, 2004, as compared to the same period of 2003, is primarily due to $600,000 of service revenues in the first quarter of 2003
generated from LiveSecurity services that were provided through certain managed security customers to their end-users in prior periods, but were identified by WatchGuard through a license compliance initiative as being previously unreported. The
decline in service revenues is also partially attributable to a reduction of LiveSecurity Service subscription prices for certain products that were implemented in the last quarter of 2003 in response to the competitive market environment.



Service revenues recognized from initial service subscription
fees are generally related to product shipments in preceding quarters, while revenues recognized from service renewals depend on the existing customer base. A decline in product shipments will result in lower initial LiveSecurity Service
subscriptions bundled with the products, while an increase in our installed customer base will increase the number of customers with the opportunity to renew their LiveSecurity Service subscriptions. As a result, it is difficult to predict future
service revenue levels.



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##### Table of Contents

Cost of Revenues and Gross Margin



|                                                      |  |                            |        |   |                             |   |        |                          |      |      |                           |      |   |        |   |  |   |        |   |  |      |   
|----------------------------------------------------- |  | -------------------------- | ------ | - | --------------------------- | - | ------ | ------------------------ | ---- | ---- | ------------------------- | ---- | - | ------ | - |  | - | ------ | - |  | ---- | --
|                                                      |  | Three Months EndedJune 30, |        |   | Percent Increase (Decrease) |   |        | Six Months EndedJune 30, |      |      | PercentIncrease(Decrease) |     
|                                                      |  | 2003                       |        |   | 2004                        |   |        |                          | 2003 |      |                           | 2004 |   |       
|Cost of revenues (in thousands):                      | 
|Product                                               |  | $                          | 6,066  |   |                             | $ | 6,566  |                          |      | 8.2  | %                         |      | $ | 11,041 |   |  | $ | 12,963 |   |  | 17.4 | % 
|Service                                               |  |                            | 1,556  |   |                             |   | 1,431  |                          |      | (8.0 | )%                        |      |   | 3,031  |   |  |   | 2,775  |   |  | (8.4 | )%
|                                                      |  |                            |        |   |                             |   |        |                          |      |      |                           |      |   |        |   |  |   |        |   |  |      |   
|Total                                                 |  | $                          | 7,622  |   |                             | $ | 7,997  |                          |      | 4.9  | %                         |      | $ | 14,072 |   |  | $ | 15,738 |   |  | 11.8 | % 
|                                                      |  |                            |        |   |                             |   |        |                          |      |      |                           |      |   |        |   |  |   |        |   |  |      |   
|Cost of revenues (as % of total revenues):            | 
|Product                                               |  |                            | 30.3   | % |                             |   | 28.5   | %                        |      |      |                           |      |   | 26.4   | % |  |   | 29.1   | % |  |      |   
|Service                                               |  |                            | 7.8    | % |                             |   | 6.2    | %                        |      |      |                           |      |   | 7.2    | % |  |   | 6.3    | % |  |      |   
|                                                      |  |                            |        |   |                             |   |        |                          |      |      |                           |      |   |        |   |  |   |        |   |  |      |   
|Total                                                 |  |                            | 38.1   | % |                             |   | 34.7   | %                        |      |      |                           |      |   | 33.6   | % |  |   | 35.4   | % |  |      |   
|                                                      |  |                            |        |   |                             |   |        |                          |      |      |                           |      |   |        |   |  |   |        |   |  |      |   
|Cost of revenues (as % of related revenue component): | 
|Product (as % of product revenues)                    |  |                            | 46.2   | % |                             |   | 40.8   | %                        |      |      |                           |      |   | 39.8   | % |  |   | 41.7   | % |  |      |   
|Service (as % of service revenues)                    |  |                            | 22.6   | % |                             |   | 20.6   | %                        |      |      |                           |      |   | 21.5   | % |  |   | 20.7   | % |  |      |   
|                                                      |  |                            |        |   |                             |  
|Gross margin (in thousands):                          |  |                            |        |   |                             |   |        |                          |      |      |                           |      |   |        |   |  |   |        |   |  |      |   
|Product                                               |  | $                          | 7,066  |   |                             | $ | 9,508  |                          |      | 34.6 | %                         |      | $ | 16,670 |   |  | $ | 18,105 |   |  | 8.6  | % 
|Service                                               |  |                            | 5,332  |   |                             |   | 5,516  |                          |      | 3.5  | %                         |      |   | 11,087 |   |  |   | 10,654 |   |  | (3.9 | )%
|                                                      |  |                            |        |   |                             |   |        |                          |      |      |                           |      |   |        |   |  |   |        |   |  |      |   
|Total                                                 |  | $                          | 12,398 |   |                             | $ | 15,024 |                          |      | 21.2 | %                         |      | $ | 27,757 |   |  | $ | 28,759 |   |  | 3.6  | % 
|                                                      |  |                            |        |   |                             |   |        |                          |      |      |                           |      |   |        |   |  |   |        |   |  |      |   
|Gross margin (as % of related revenue component):     | 
|Product (as % of product revenues)                    |  |                            | 53.8   | % |                             |   | 59.2   | %                        |      |      |                           |      |   | 60.2   | % |  |   | 58.3   | % |  |      |   
|Service (as % of service revenues)                    |  |                            | 77.4   | % |                             |   | 79.4   | %                        |      |      |                           |      |   | 78.5   | % |  |   | 79.3   | % |  |      |   
|Total (as % of total revenues)                        |  |                            | 61.9   | % |                             |   | 65.3   | %                        |      |      |                           |      |   | 66.4   | % |  |   | 64.6   | % |  |      |   



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



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



The dollar increase in cost of product revenues for the three months ended
June 30, 2004, as compared to the same period of 2003, resulted from the following:



| |  | increased unit volume for all major product lines, with the largest cost increase from the Firebox line as a result of the Firebox X introduction;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------



| |  | increased manufacturing costs due to selected stock refurbishing; and
| | - | ---------------------------------------------------------------------



| |  | increased freight costs.
| | - | ------------------------



Those increases were partially offset by a reduction in costs of excess and obsolete inventory. In the second quarter of 2003, we recorded an additional
provision for inventory reserves for certain of our products and related components, including our RapidStream Secured by Check Point brand product based on the technology obtained in our April 2002



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##### Table of Contents

acquisition of RapidStream. Our increased focus on our core market of small- to medium-size enterprises, resulting in a
curtailment of further marketing and development of this brand, combined with its historically poor sales performance, led management to reduce future sales projections for this brand in the second quarter of 2003.



Gross product margins in absolute dollars and as a percentage of product
revenues for the three months ended June 30, 2004, as compared to the same period of 2003, were positively affected by volume growth and a reduction in costs of excess and obsolete inventory. The costs of obsolete and excess inventory, combined with
losses on noncancelable purchase commitments in excess of projected demand, decreased by $740,000 for the three month ended June 30, 2004, as compared to the same period of 2003. Had those costs been excluded from the calculation of product margins,
the product margins as a percentage of product revenues would have been approximately 62.5% for the three months ended June 30, 2003 and 61.6% for the three month ended June 30, 2004. The percentage decline in margins prior to inventory reserves is
caused by continued competitive pricing in the market place for our products and a slight increase in manufacturing costs.



The dollar increase in cost of product revenues for the six months ended June 30, 2004, as compared to the same period of 2003, resulted from the
following:



| |  | increased volume for all major product lines;
| | - | ---------------------------------------------



| |  | increased manufacturing costs due to selected stock upgrades and refurbishing; and
| | - | ----------------------------------------------------------------------------------



| |  | increased costs of distribution operations.
| | - | -------------------------------------------



As discussed above, due to additional costs of excess and obsolete inventory recorded in the second quarter of 2003, the cost increases in the six months
ended June 30, 2004, as compared to the same period of 2003 were partially offset by the reduction in inventory reserves.



Gross product margins in absolute dollars for the six months ended June 30, 2004, as compared to the same period of 2003, were positively affected by the
unit volume growth; however percentage product margins declined as a result of continued competitive pricing pressure and manufacturing cost increases.



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



Cost of service revenues declined in absolute dollars and as a percentage of
related revenues for the three and six months ended June 30, 2004, as compared to the corresponding periods of 2003, resulting in a corresponding increase in service gross margins as a percentage of related revenues. The dollar decrease in service
costs is the result of cost savings achieved after transitioning first-level customer support services to a lower-cost third-party provider in the fourth quarter of 2003.



Service gross margins declined in absolute dollars for the six months ended June 30, 2004, as compared to the same period of
2003, despite the percentage margin improvement. This decline in dollar service margin is primarily attributable to $600,000 of service revenue that was recognized in the first quarter of 2003, without significant additional costs, from our license
compliance initiative, discussed above in conjunction with service revenues.



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



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##### Table of Contents

Operating Expenses



Sales and Marketing



|                                                      |  |                             |       |   |                     |   |       |                          |      |     |                    |      |   |        |   |  |   |        |   |  |      |   
|----------------------------------------------------- |  | --------------------------- | ----- | - | ------------------- | - | ----- | ------------------------ | ---- | --- | ------------------ | ---- | - | ------ | - |  | - | ------ | - |  | ---- | --
|                                                      |  | Three Months Ended June 30, |       |   | Percentage Increase |   |       | Six Months EndedJune 30, |      |     | PercentageDecrease |     
|                                                      |  | 2003                        |       |   | 2004                |   |       |                          | 2003 |     |                    | 2004 |   |       
|Sales and marketing expenses (in thousands)           |  | $                           | 8,204 |   |                     | $ | 8,300 |                          |      | 1.2 | %                  |      | $ | 16,877 |   |  | $ | 16,695 |   |  | (1.1 | )%
|Sales and marketing expenses (as % of total revenues) |  |                             | 41.0  | % |                     |   | 36.1  | %                        |      |     |                    |      |   | 40.4   | % |  |   | 37.5   | % |  |      |   



Sales and marketing
expenses include salaries, commissions and employee-related expenses and certain variable marketing expenses, including distributor promotional costs, public relations costs, marketing collateral, trade shows, advertising expenses, direct marketing
and costs of demo units.



The slight increase in sales and
marketing expenses in absolute dollars for the three months ended June 30, 2004, as compared to the same period of 2003, was primarily due to the following:



| |  | a $550,000 increase in compensation related costs, travel costs and sales offices support costs, primarily due to increases in revenue-based commissions and to the increase in APAC
regional sales headcount; and
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | a $140,000 increase in information technology support costs for marketing and sales departments due to consolidation of our customer-facing applications and databases and their
migration onto more scalable and extensible application platforms.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



These larger increases were mostly offset by decreases in our variable marketing programs, especially in relation to demand generation, public relations and trade show activities, including the reductions in
international marketing programs, as we lowered our discretionary spending and refocused on core strategic areas.



The decline in sales and marketing expenses in absolute dollars for the six months ended June 30, 2004, as compared to the same period of 2003, is related
primarily to a $520,000 reduction in our variable marketing programs, mostly achieved in the second quarter of 2004 and discussed above. Those costs reductions were partially offset by the increase in information technology costs in support of
sales-related customer relations management applications.



Sales and marketing expenses declined as a percentage of revenue for the three and six months ended June 30, 2004, as compared to the corresponding periods of 2003, as we focused on improving the productivity of our sales channels and the
efficiency of our marketing campaigns.



Research and
Development



|                                                           |  |                            |       |   |                     |   |       |                          |      |       |                    |      |   |        |   |  |   |       |   |  |       |   
|---------------------------------------------------------- |  | -------------------------- | ----- | - | ------------------- | - | ----- | ------------------------ | ---- | ----- | ------------------ | ---- | - | ------ | - |  | - | ----- | - |  | ----- | --
|                                                           |  | Three Months EndedJune 30, |       |   | Percentage Decrease |   |       | Six Months EndedJune 30, |      |       | PercentageDecrease |     
|                                                           |  | 2003                       |       |   | 2004                |   |       |                          | 2003 |       |                    | 2004 |   |       
|Research and development expenses (in thousands)           |  | $                          | 5,337 |   |                     | $ | 4,708 |                          |      | (11.8 | )%                 |      | $ | 10,556 |   |  | $ | 9,247 |   |  | (12.4 | )%
|Research and development expenses (as % of total revenues) |  |                            | 26.6  | % |                     |   | 20.5  | %                        |      |       |                    |      |   | 25.2   | % |  |   | 20.8  | % |  |       |   



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



Research and development expenses decreased in both absolute dollars and as a
percentage of revenues for the three and six months ended June 30, 2004, as compared to the corresponding periods of 2003, primarily due to the following:



| |  | Outsourced development and certification costs declined by $460,000 for the three months ended June 30. 2004 and by $910,000 for the six months ended June 30, 2004, primarily due to
higher costs incurred in those areas in the first three and six months of 2003 in connection with the evaluation for certification for the Firebox Vclass product line and in connection with product integration effort, as a result of addition of
technology obtained in the 2002 RapidStream acquisition.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  | Depreciation expenses and costs of information technology in support of research and development declined by $150,000 for the three months ended June 30, 2004 and by $310,000 for
the six months ended June 30, 2004 due primarily to cost containment for research and development capital expenditures in 2002 and 2003 and the expiration of depreciation on earlier purchases.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We intend to continue to fund our research and development efforts in order
to meet the changing requirements of our customers, to provide for continued introduction of new products as technology advances and to enhance and expand our current product offerings. Significant efforts are currently underway aimed at converging
software codes associated with our original security features and the software networking technology obtained in the RapidStream acquisition. We expect to continue to invest in key areas aimed at the development of new generations of our products,
further extension of our existing product lines and the development of future technologies.



General and Administrative



|                                                             |  |                            |       |   |                    |   |       |                          |      |     |                    |      |   |       |   |  |   |       |   |  |     |  
|------------------------------------------------------------ |  | -------------------------- | ----- | - | ------------------ | - | ----- | ------------------------ | ---- | --- | ------------------ | ---- | - | ----- | - |  | - | ----- | - |  | --- | -
|                                                             |  | Three Months EndedJune 30, |       |   | PercentageIncrease |   |       | Six Months EndedJune 30, |      |     | PercentageIncrease |     
|                                                             |  | 2003                       |       |   | 2004               |   |       |                          | 2003 |     |                    | 2004 |   |      
|General and administrative expenses (in thousands)           |  | $                          | 2,016 |   |                    | $ | 2,079 |                          |      | 3.1 | %                  |      | $ | 3,950 |   |  | $ | 4,331 |   |  | 9.6 | %
|General and administrative expenses (as % of total revenues) |  |                            | 10.1  | % |                    |   | 9.0   | %                        |      |     |                    |      |   | 9.5   | % |  |   | 9.7   | % |  |     |  



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.



General and administrative expenses increased in absolute
dollars for the three and six months ended June 30, 2004, as compared to the corresponding periods of 2003. The dollar increase in general and administrative expenses resulted primarily from an increases of $230,000 for the three months and of
$320,000 for the six months ended June 30, 2004, as compared to the corresponding periods of 2003, in legal and accounting fees as a result of enhanced regulatory and corporate governance requirements pursuant to the Sarbanes-Oxley Act of 2002. For
the three months ended June 30, 2004, as compared to the same period of 2003, this increase was partially offset by a reduction in incentive compensation. For the six months ended June 30, 2004, as compared to the same period of 2003, the increase
in general and administrative expenses was also caused by additional provision for bad debt made in 2004 for a particular domestic distributor as a result of bankruptcy proceedings. In the future, we expect to continue incurring additional expenses
in connection with enhanced regulatory and corporate governance requirements



Operating Expenses Outlook



In the near term, we expect our overall operating expenses that consist primarily of sales and marketing, research and development and general and administrative expenses, in absolute dollar terms, to remain relatively comparable to the
levels incurred in the second quarter of 2004. In the future, we anticipate the need to increase our operating expenses to grow revenues and increase our market share. Our actual operating expenses could differ materially from those anticipated,
which could have an adverse effect on our results of operations.



Stock-Based Compensation



|                                                              |  |                            |    |                     |   |   |                          |       |                    |  |   |     |  |   |    |  |       |   
|------------------------------------------------------------- |  | -------------------------- | -- | ------------------- | - | - | ------------------------ | ----- | ------------------ |  | - | --- |  | - | -- |  | ----- | --
|                                                              |  | Three Months EndedJune 30, |    | Percentage Decrease |   |   | Six Months EndedJune 30, |       | PercentageDecrease | 
|                                                              |  | 2003                       |    | 2004                |   |   | 2003                     |       | 2004               | 
|Total amortization of stock-based compensation (in thousands) |  | $                          | 62 |                     | $ | 7 |                          | (88.7 | )%                 |  | $ | 183 |  | $ | 18 |  | (90.2 | )%



Stock-based
compensation expenses arise primarily from amortization of previously deferred stock-based compensation over the vesting periods of stock options and restricted stock.



Deferred stock-based compensation is initially recorded as a component of stockholders equity in the amount of the
excess of the fair value of our common stock on the date of grant over the exercise price of options and also in the amount of the fair value of temporarily restricted common stock that we issued in our April 2002 acquisition of RapidStream.



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Amortization of Other Intangible Assets Acquired



Amortization of other intangible assets acquired in the three and six months
ended June 30, 2004 consisted of amortization of capitalized technology obtained in our acquisition of RapidStream in 2002. This technology will be amortized in full by March 31, 2007. In the same periods of 2003, the amortization additionally
included the amortization of capitalized technology related to our acquisition of Qiave in 2000. The Qiave technology was fully amortized by the end of 2003.



We are amortizing the intangible assets on a straight-line basis over the useful life of five years. The amortization expense decreased from $554,000 for
the three months ended June 30, 2003 to $243,000 for the three months ended June 30, 2004. The amortization expense decreased from $1.1 million for the six months ended June 30, 2003 to $487,000 for the six months ended June 30, 2004.



The decrease in the amortization expense for the three and six months ended
June 30, 2004, as compared to the same periods of 2003, resulted primarily from the reduction of the amortizable basis of technology obtained in the 2002 RapidStream acquisition and the completion of the amortization of technology obtained in the
2000 acquisition of Qiave.



The technology underlying the
RapidStream Secured by Check Point product brand was determined to be impaired in the second half of 2003 and we therefore recorded an impairment charge of $3.5 million for the remaining book value of this intangible asset. Our increased
focus on the SME market, resulting in a significant reduction in our sales, marketing and development efforts in support of this brand, together with the historically poor performance of this brand, led management to reduce the future sales
projections for the brand and later to exit the market segment served by this product.



Interest Income and Interest Expense



Interest income is generated primarily from our short-term investments. Interest income decreased from $325,000 for the three months ended June 30, 2003 to $298,000 for the three months ended June 30, 2004 and from
$738,000 for the six months ended June 30, 2003 to $572,000 for the six months ended June 30, 2004. The decrease was caused by both a decrease in the average balance invested and a decline in the average rates of return.



Interest expense primarily represents financing costs incurred due to term
discounts taken by our customers. Interest expense increased from $142,000 for the three months ended June 30, 2003 to $195,000 for the three months ended June 30, 2004 and from $292,000 for the six months ended June 30, 2003 to $364,000 for the six
months ended June 30, 2004. These increases are caused by the corresponding increases in revenues generated in the same periods.



Income Taxes



Income tax expense was $8,000 in the three months ended June 30, 2003 and $29,000 in the three months ended June 30, 2004. Income tax expense was $14,000
in the six months ended June 30, 2003 and $43,000 in the six months ended June 30, 2004. Income tax primarily relates to our provision for foreign income taxes associated with our international operations. We have experienced losses since inception,
resulting in a net operating loss carry forward position for federal income tax purposes of approximately $198 million as of June 30, 2004. These carryforwards, 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 $105 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.



Liquidity and Capital Resources



At June 30, 2004, we had $77.3 million in cash, cash equivalents and short-term investments, which was invested primarily in high-quality money market accounts and marketable securities. Our working capital at June 30, 2004 was $65.0
million.



Operating Activities



Our operating activities resulted in net cash outflows of $3.7 million for
the six months ended June 30, 2003 and $2.5 million for the six months ended June 30, 2004. The operating cash outflows for the six months ended June 30, 2003 resulted primarily from net losses. The operating cash outflows for the six months ended
June 30, 2004 resulted primarily from the increases in net working capital, apart from cash and investments.



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The difference between our net loss and our operating cash outflow is attributable to noncash expenses
included in net loss, and changes in operating assets and liabilities, as presented below (in thousands):



|                                                 |  |                          |        |   |      |   |        |  
|------------------------------------------------ |  | ------------------------ | ------ | - | ---- | - | ------ | -
|                                                 |  | Six Months EndedJune 30, |       
|                                                 |  | 2003                     |        |   | 2004 |  
|Net loss                                         |  | $                        | (4,449 | ) |      | $ | (1,854 | )
|Add: noncash expenses                            |  |                          | 2,674  |   |      |   | 1,903  |  
|Add: changes in operating assets and liabilities |  |                          | (1,894 | ) |      |   | (2,593 | )
|                                                 |  |                          |        |   |      |   |        |  
|Net cash used in operating activities            |  | $                        | (3,669 | ) |      | $ | (2,544 | )
|                                                 |  |                          |        |   |      |   |        |  



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



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



Trade Accounts Receivable,
Net increased from $6.7 million at December 31, 2003 to $8.1 million at June 31, 2004, primarily reflecting higher total revenues in the first six months of 2004, as compared to the same period of 2003. Days sales outstanding, or DSOs,
calculated on a quarterly basis, increased from 31 days at December 31, 2003 to 32 days at June 30, 2004. DSOs are affected by:



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



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



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



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



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



Based on our current sales mix, the linearity of
revenues in past and future quarters and timing differences arising from the varying payment terms in our customer agreements, we expect our DSOs to generally range from 35 to 45 days in the future. Any change in these factors, however, could
negatively affect expected DSO results.



Net Inventories
increased from $3.1 million at December 31, 2003 to $4.5 million at June 30, 2004, as we had to build up our safety stock in response to the growth in shipments of Firebox X launched in February 2004 as well as in response to the increased sales
volumes of SOHO in the second quarter of 2004.



Total
Accrued Restructuring and Acquisition Costs decreased from $6.5 million at December 31, 2003 to $5.5 million at June 30, 2004, due to the ongoing payment of rents on abandoned facilities.



Total Deferred Revenuesincreased from $16.7 million at December 31,
2003 to $17.8 million at June 30, 2004. The increase in deferred revenues is attributed primarily to the increase in LiveSecutiry subscription renewals on a growing installed customer base.



Investing Activities



Cash provided by investing activities was $5.4 million for the six months
ended June 30, 2003, compared to $838,000 for the six months ended June 30, 2004. In both periods, these activities are primarily related to changes in short-term investments, offset by capital expenditures for property and equipment.



Financing Activities



Cash provided by financing activities totaled $805,000 for the six months
ended June 30, 2003 and $2.1 million for the six months ended June 30, 2004. 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 for at least the next 12 months. We may seek additional



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funding before that time through public or private financings or other arrangements, however, if the underlying assumed
levels of spending prove to be inaccurate, or if we choose to pursue acquisitions or investments in complementary business technology.



Contractual Obligations and Contingencies



We lease office space and some computer equipment under operating leases that are 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, San Jose and Tustin, California and Waltham, Massachusetts under operating leases that expire between 2004 and 2007, in addition to leases for other sales offices under operating leases or
other lease obligations that expire over various terms. Our excess facilities at our corporate headquarters in Seattle, in Aliso Viejo and San Jose, California, and Waltham, Massachusetts, are partially subleased to tenants, with sublease terms that
expire between 2004 and 2010. We also have several operating leases for computer equipment. WatchGuard is a party to several noncancelable and nonrefundable agreements to purchase inventory.



Our contractual commitments at June 30, 2004 associated with lease
obligations and purchase obligations, net of future minimum rental income from subleases of $1.7 million, are presented below (in thousands). This future rental income from subleases may be adversely affected if the financial condition of our
tenants were to deteriorate, resulting in an impairment of their ability to make lease payments.



|                               |  |                       |        |                  |   |                  |  |                  |       |                  |   |       |  |   |      
|------------------------------ |  | --------------------- | ------ | ---------------- | - | ---------------- |  | ---------------- | ----- | ---------------- | - | ----- |  | - | -----
|                               |  | Payment due by period
|                               |  |                       |        | Before           |   | After           
|                               |  | Total                 |        | December 31,2004 |   | December 31,2006 |  | December 31,2008 |       | December 31,2008
|Operating lease obligations    |  | $                     | 18,910 |                  | $ | 2,016            |  | $                | 5,797 |                  | $ | 5,910 |  | $ | 5,187
|Inventory purchase obligations |  |                       | 2,922  |                  |   | 2,922            |  |                  |      |                  |   |      |  |   |     
|                               |  |                       |        |                  |   |                  |  |                  |       |                  |   |       |  |   |      
|Total                          |  | $                     | 21,832 |                  | $ | 4,938            |  | $                | 5,797 |                  | $ | 5,910 |  | $ | 5,187
|                               |  |                       |        |                  |   |                  |  |                  |       |                  |   |       |  |   |      



In addition, we have
contractual agreements with some of our distributors to reimburse them for advertising and other marketing activities that they may incur to promote our products, contingent on performance of those activities in the future. At June 30, 2004, the
total amount of those agreements was $1.4 million.



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



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



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



Since inception, we have incurred net losses and
experienced negative cash flows from operations in each quarter, except that we had net income and a positive cash flow from operations in the third quarter of 2000 and a positive cash flow from operations in the third quarter of 2001. As of June
30, 2004, we had an accumulated deficit of approximately $132 million. Although our revenues have increased each year since we began operations, the historical percentage growth rate of our revenues may not be sustainable as our revenue base
increases, we may not achieve or sustain profitability in future periods or we may not be able to continue to grow our revenues at all. We expect that over time we will have to increase our operating expenses in connection with:



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



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



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



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



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



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



| |  | 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. While there has been some early signs of improvement in certain geographical areas, we do not know how long this economic downturn
will last or whether it will become more severe. 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;
| | - | ------------------------------------------------------------



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



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



| |  | restructuring reserves; 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 excess and obsolete inventory, which may increase above current estimates, if our revenues fall below our sales forecasts, costs of our
2001 and 2002 restructuring, impairment analysis of the intangible assets obtained in our 2002 acquisition of RapidStream, as well as goodwill relating to the acquisitions of BeadleNet, Qiave and RapidStream. Although we do not anticipate further
significant adjustments to our 2001 and 2002 restructuring in addition to the $1 million charge we recorded in the fourth quarter of 2003, the actual costs related to the restructuring may differ from our estimate if it takes us longer than expected
to find suitable tenants for our excess facilities or if there are further changes in the real estate market where excess facilities are located. Actual results may differ from these and other estimates if our assumptions change or if actual
circumstances differ from those in our assumptions, which could cause our operating results to fall below the expectations of securities analysts and investors, resulting in a decline in our stock price.



If 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, VARs and ISPs and other managed service providers, to obtain and retain customers. Some of our Firebox products, particularly our key Firebox X
line of products, however, are relatively new and unproven. The Firebox X line of products has only been available since February 2004. The Firebox X line of products, which replace a product line that represented a majority of our revenues, also
represent a new approach to providing security to the SME in that they are designed to be expandable both to incorporate additional features and to provide increased performance, and we may be unsuccessful in marketing and selling this type of
product. In the second half of 2004, we are planning to introduce a new line of integrated and scalable security appliances that is targeted at the lower-end of the SME market and is intended to augment our existing SOHO security products. While we
believe we are prepared to educate and train our customers on our new product line, there is a risk that we will be unsuccessful in marketing and selling this new product line or that the introduction of this product line could cause customers to
delay purchases of both the current SOHO product line and the new product line, which could adversely affect our revenues. In addition, if sales of our Firebox products do not meet expectations, we may have excess inventory of products or components
and such excess inventory would have a negative impact on our operating results.



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.
SMEs 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.



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



The market for Internet security products is intensely competitive and we expect competition to intensify in the future. An
increase in competitive pressures in our market or our failure to compete effectively may result in pricing reductions, reduced gross margins and loss of market share. Currently, the primary competitors in our industry include Check Point, Cisco
Systems, Inc., Fortinet Inc., Juniper Networks, Inc., Nokia Corporation, SonicWALL, Inc. and Symantec Corporation. Other competitors offering security products include hardware and software vendors such as 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. Our current and potential competitors may establish cooperative relationships among themselves or with third parties that may further enhance their
resources. In addition, current or potential competitors may be acquired by third parties with greater available resources, as has happened as a result of Junipers acquisition of Netscreen Technologies, Inc. As a result of such acquisitions,
our current or potential competitors might be able to adapt more quickly to new technologies and customer needs, devote greater resources to the promotion or sale of their products and services, initiate or withstand substantial price competition,
take advantage of acquisition or other opportunities more readily or develop and expand their product and service offerings more quickly. In addition, our competitors may bundle products competitive with ours with other products that they may sell
to our current or potential customers. These customers may accept these bundled products rather than separately purchasing our products.



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. The loss of one of these channel customers, 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 reorganizing our channel in the Asia Pacific region and,
particularly, Japan. If this reorganization causes disruption, we could experience a loss or reduction in sales involving one or more of our channel customers.



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



We provide most of our channel customers with product return rights for
stock rotation and price protection rights for their inventories, which they may exercise if we lower our prices for those products. We also provide promotional rebates to some of our channel customers. We may experience significant returns, price
adjustments and rebate costs for which we may not have adequate allowances, particularly with the recent introduction of our Firebox X line of products, which replaced the Firebox III line of products. The short life cycles of our products and the
difficulty of predicting future sales increase the risk that new product introductions or price reductions by us or our competitors could result in significant product returns or price adjustments. When we introduced the Firebox II, the Firebox III
and then later the Firebox X, security appliances, we experienced an increase in returns of previous products and product versions. Provisions for returns and allowances were $4.6 million in 2002 and $7.3 million in 2003 or 5.7% and 8.4% of total
revenues before returns and allowances. The provision for returns and allowances was $4.0 million, or 8.2% of total revenues before returns and allowances in the six months ended June 30, 2004. While we review and adjust our provision for returns
and allowances in order to properly reflect the potential for promotional rebate costs, increased returns and pricing adjustments associated with the introduction of new products, such as the Firebox X product line, the provision may still be
inadequate. An increase in the provision for returns and allowances will result in the reduction of revenues.



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



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



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



Releasing new or improved products and services prematurely may result in quality problems, and releasing them late may result in loss of customer
confidence and market share. In the past, we have experienced delays in the scheduled or expected introduction of new and improved products and services, and we may experience delays, or be unable to introduce an expected new or improved product or
service at all, 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. In the past, when we have introduced new or improved products or services, we have experienced issues with the transitions that had an
adverse effect on our operating results. These have included, but were not limited to, issues such as excess inventories of products that were replaced as customer demand for those product decreased, shortages of new product due to manufacturing and
delivery issues that prevented us from delivering enough new product to meet demand and offset to the extent expected the loss of sales from the products that were replaced and lower than expected initial sales of new or improved products as our
sales personnel and channels adapted to selling the new or improved products or services.



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



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



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



We obtain the component
parts for our hardware from a variety of manufacturers. Companies in the electronics industry regularly experience lower-than-required component allocations, and the industry is subject to frequent component shortfalls. We have experienced such
component shortfalls recently with memory and flash component manufacturers providing these components on a limited allocation basis only. Although we have found additional or replacement sources for hardware components in the past, and believe that
we could find additional or replacement sources for our hardware components to address future shortfalls, our operations could be disrupted or negatively affected if we have to add or switch to a replacement vendor, if our component supply is
interrupted for an extended period or if the costs of the components increase due to shortages. This could result in loss of customer orders and revenue.



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



Our future success will depend largely on the efforts and abilities of our senior management and our key development, technical, operations, information systems, customer support and sales and marketing personnel, and on our ability to
retain them. These employees are not obligated to continue their employment with us and may leave us at any time. In addition, there have been changes to our management team recently, including the addition of a new chief executive officer and
interim chief financial officer. If these changes cause disruption within our organization or with our channels or customers, do not positively affect our ability to formulate and execute our business strategy, or otherwise have a negative impact on
our operations, our business and operating results could be adversely affected.



Because many potential customers do not fully understand or remain unaware of the need for comprehensive and up-to-date Internet security 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 and up-to-date Internet security products and services. Historically, only enterprises having substantial resources have developed or
purchased comprehensive Internet security solutions and kept such security up-to-date. Also, there is a perception that comprehensive Internet security is costly and difficult to implement. We will therefore not succeed unless the market understands
the need for comprehensive and up-to-date Internet security and we can convince our potential customers of our ability to provide this security in an integrated, cost-effective and administratively feasible manner. Although we have spent, and will
continue to spend, considerable resources educating potential customers about the need for comprehensive and up-to-date Internet security and the benefits of our products and services, our efforts may be unsuccessful.



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



Our operational systems have not been tested at the customer volumes that may be required in the future. In addition, our operational systems required for
the delivery of products and services through license-key activation have not been tested at the combination of the number product and service offerings and customer volumes that may be required in the future. We may encounter performance
difficulties when operating with a substantially greater number of customers or a substantially greater number of products and services offered through license-key activation or a combination of the two. These 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 or increased number of products and services offered through
license-key activation may cause unanticipated system disruptions, slower response times and poor customer service, including problems filling customer orders.



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



We rely on third party contract manufacturers for the assembly of all of our security appliance hardware platforms and for
the design of certain of our security appliance hardware platforms. Although we believe that we could find a replacement source for these finished products, our operations could be disrupted if we have to add or switch to a replacement manufacturer,
particularly if we were required to replace or redesign a hardware platform, or if our finished goods supply is interrupted for an extended period. This could result in loss of customer orders and revenue.



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, including open source software,
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.



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



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



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



Despite our efforts to protect our proprietary rights, unauthorized parties may misappropriate or infringe on our patents, trade secrets, copyrights,
trademarks, service marks and similar proprietary rights. 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
eleven issued patents and 12 patents pending, but our patent applications may not result in issued patents. Even if we secure a patent, the patent may not provide meaningful protection. In addition, we rely on unpatented proprietary technology.
Because this proprietary technology does not have patent protection, we may be unable to meaningfully protect this technology from unauthorized use or misappropriation by a third party. In addition, our competitors may independently develop similar
or superior technologies or duplicate any unpatented technologies that we have developed, which could significantly reduce the value of our proprietary technology or threaten our market position.



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



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

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



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



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



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



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



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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 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 58.5% and 54.1% in 2002 and 2003 respectively. Sales to customers outside the United States accounted for 52.4% in the six months ended
June 30, 2004. The failure of our channel customers to sell our products internationally would limit our ability to increase our revenues. In addition, our international sales are subject to the risks inherent in international business activities,
including

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



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



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



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



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



Our international sales currently are U.S. dollar-denominated. As a result, any increase in the value of the U.S. dollar relative to foreign currencies
makes our products less competitive in international markets. Because of this, we may be required to denominate our sales in foreign currencies at some point in the future to remain competitive.



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



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



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



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



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



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



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



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



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



We believe
that existing cash and cash equivalent balances will be sufficient to meet our capital requirements for at least the next 12 months. Our capital requirements will depend on several factors, however, including



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



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



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



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



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



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



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



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



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



Our stock price is volatile.



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



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



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



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



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



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



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



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



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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 six months ended June 30, 2004 and expect to continue to do so in the future, we do
not anticipate that foreign exchange gains or losses will be material to us. Although we have not engaged in foreign currency hedging to date, we may do so in the future. In addition, we may be required to denominate our sales in foreign currencies
at some point in the future to remain competitive.



ITEM 4. CONTROLS AND PROCEDURES



Evaluation of disclosure controls and procedures. Our chief executive officer and our chief financial officer, after evaluating the effectiveness
of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this quarterly report, have concluded that, as of that date, our
disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in this report is accumulated and communicated by our management, to allow timely decisions regarding required disclosure.



There were no changes in our internal controls during the second quarter of
2004 that have materially affected, or are reasonably likely to materially affect, our internal controls.



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PART II. OTHER INFORMATION



ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS



At our annual meeting of stockholders held on June 3, 2004, stockholders
representing a total of 30,633,700 shares of common stock (representing 91.69% of the outstanding shares of common stock) were present at the meeting, either in person or represented by proxy, which constituted a quorum, and voted to:



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



|                           |  |            |  |          
|-------------------------- |  | ---------- |  | ---------
|                           |  | For        |  | Withheld 
|Michael R. Hallman         |  | 30,102,257 |  | 531,443  
|Richard A. LeFaivre, Ph.D. |  | 29,476,487 |  | 1,157,213
|William J. Schroeder       |  | 29,478,456 |  | 1,155,244



|(2) | Ratify the appointment of Ernst & Young LLP as our independent auditors for the year ending December 31, 2004.
|--- | --------------------------------------------------------------------------------------------------------------



|        |  |           
|------- |  | ----------
|For     |  | 30,130,229
|Against |  | 417,409   
|Abstain |  | 86,062    



ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K



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



|     |  |                                                                                                                                            
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------
|3.1  |  | Restated Certificate of Incorporation of the registrant (Exhibit 3.1) (A)                                                                  
|     | 
|3.2  |  | Amended and Restated Bylaws of the registrant                                                                                              
|     | 
|10.1 |  | Offer Letter dated June 30, 2004 from the registrant to Edward J. Borey                                                                    
|     | 
|31.1 |  | Section 302 Certification of Edward J. Borey                                                                                               
|     | 
|31.2 |  | Section 302 Certification of James A. Richman                                                                                              
|     | 
|32.1 |  | Certification of Edward J. Borey pursuant to 18 U.S.C. Section 13.50, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 
|     | 
|32.2 |  | Certification of James A. Richman pursuant to 18 U.S.C. Section 13.50, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

---

|(A) | Incorporated by reference to the specified exhibit to the registrants Registration Statement on Form S-1 (File No. 333-76587), filed with the SEC on April 20, 1999, as
amended.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



On April 22, 2004, we furnished a Current Report on Form 8-K announcing our financial results for the quarter ended March 31, 2004.



On July 1, 2004, we filed a Current Report on Form 8-K announcing the
appointment of Edward J. Borey as our Chairman, President and Chief Executive Officer.



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SIGNATURES



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



August 9, 2004



WATCHGUARD TECHNOLOGIES, INC.By:

/s/James A. RichmanJames A. RichmanChief Financial Officer(Authorized Officer)(Principal Financial and Accounting Officer)




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INDEX TO EXHIBITS



|     |  |                                                                                                                                            
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------
|3.1  |  | Restated Certificate of Incorporation of the registrant (Exhibit 3.1) (A)                                                                  
|     | 
|3.2  |  | Amended and Restated Bylaws of the registrant                                                                                              
|     | 
|10.1 |  | Offer Letter dated June 30, 2004 from the registrant to Edward J. Borey                                                                    
|     | 
|31.1 |  | Section 302 Certification of Edward J. Borey                                                                                               
|     | 
|31.2 |  | Section 302 Certification of James A. Richman                                                                                              
|     | 
|32.1 |  | Certification of Edward J. Borey pursuant to 18 U.S.C. Section 13.50, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 
|     | 
|32.2 |  | Certification of James A. Richman pursuant to 18 U.S.C. Section 13.50, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

---

|(A) | Incorporated by reference to the specified exhibit to the registrants Registration Statement on Form S-1 (File No. 333-76587), filed with the SEC on April 20, 1999, as
amended.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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