<PAGE>

                                UNITED STATES
                     SECURITIES AND EXCHANGE COMMISSION

                           WASHINGTON, D.C. 20549

                                  FORM 10-Q
(Mark One)

[X]  Quarterly report pursuant to Section 13 or 15(d) of the Securities
     Exchange Act of 1934.

     For the quarterly period ended December 31, 1999.

                                     or

[_]  Transition report pursuant to Section 13 or 15(d) of the Securities
     Exchange Act of 1934.

                       Commission File Number: 0-24507

                        PILOT NETWORK SERVICES, INC.
           (Exact name of registrant as specified in its charter)

          DELAWARE                                94-3305774
(State or other jurisdiction of                (I.R.S. Employer
 incorporation or organization)             Identification Number)

                         1080 MARINA VILLAGE PARKWAY
                              ALAMEDA, CA 94501
        (Address of principal executive offices, including zip code)

                               (510) 433-7800
            (Registrant's telephone number, including area code)

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 such filing
requirements for the past 90 days.

                               Yes __X__  No ___

At December 31, 1999, there were 14,821,384 shares of the Registrant's Common
Stock outstanding.

                                  Page 1 of 17
<PAGE>

<TABLE>
<CAPTION>
                        PILOT NETWORK SERVICES, INC.
                        QUARTERLY REPORT ON FORM 10-Q
                                    INDEX

                                                                              Page Number
<S>                                                                           <C>
PART I.  FINANCIAL INFORMATION

Item 1.     Financial Statements.............................................     3

            Condensed Balance Sheets as of
            March 31, 1999 and December 31, 1999.............................     3

            Condensed Statements of Operations for the three months and nine
            months ended December 31, 1998 and 1999..........................     4

            Condensed Statements of Cash Flows for the
            nine months ended December 31, 1998 and 1999.....................     5

            Notes to Condensed Financial Statements..........................     6

Item 2.     Management's Discussion and Analysis of Financial Condition and
            Results of Operations............................................     7

Item 3.     Quantitative and Qualitative Disclosures About Market Risk.......    14

PART II.    OTHER INFORMATION................................................    15

Item 2.     Changes in Securities and Use of Proceeds........................    15

Item 6.     Exhibits and Reports on Form 8-K.................................    16

SIGNATURES...................................................................    16

INDEX TO EXHIBITS............................................................    17
</TABLE>

                                  Page 2 of 17
<PAGE>

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

                          PILOT NETWORK SERVICES, INC.

                            CONDENSED BALANCE SHEETS
                       (in thousands, except share data)
                                  (unaudited)
<TABLE>
<CAPTION>
                                                                                  March 31,         December 31,
                                                                                     1999              1999
                                                                                ---------------   ----------------
<S>                                                                            <C>               <C>
ASSETS
Current assets:
 Cash and cash equivalents...................................................         $ 10,660            $  1,759
 Short-term investments......................................................           12,352               1,097
 Trade receivables, less allowance for doubtful accounts of $157 and $302 as
  of March 31, 1999 and December 31, 1999, respectively......................            3,438               6,754
 Receivable from sale of common stock........................................                -              15,000
 Prepaid and other current assets............................................              783               1,426
                                                                                      --------            --------
  Total current assets.......................................................           27,233              26,036
Property and equipment, net..................................................           14,184              20,560
Other assets.................................................................              698               1,404
                                                                                      --------            --------
                                                                                      $ 42,115            $ 48,000
                                                                                      ========            ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
 Accounts payable............................................................         $  2,334            $  4,374
 Accrued expenses............................................................            1,675               1,856
 Line of credit..............................................................            1,439               4,830
 Term loan...................................................................            3,000               3,000
 Current portion of capital lease obligation.................................            2,175               2,380
 Deferred revenue............................................................            2,027               1,894
                                                                                      --------            --------
  Total current liabilities..................................................           12,650              18,334
Capital lease obligations, net of current portion............................            4,830               4,061
                                                                                      --------            --------
  Total liabilities..........................................................           17,480              22,395
                                                                                      --------            --------
Common stock held in escrow, net of issuance costs; 919,540 shares...........                -              14,750
                                                                                      --------            --------
Stockholders' equity:
 Common stock, $0.001 par value; 40,000,000 shares authorized; 13,913,024
  and 13,901,844 shares issued and outstanding as of March 31, 1999 and
  December 31, 1999, respectively............................................               14                  15
 Additional paid-in capital..................................................           59,563              61,247
 Accumulated other comprehensive income......................................              127                  40
 Deferred stock compensation.................................................           (1,097)               (443)
 Accumulated deficit.........................................................          (31,278)            (47,310)
 Treasury stock, 450,936 shares of common stock at cost
        as of March 31, 1999 and December 31, 1999...........................           (2,694)             (2,694)
                                                                                      --------            --------
  Total stockholders' equity.................................................           24,635              10,855
                                                                                      --------            --------
                                                                                      $ 42,115            $ 48,000
                                                                                      ========            ========
</TABLE>
           See accompanying notes to condensed financial statements.

                                  Page 3 of 17
<PAGE>

                          PILOT NETWORK SERVICES, INC.

                       CONDENSED STATEMENTS OF OPERATIONS
                     (in thousands, except per share data)
                                  (unaudited)

<TABLE>
<CAPTION>

                                                       Three months ended              Nine months ended
                                                          December 31,                    December 31,
                                                        1998            1999            1998            1999
                                                       -------         -------        --------        --------
<S>                                              <C>             <C>             <C>             <C>
Service revenues...............................        $ 4,480         $ 8,465        $ 11,970        $ 21,411
Cost of service revenues.......................          5,263           8,188          13,867          21,997
                                                       -------         -------        --------        --------
Gross margin...................................           (783)            277          (1,897)           (586)
                                                       -------         -------        --------        --------
Operating costs and expenses:
 Sales and marketing...........................          2,724           3,342           6,992           9,498
 Engineering and development...................            386           1,134           1,071           2,536
 General and administrative....................            722             983           2,138           2,713
                                                       -------         -------        --------        --------
 Operating expenses............................          3,832           5,459          10,201          14,747
                                                       -------         -------        --------        --------
Operating loss.................................         (4,615)         (5,182)        (12,098)        (15,333)
Interest expense, net..........................            (47)           (412)         (1,286)           (699)
                                                       -------         -------        --------        --------
Net loss.......................................         (4,662)         (5,594)        (13,384)        (16,032)
Accretion on redeemable convertible preferred
 stock.........................................              -               -            (488)              -
                                                       -------         -------        --------        --------
Net loss attributable to common stockholders...        $(4,662)        $(5,594)       $(13,872)       $(16,032)
                                                       =======         =======        ========        ========
Basic and diluted net loss per share...........        $ (0.34)        $ (0.40)       $  (1.68)       $  (1.17)
                                                       =======         =======        ========        ========
Shares used in computing net loss per share....         13,580          13,859           8,266          13,705
                                                       =======         =======        ========        ========
</TABLE>

           See accompanying notes to condensed financial statements.

                                  Page 4 of 17
<PAGE>

                          PILOT NETWORK SERVICES, INC.

                       CONDENSED STATEMENTS OF CASH FLOWS
                           (in thousands, unaudited)

<TABLE>
<CAPTION>
                                                                         Nine months ended
                                                                            December 31,
                                                                        1998            1999
                                                                   --------------  --------------
<S>                                                                <C>             <C>
Cash flows from operating activities:
 Net loss........................................................       $(13,384)       $(16,032)
 Adjustments to reconcile net loss to net cash used in operating
  activities:
  Depreciation and amortization..................................          2,816           5,294
  Amortization of deferred compensation..........................          1,111             225
  Amortization of loan fees......................................            900             275
  Changes in operating assets and liabilities:
   Trade receivables.............................................         (2,150)         (3,316)
   Prepaid and other assets......................................           (688)           (624)
   Accounts payable..............................................            160           2,040
   Accrued expenses..............................................            802             181
   Deferred revenue..............................................            177            (133)
                                                                        --------        --------
   Net cash used in operating activities.........................        (10,256)        (12,090)
                                                                        --------        --------
Cash flows used in investing activities:
 Purchases of property and equipment.............................         (3,646)        (10,496)
 Purchases of short-term investments.............................        (14,553)              -
 Proceeds from short-term investments............................              -          11,168
                                                                        --------        --------
   Net cash provided by (used in) investing activities...........        (18,199)            672
                                                                        --------        --------
Cash flows from financing activities:
 Proceeds from issuance of common stock, net of receivable.......         43,335             864
 Proceeds from working capital line of credit....................            673           3,391
 Proceeds from term loan.........................................          6,000           3,000
 Payments of term loan...........................................         (3,000)         (3,000)
 Purchases of treasury stock.....................................         (2,694)              -
 Principal payments of obligations under capital leases..........         (1,498)         (1,738)
                                                                        --------        --------
   Net cash provided by financing activities.....................         42,816           2,517
                                                                        --------        --------
Net increase (decrease) in cash and cash equivalents.............         14,361          (8,901)
Cash and cash equivalents, beginning of period...................          1,447          10,660
                                                                        --------        --------
Cash and cash equivalents, end of period.........................       $ 15,808        $  1,759
                                                                        ========        ========
Supplemental disclosure of cash flow information:
 Cash paid during the period for interest........................       $  1,095        $  1,014
                                                                        ========        ========
 Noncash financing activities:
  Assets acquired under capital lease obligations................       $  2,754        $  1,174
                                                                        ========        ========
  Accretion on preferred stock...................................       $    488        $      -
                                                                        ========        ========
</TABLE>

           See accompanying notes to condensed financial statements.

                                  Page 5 of 17
<PAGE>

NOTES TO CONDENSED FINANCIAL STATEMENTS


1.   Basis of presentation

     The financial statements included herein for Pilot Network Services, Inc.
(the "Company") have been prepared by the Company, without audit, pursuant to
the rules and regulations for Form 10-Q of the Securities and Exchange
Commission. In management's opinion, the interim financial data presented
includes all adjustments (which include only normal and recurring adjustments)
necessary for a fair presentation. Certain information and footnote disclosures
normally included in the financial statements prepared in accordance with
generally accepted accounting principles have been condensed or omitted pursuant
to such rules and regulations. The results of operations for the three months
ended December 31, 1999 are not necessarily indicative of the operating results
expected for the entire year. The financial statements included herein should be
read in conjunction with other documents the Company files from time to time
with the Securities and Exchange Commission, including the Company's March 31,
1999, financial statements and notes thereto included in the Company's Annual
Report on Form 10-K dated June 29, 1999 and its Quarterly Reports on Form 10-Q
dated August 16, 1999, and November 15, 1999.


2.   Basic and diluted net loss per share

     Basic and diluted loss per share is computed using the weighted average
number of common shares outstanding during the period. Inclusion of common share
equivalents would be anti-dilutive and have been excluded from per share
calculations.

     As part of Pilot's initial public offering on August 10, 1998, 7,763,030
shares of common stock were issued from the conversion of the Series A, B, C, D,
E and F preferred stock. Prior to August 10, 1998, those shares were not
included in calculating diluted earnings per share because the effects would be
anti-dilutive. Also excluded from the computation of diluted earnings per share
for the three and nine-month periods ending December 31, 1998, are options to
acquire 1,901,568 shares of common stock and 292,910 common share equivalents
from the assumed exercise of common stock warrants because their effects would
be anti-dilutive. Excluded from the computation of diluted earnings per share
for the three and nine-month periods ending December 31, 1999, are options to
acquire 2,336,134 shares of common stock and 464,086 common share equivalents
from the assumed exercise of common stock warrants because their effects would
be anti-dilutive.

3.   Recent accounting pronouncements

     In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative
Instruments and Hedging Activities." This statement establishes standards for
accounting for derivative instruments and hedging activities. The Company is
required to adopt SFAS No. 133, as amended by SFAS No. 137, in the first quarter
of fiscal year 2002. The Company does not anticipate that SFAS No. 133 will have
a material impact on its financial statements.

4.   Comprehensive Loss

     Total comprehensive loss for the quarter and nine months ended December 31,
1999, was $5,594,000 and $16,119,000, respectively.

5.  Subsequent Event

     On December 28, 1999, the Company entered into an agreement with Primus
Telecommunications Group, Inc. ("Primus") that included the purchase by Primus
of 919,540 shares of the Company's common stock for $16.3125 per share for a
total purchase price of $15.0 million. The $16.3125 per share price was

                                  Page 6 of 17
<PAGE>

the closing price of the Company's common stock on December 27, 1999.
Additionally, the Company issued to Primus a warrant to purchase 200,000 shares
of common stock at $25 per share. The warrant is exercisable for three years
following its issuance. As of December 31, 1999, the purchase price, the common
stock shares and the warrant were held in escrow. On January 5, 2000, the
Company received the full amount of the purchase price in cash and the shares
and warrant were released to Primus.



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

   In addition to historical information, this Quarterly Report contains
forward-looking statements.  The forward-looking statements are subject to
certain risks and uncertainties that could cause actual results to differ
materially from those reflected in such forward-looking statements.  Factors
that might cause such a difference include, but are not limited to, those
discussed in the section entitled "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Factors That May Affect Future
Results and Market Price of Stock."  Readers are cautioned not to place undue
reliance on these forward-looking statements, which reflect management's
opinions only as of the date hereof. The Company undertakes no obligation to
revise or publicly release the results of any revision to these forward-looking
statements. Readers should carefully review the risk factors that may be
described in other documents the Company files from time to time with the
Securities and Exchange Commission, including its Annual Report on Form 10-K
filed by the Company on June 29, 1999, its Quarterly Reports on Form 10-Q filed
by the Company on August 16, 1999, and November 15, 1999, and any Quarterly
Reports on Form 10-Q filed by the Company in the future.

OVERVIEW

   Pilot Network Services, Inc. provides a wide range of secure Internet
services that incorporate high-bandwidth connectivity and enable secure
electronic business over the Internet. The services are offered for a fixed
monthly fee on an annual subscription-basis. The Company's services include
secure hosting and Internet connectivity services that enable secure
connectivity between a corporate network and the Internet and secure virtual
private networking services that enable remote users and wide-area networks to
securely communicate enterprise-wide and over the Internet. The Company offers a
scalable solution that allows customers to quickly deploy and expand electronic
business capabilities by subscribing to Pilot's secure Internet services.

RESULTS OF OPERATIONS

THREE MONTHS ENDED DECEMBER 31, 1998 AND 1999

   SERVICE REVENUES. In the three months ended December 31, 1999, service
revenues increased 89% to $8.5 million from $4.5 million in the three months
ended December 31, 1998. This growth was due primarily to increases in service
agreements and project revenues from new and current customers. To a lesser
extent, annual price increases for various offered services also contributed to
this growth. Additionally, the Company was able to shorten the implementation
time for certain new services, allowing for earlier recognition of
implementation fees and billing of fees for recurring services.

   COST OF SERVICE REVENUES. Cost of service revenues increased 56% to $8.2
million, or 97% of service revenues, in the three months ended December 31,
1999, compared to $5.3 million, or 117% of service revenues, in the three months
ended December 31, 1998. The increase in cost of service revenue was a result of
an increase in security implementation, customer service and operations
personnel from 75 at December 31, 1998, to 91 at December 31, 1999, as well as
increases in the average cost of those personnel. Other incremental expenses
included consulting and temporary labor, facilities rent, telecommunications,
equipment leases and depreciation directly related to the Company's revenue
growth. Additionally, incremental costs associated with the opening of a new
Network Security Center in Alameda,

                                  Page 7 of 17
<PAGE>

California contributed to the increase in cost of service revenues. The Company
expects the cost of service revenues to continue to increase on an absolute
basis as a result of expected customer expansion in the Company's Network
Security Centers.

   SALES AND MARKETING. Sales and marketing expenses increased 23% to $3.3
million in the three months ended December 31, 1999, from $2.7 million in the
three months ended December 31, 1998, but decreased as a percentage of service
revenues to 39% for the three months ended December 31, 1999, from 61% for the
three months ended December 31, 1998.  The increase in sales and marketing
expense was a result of an increase in sales and marketing personnel from 43 at
December 31, 1998, to 51 at December 31, 1999, as well as in recruiting and
commissions directly related to the expanded sales activity. The Company expects
that its sales and marketing expenses will continue to increase in absolute
dollars for at least the next twelve months as the Company makes additional
investments in expanding its sales and marketing activities.

   ENGINEERING AND DEVELOPMENT. Engineering and development expenses increased
194% to $1.1 million in the three months ended December 31, 1999, from $0.4
million in the three months ended December 31, 1998, and increased as a
percentage of service revenues to 13% for the three months ended December 31,
1999, from 9% for the three months ended December 31, 1998.  The increase in
engineering and development expense was a result of an increase in personnel
from 11 at December 31, 1998, to 26 at December 31, 1999, as well as an increase
in consulting and other professional services. The Company expects that its
engineering and development expenses will continue to increase in absolute
dollars for at least the next twelve months as the Company makes additional
investments in developing its secure electronic commerce services.

   GENERAL AND ADMINISTRATIVE. General and administrative expenses increased 36%
to $1.0 million in the three months ended December 31, 1999 from $0.7 million in
the three months ended December 31, 1998, but decreased as a percentage of
service revenues to 12% for the three months ended December 31, 1999, from 16%
for the three months ended December 31, 1998. The increase in general and
administrative expense was a result of an increase in personnel from 15 at
December 31, 1998, to 18 at December 31, 1999, as well as increases in
professional fees and business taxes as well as other costs associated with
being a public company. The Company expects that its general and administrative
expenses will continue to increase in absolute dollars for at least the next
twelve months as the Company continues to expand its operations.


NINE MONTHS ENDED DECEMBER 31, 1998 AND 1999

   SERVICE REVENUES. In the nine months ended December 31, 1999, service
revenues increased 79% to $21.4 million from $12.0 million in the nine months
ended December 31, 1998. This growth was due primarily to increases in service
agreements and project revenues from new and current customers. To a lesser
extent, annual price increases for various offered services also contributed to
this growth. Additionally, the Company was able to shorten the implementation
time for certain new services, allowing for earlier recognition of
implementation fees and billing of fees for recurring services.

   COST OF SERVICE REVENUES. Cost of service revenues increased to $22.0
million, or 103% of service revenues, in the nine months ended December 31,
1999, compared to $13.9 million, or 116% of service revenues, in the nine months
ended December 31, 1998. The increase in cost of service revenue was a result of
an overall increase in security implementation, customer service and operations
personnel as well as an increase in the average cost of such personnel.
Additionally, increases in consulting, telecommunications, facilities rent,
equipment leases and depreciation, all associated with existing operations as
well as the opening of a new Network Security Center in Alameda, California
contributed to the increase in cost of service revenue. The Company expects that
cost of service revenues will continue to increase in absolute dollars for the
remainder of the fiscal year.

   SALES AND MARKETING. Sales and marketing expenses increased 36% to $9.5
million in the nine months ended December 31, 1999 from $7.0 million in the nine
months ended December 31, 1998 but

                                  Page 8 of 17
<PAGE>

decreased as a percentage of service revenues to 44% for the nine months ended
December 31, 1999 from 58% for the nine months ended December 31, 1998. The
increase in sales and marketing expense resulted from increase in sales and
marketing personnel as well as in recruiting and commissions directly related to
the expanded sales activity in connection with the Company's expansion of its
operations. The Company expects that sales and marketing expenses will continue
to increase in absolute dollars for the remainder of the fiscal year.

   ENGINEERING AND DEVELOPMENT. Engineering and development expenses increased
137% to $2.5 million in the nine months ended December 31, 1999 from $1.1
million in the nine months ended December 31, 1998 and increased as a percentage
of service revenues to 12% for the nine months ended December 31, 1999 from 9%
for the nine months ended December 31, 1998. The increase in engineering and
development expense was a result of increases in personnel and consulting
related expenses in connection with continuing efforts to develop new security
methodologies, integrate and enhance acquired third-party technologies to
support the Company's security and add new service offerings. The Company
expects that its engineering and development expenses will continue to increase
in absolute dollars for the remainder of the fiscal year as a result of this
increased investment activity.

   GENERAL AND ADMINISTRATIVE. General and administrative expenses increased 27%
to $2.7 million in the nine months ended December 31, 1999 from $2.1 million in
the nine months ended December 31, 1998 but decreased as a percentage of service
revenues to 13% for the nine months ended December 31, 1999 from 18% for the
nine months ended December 31, 1998. The increase in general and administrative
expense was a result of increases in personnel, professional fees and business
taxes. The Company expects that its general and administrative expenses will
continue to increase in absolute dollars for the remainder of the fiscal year as
the Company continues to expand its operations.


LIQUIDITY AND CAPITAL RESOURCES

   At December 31, 1999, the Company's cash, cash equivalents and short-term
investments totaled $2.9 million compared to cash, cash equivalents and short-
term investments of $23.0 million at March 31, 1999.

   As of December 31, 1999, the Company had an $8.0 million equipment line of
credit and lease facility for financing of equipment purchases at interest rates
of approximately 15%. Borrowings under the facilities are repayable in monthly
installments of principal and interest over 48 months and are secured by a lien
on the financed equipment. As of December 31, 1999, the Company had fully
utilized these lines of credit and lease facilities. The Company intends to
secure additional equipment lease lines of credit to fund growth in capital
equipment purchases.

   On December 28, 1999, the Company entered into an agreement with Primus
Telecommunications Group, Inc. ("Primus") that included the purchase by Primus
of 919,540 shares of the Company's common stock for $16.3125 per share for a
total purchase price of $15.0 million. The $16.3125 per share price was the
closing price of the Company's common stock on December 27, 1999. Additionally,
the Company issued to Primus a warrant to purchase 200,000 shares of common
stock at $25 per share. The warrant is exercisable for three years following its
issuance. As of December 31, 1999, the purchase price, the common stock shares
and the warrant were held in escrow.  On January 5, 2000, the Company received
the full amount of the purchase price in cash and the shares and warrant were
released to Primus. Under the terms of the agreement, Pilot will configure
Primus Operations Centers around the world with Pilot's Heuristic Defense
Infrastructure.

   On November 10, 1999, the Company completed an $8.0 million credit facility
with a financial institution consisting of a $5.0 million revolving line of
credit and a $3.0 million term loan. The line of credit is renewable in
successive one-year terms the term loan matures in one year. Both loans
currently bear interest of 10.50% per annum. Additionally, the term loan must be
pre-paid, without penalty, if the Company raises more than $15 million in
equity. The credit facility is secured by the general assets of the Company. As
additional consideration, the Company issued a warrant to purchase 121,212
shares of

                                  Page 9 of 17
<PAGE>

common stock at $8.25 per share. The Company calculated a fair value of the
warrants of $1.0 million which amount will be capitalized and amortized over the
expected terms of the loans. At December 31, 1999, $170,000 of the revolving
line of credit remained available.

   On October 19, 1998, the Company announced an open-market common stock
repurchase program under which the Company would repurchase up to 1.5 million
shares of its Common Stock.  As of June 30, 1999, 450,936 shares had been
repurchased, at an aggregate cost to the Company of approximately $2.7 million.
The Company does not anticipate making any additional repurchases under this
program.

   On June 30, 1998, the Company completed a borrowing arrangement with two
lenders providing $6.0 million of short term financing bearing interest at 13.5%
per annum. The loans expired in June 1999. The loans contained various pre-
payment options available after the Company's initial public offering date of
August 10, 1998. As additional consideration, the Company issued 150,000
warrants to purchase common stock at $11.20 per share. The Company calculated a
fair value of the warrants of $1.2 million which amount was capitalized and
amortized over the expected terms of the loans. One of the lenders exercised its
option for repayment of $3.0 million which was repaid in October 1998. On July
1, 1999, the Company repaid the remaining $3.0 million liability to the other
lender.

   On May 11, 1998, the Company negotiated a line of credit with a financial
institution for an aggregate amount of $1.5 million and was secured by assets of
the Company. This line of credit has since been repaid from proceeds of the $3.0
million term loan and terminated.

   The Company's working capital and capital requirements will depend upon
numerous factors including plans to incur substantial additional capital
expenditures primarily for additions to and expansions of its Network Security
Centers, developing, acquiring or licensing new applications and technologies,
and the level of resources that the Company devotes to its sales and marketing
activities. In addition to the recently completed $15.0 million equity
investment and $8.0 million credit facility, the Company believes that it will
require additional equity financing, which it is actively pursuing. In addition,
the Company will pursue additional equipment lease financing. However, there can
be no assurance that the Company will be successful in generating anticipated
levels of cash from operations or in obtaining equity or equipment lease
financing. If the Company is unable to generate sufficient cash flow from
operations, or is unable to obtain additional equity or equipment lease
financing, it may be required to sell assets, scale down its operations and
expansion plans, refinance all or a portion of its existing indebtedness or
obtain other sources of financing earlier than planned, any of which could have
a material adverse impact on the Company's business, results of operations and
financial condition. There can be no assurance that any such refinancing would
be available on commercially reasonable terms, or at all, or that any other
financing could be obtained.


YEAR 2000 RISKS

   The Company experienced no material adverse effects from the Year 2000
problem and does not believe it will incur significant incremental costs in
order to comply with Year 2000 requirements in the foreseeable future.


FACTORS THAT MAY AFFECT FUTURE RESULTS AND MARKET PRICE OF STOCK

   The Company operates in a rapidly changing environment that involves numerous
risks, some of which are beyond the Company's control. The following discussion
highlights some of these risks.

   FUTURE CAPITAL NEEDS. The Company's working capital and capital requirements
will depend upon numerous factors including plans to incur substantial
additional capital expenditures primarily for additions to and expansions of its
Network Security Centers, developing, acquiring or licensing new applications
and technologies, and the level of resources that the Company devotes to its
sales and

                                 Page 10 of 17
<PAGE>

marketing activities. In addition to the recently completed $15.0 million equity
investment and $8.0 million credit facility, the Company believes that it will
require additional equity financing, which it is actively pursuing. In addition,
the Company will pursue additional equipment lease financing. However, there can
be no assurance that the Company will be successful in generating anticipated
levels of cash from operations or in obtaining equity or equipment lease
financing. If the Company is unable to generate sufficient cash flow from
operations, or is unable to obtain additional equity or equipment lease
financing, it may be required to sell assets, scale down its operations and
expansion plans, refinance all or a portion of its existing indebtedness or
obtain other sources of financing earlier than planned, any of which could have
a material adverse impact on the Company's business, results of operations and
financial condition. There can be no assurance that any such refinancing would
be available on commercially reasonable terms, or at all, or that any other
financing could be obtained.

   LIMITED OPERATING HISTORY; HISTORY OF LOSSES. The Company began operations in
1993, and has experienced operating losses and negative cash flows from
operations in each quarterly and annual period. As of December 31, 1999, the
Company had an accumulated deficit of approximately $47.3 million. The revenue
and income potential of the Company's business and market is unproven, and the
Company's limited operating history makes an evaluation of the Company and its
prospects difficult. The Company has recently made and expects to continue
making significant investments in security technologies, new and existing
Network Security Centers, sales and marketing activities, and the development of
new services. As a result, the Company experienced a decline in gross margin and
an increase in net loss in fiscal 1998 and fiscal 1999 and expects to continue
experiencing significant net losses on a quarterly and annual basis for the
foreseeable future, including a negative gross margin at least for the next six
months. Failure of the Company's services to achieve market acceptance would
have a material adverse effect on the Company's business, results of operations
and financial condition. There can be no assurance that the Company will ever
achieve profitability on a quarterly or an annual basis or will sustain
profitability if achieved.

   POTENTIAL FLUCTUATIONS IN RESULTS OF OPERATIONS. The Company derives revenue
from its customers primarily through initial setup fees and ongoing monthly
service charges. For each new customer, the Company must incur costs in
anticipation of the customer's decision to use the Company's services and in
advance of the receipt of sufficient revenues to repay these costs and provide a
return on the Company's investment. As a result, a relatively large portion of
the Company's expenditures are fixed in the short-term, and the Company's
success is substantially dependent on the continued growth in its customer base
and the retention of its customers for sufficient periods to provide returns on
the Company's investment. There can be no assurance that the Company's customers
will maintain or renew their commitments to use the Company's services. The
Company typically experiences a lengthy sales cycle for its services,
particularly given the importance to customers of adequately securing Internet
connectivity for electronic commerce and the need to educate them regarding the
requirements for effective network security. Changes in the rate of growth in
the Company's customer base, customer renewal rates and the sales cycle for the
Company's services, have caused, or are expected in the future to cause,
significant fluctuations in the Company's results of operations on a quarterly
and an annual basis.

   For these and other reasons, in some future quarters, the Company's results
of operations may fall below the expectations of securities analysts or
investors, which could have a material adverse effect on the market price of the
Company's Common Stock.

   RISKS ASSOCIATED WITH SECURITY BREACHES. The Company's success is
substantially dependent on the continued confidence of its current and future
customers that the Company provides superior network security protection.
Despite the Company's focus on Internet security, there can be no assurance that
the Company will be able to stop unauthorized attempts, whether made
unintentionally or by computer "attackers," to gain access to or disrupt the
network operations of the Company's customers. The Company's Heuristic Defense
Infrastructure delivered through its Network Security Centers is designed to
prevent unauthorized access to customers' networks from the Internet. Any
failure by the Company to stop unauthorized access from the Internet or
disruptions to related Internet operations of its customers could materially
adversely affect such customers and the Company. Although the Company generally
limits warranties and liabilities relating to security in its customer
contracts, the Company's customers may seek

                                 Page 11 of 17
<PAGE>

to hold the Company responsible for any losses suffered by the customer as a
result of unauthorized access to customers' network systems from the Internet.
This could result in liability to the Company, which could have a material
adverse effect upon its business, operating results and financial condition.
Moreover, computer attackers from the Internet could infiltrate the Company's
network and seek to sabotage its network or services by creating bugs or viruses
or through other means. In addition, any adverse publicity resulting from any
such unauthorized access could deter future customers from using the Company's
services and could cause current customers to cease using the Company's
services, which could have a material adverse effect upon the Company's
business, operating results and financial condition.

   RISKS ASSOCIATED WITH THE EMERGING MARKET FOR OUTSOURCED NETWORK SECURITY
SERVICES. The market for Internet security monitoring, detection and defense
services in general is new and rapidly evolving. If the market for such services
fails to grow or grows more slowly than the Company currently anticipates, the
Company's business, operating results and financial condition would be
materially and adversely affected.

   RISKS OF BUSINESS EXPANSION AND MANAGEMENT OF GROWTH. The Company intends to
expand domestically and internationally by adding Network Security Centers in
new locations and expanding Network Security Centers in existing locations. The
Company's inability to manage effectively its expansion, including any
disruption of service to current customers, would have a material adverse effect
upon the Company's business, results of operations and financial condition.

   In addition, the Company will be required to expend substantial resources for
leases and improvements of facilities, purchases of equipment, implementation of
multiple telecommunications connections and hiring of network, administrative,
customer support, and sales and marketing personnel. Furthermore, any problems
encountered in connection with the expansion of existing Network Security
Centers may cause the interruption of service to current customers.

   The Company has recently hired large numbers of new employees. This growth
has placed and may continue to place a significant strain on the Company's
financial, management, operational and other resources. If the Company's
executives were unable to manage growth effectively, the Company's business,
results of operations and financial condition would be materially adversely
affected.

   COMPETITION. The market served by the Company is new, rapidly evolving,
highly competitive and largely undefined. There are few general barriers to
entry, and the Company expects that it will face additional competition from
existing competitors and new market entrants in the future. There can be no
assurance that the Company will have the resources or expertise to compete
successfully in the future.

   The Company competes with a broad range of products and services. Many of the
Company's competitors have substantially greater financial, technical and
marketing resources, larger customer bases, longer operating histories, greater
name recognition and more established relationships in the industry than the
Company. As a result, certain of these competitors may be able to develop and
expand their network infrastructures and service offerings more quickly, adapt
to new or emerging technologies and changes in customer requirements more
quickly, take advantage of acquisition and other opportunities more readily,
devote greater resources to the marketing and sale of their products and adopt
more aggressive pricing policies than the Company. In addition, the Company
believes that the businesses in which the Company competes are likely to
encounter consolidation in the near future, which could result in increased
price and other competition that could have a material adverse effect on the
Company's business, results of operations and financial condition.

   RISK OF SYSTEM FAILURE. The Company's success depends on the excellence of
security protection and uninterrupted operation of its network infrastructure.
Despite existing and planned precautions by the Company, the occurrence of a
natural disaster or other unanticipated problems at one or more of the Company's
Network Security Centers could result in interruptions in the services provided
by the Company. Any damage to or failure of the Company's systems or those of
its service providers could result in reductions in, or terminations of,
services supplied to the Company's customers. Such reductions

                                 Page 12 of 17
<PAGE>

or terminations in service could materially and adversely impact the Company's
customers, which could have a material adverse effect on the Company's business,
results of operations and financial condition.

   RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS. A key component of the
Company's long-term strategy is to expand into international markets. If revenue
generated by any international Network Security Center is not adequate to offset
the expense of establishing and maintaining any such international operation,
the Company's business, results of operations and financial condition could be
materially adversely affected. In addition, the Company faces certain risks
inherent in conducting business internationally, any of which could adversely
affect the Company's international operations.

   DEPENDENCE UPON SCALABILITY OF THE COMPANY'S NETWORK. The Company must
continue to expand and adapt its network infrastructure as the number of
customers and the amount of information they wish to transmit increases, and as
customer requirements change. The expansion and adaptation of the Company's
telecommunications infrastructure will require substantial financial,
operational and management resources. Due to the limited deployment of the
Company's services to date, the ability of the Company's network to connect and
manage a substantially larger number of customers at high transmission speeds is
as yet unknown, and the Company faces risks related to the network's ability to
operate with higher customer levels while maintaining superior performance. The
Company's failure to achieve or maintain high capacity data transmission could
significantly reduce customer demand for its services and have a material
adverse effect on its business, results of operations and financial condition.
There can be no assurance that the Company will be able to expand or adapt its
telecommunications infrastructure to meet additional demand or its customers'
changing requirements.

   DEPENDENCE UPON THIRD PARTY NETWORK INFRASTRUCTURE PROVIDERS. The Company's
success will depend upon third party network infrastructure providers. In
addition, the Company relies on a number of public and private peering
interconnections (i.e., arrangements among access providers to carry traffic of
each other) to deliver its services. If the carriers that operate the Internet
exchange points ("IXPs") were to discontinue their support of the peering points
or to refuse to offer services to the Company and no alternative providers were
to emerge, or such alternative providers were to increase the cost of utilizing
the IXPs, the transmission of network traffic by the Company would be
significantly constrained. If the Company were unable to access on a cost-
effective basis alternative networks to distribute its customers' content or
pass through any additional costs of utilizing these networks to its customers,
the Company's business, results of operations and financial condition could be
materially adversely affected.

   DEPENDENCE ON OTHER THIRD-PARTY RELATIONSHIPS. The Company is dependent on
other companies to supply certain key components of its telecommunications
infrastructure and system and network management solutions that, in the
quantities and quality demanded by the Company, are available only from sole or
limited sources. Any failure to obtain required components or software on a
timely basis and at an acceptable cost would have a material adverse effect on
the Company's business, results of operations and financial condition. The
Company also intends to develop alternative distribution and lead generation
channel partners for the Company's services, such as systems integration firms
and bandwidth providers. Any failure by the Company to develop these channel
partners could materially and adversely impact the ability of the Company to
generate increased revenues, which could have a material adverse effect on the
Company's business, results of operations and financial condition.

   RAPID TECHNOLOGICAL CHANGE; EVOLVING INDUSTRY STANDARDS. The Company's future
success will depend, in part, on its ability to offer services that incorporate
leading technology, address the increasingly sophisticated and varied needs of
its current and prospective customers and respond to technological advances and
emerging industry standards and practices on a timely and cost-effective basis.
The market for the Company's services is characterized by rapidly changing and
unproven technology, evolving industry standards, changes in customer needs,
emerging competition and frequent new service introductions. There can be no
assurance that future advances in technology will be beneficial to, or
compatible with, the Company's business or that the Company will be able to
incorporate such advances on a cost-effective and timely basis into its
business. The Company believes that its ability to compete successfully is also
dependent upon the continued compatibility and interoperability of its services

                                 Page 13 of 17
<PAGE>

with products, services and architectures offered by various vendors as part of
the Company's services. There can be no assurance that such products will be
compatible with the Company's infrastructure or that such products will
adequately address changing customer needs. In addition, there can be no
assurance that products, services or technologies developed by others will not
render the Company's services uncompetitive or obsolete.

   DEPENDENCE ON KEY PERSONNEL. The Company's success depends in significant
part upon the continued services of its key technical, sales and senior
management personnel, including the Company's President and Chief Executive
Officer, Marketta Silvera, and the Company's Vice President, Engineering and
Development, Thomas Wadlow. Any officer or employee of the Company can terminate
his or her relationship with the Company at any time. The loss of the services
of one or more of the Company's key employees or the Company's failure to
attract additional qualified personnel could have a material adverse effect on
the Company's business, results of operations and financial condition.

   RISKS ASSOCIATED WITH INFORMATION DISSEMINATED THROUGH THE COMPANY'S NETWORK.
The law relating to the liability of on-line services companies and Internet
access providers for information carried on or disseminated through their
networks is currently unsettled. It is possible that claims could be made
against on-line services companies and Internet access providers under both
United States and foreign law for defamation, negligence, copyright or trademark
infringement, or other theories based on the nature and content of the materials
disseminated through their networks. The imposition upon the Company and other
Internet network providers of potential liability for information carried on or
disseminated through their systems could require the Company to implement
measures to reduce its exposure to such liability, which may require the
expenditure of substantial resources, or to discontinue certain service or
product offerings.

   PROTECTION AND ENFORCEMENT OF INTELLECTUAL PROPERTY RIGHTS. The Company
relies on a combination of copyright, trademark, patent, service mark and trade
secret laws and contractual restrictions to establish and protect certain
proprietary rights in technology underlying its services. There can be no
assurance that patents or trademarks will be issued or granted from currently
pending or any future applications, or that any patents or trademarks that may
be issued or granted will be sufficient in scope or strength to provide
meaningful protection or any commercial advantage to the Company. The laws of
certain foreign countries may not protect the Company's products, services or
intellectual property rights to the same extent as do the laws of the United
States.

   There can be no assurance that contractual arrangements or other steps taken
by the Company to protect its intellectual property will prove sufficient to
prevent infringement of or misappropriation of the Company's technology or to
deter independent third-party development of similar technologies. Any such
infringement or misappropriation, should it occur, could have a material adverse
effect on the Company's business, results of operation and financial condition.

   To date, the Company has not been notified that the Company's products
infringe the proprietary rights of third parties, but there can be no assurance
that third parties will not claim infringement or indemnification by the Company
with respect to current or future products. Any such claim, whether meritorious
or not, could be time-consuming, result in costly litigation, cause product
installation delays, prevent the Company from using important technologies or
methods, subject the Company to substantial damages, or require the Company to
enter into royalty or licensing agreements. As a result, any such claim could
have a material adverse effect upon the Company's business, results of
operations and financial condition.

ITEM 3.  Quantitative and Qualitative Disclosures About Market Risk.

   The Company has limited exposure to financial market risks, including changes
in interest rates.  The fair value of Pilot's investment portfolio or related
income would not be significantly impacted by a 100 basis point increase or
decrease in interest rates due mainly to the short-term nature of the major
portion of our investment portfolio.  An increase or decrease in interest rates
would not significantly increase or decrease interest expense on debt

                                 Page 14 of 17
<PAGE>

obligations due to the fixed nature of the Company's debt obligations.  Pilot's
foreign operations are limited in scope and thus the Company is not materially
exposed to foreign currency fluctuations.


PART II.  OTHER INFORMATION.

ITEM 2.    CHANGES IN SECURITIES AND USE OF PROCEEDS.

   The Company filed a registration statement on Form S-1, File No. 333-57453,
for an initial public offering of Common Stock which was declared effective by
the Securities and Exchange Commission on August 10, 1998. In that offering, the
Company sold an aggregate of 3,110,000 shares of its Common Stock with net
offering proceeds of $39.4 million. As of December 31, 1999, the Company had
used approximately $39.4 million of those proceeds as follows:

 Construction of plant, building and facilities:        $4.3 million
 Purchase and installation of machinery and equipment:  $9.4 million
 Purchases of real estate:                              None
 Acquisition of other businesses:                       None
 Repayment of indebtedness:                             $9.5 million
 Working capital:                                       $1.1 million
 Repurchase of Common Stock:                            $2.7 million
 Cash loss from operations:                             $12.4 million

   The foregoing amounts represent the Company's best estimate of its use of
proceeds for the period indicated. No payments were made to directors or
officers of the Company or their associates, holders of 10% or more of any class
of equity securities of the Company or to affiliates of the Company.

   On December 28, 1999, the Company sold unregistered shares of its common
stock and a warrant to purchase common stock to Primus, as more fully described
in "Item 2 - Management's Discussion and Analysis of Financial Condition and
Results of Operations - Liquidity and Capital Resources," which is hereby
incorporated by reference. The securities were exempt from registration pursuant
to Section 4(2) of the Securities Act of 1933 as they were sold in a privately-
negotiated transaction not involving any public offering.

                                 Page 15 of 17
<PAGE>

ITEM 6.    EXHIBITS AND REPORTS ON FORM 8-K


A. Exhibits

Exhibit
Number          Description of Exhibit
-------         ----------------------

10.2  Common Stock Purchase Agreement dated December 28, 1999, between the
      Company and Primus Telecommunications Group, Inc.

10.3  Warrant to Purchase Stock dated December 28, 1999, between the Company and
      Primus Telecommunications Group, Inc.

10.4  Loan and Security Agreement dated November 9, 1999, between the Company
      and Greyrock Capital, a division of Banc of America Commercial Finance
      Corporation.

10.5  Warrant to Purchase Stock dated November 9, 1999, between the Company and
      Greyrock Capital, a division of Banc of America Commercial Finance
      Corporation.

10.6  Patent and Trademark Security Agreement dated November 9, 1999, between
      the Company and Greyrock Capital, a division of Banc of America Commercial
      Finance Corporation.

27.1  Financial Data Schedule.


B. Reports on Form 8-K

On January 5, 2000, the Company filed with the Securities and Exchange
Commission a Report on Form 8-K dated December 28, 1999, describing the
Company's sale of securities to Primus as well as certain other agreements with
Primus.


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.


February 14, 2000       /s/ William C. Leetham
-----------------       ----------------------
                        William C. Leetham
                        Senior Vice President, Finance and Administration
                        Chief Financial Officer, Treasurer and Secretary
                        (Principal Financial and Accounting Officer)

                                 Page 16 of 17
<PAGE>

                               INDEX TO EXHIBITS


Exhibit
Number                  Description of Exhibit
-------                 ----------------------

10.2    Common Stock Purchase Agreement dated December 28, 1999, between the
        Company and Primus Telecommunications Group, Inc.

10.3    Warrant to Purchase Stock dated December 28, 1999, between the Company
        and Primus Telecommunications Group, Inc.

10.4    Loan and Security Agreement dated November 9, 1999, between the Company
        and Greyrock Capital, a division of Banc of America Commercial Finance
        Corporation.

10.5    Warrant to Purchase Stock dated November 9, 1999, between the Company
        and Greyrock Capital, a division of Banc of America Commercial Finance
        Corporation.

10.6    Patent and Trademark Security Agreement dated November 9, 1999, between
        the Company and Greyrock Capital, a division of Banc of America
        Commercial Finance Corporation.

27.1    Financial Data Schedule

                                 Page 17 of 17