##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549
 FORM 10-Q (Mark One)þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended March 31, 2005ORo
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from to
 Commission file number 0-24544 CYBERGUARD CORPORATION(Exact name of Registrant as Specified in Its Charter)
 Florida
    
    65-0510339(State or Other Jurisdiction of Incorporation or Organization)
    
    (I.R.S. Employer Identification No.)
 350 SW 12thAvenue, Deerfield Beach, Florida
    
    33442(Address of Principal Executive Offices)
    
    (Zip Code)
 Registrants Telephone Number, Including Area Code 954-375-3500 Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report
 Indicate by check whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Act of 1934 during the preceding 12 months (or for such
shorter period that the registrant was required to file such reports), Yes þ      No o and (2) has been subject to such filing requirements for the past 90 days. Yes þ     No o Indicate by check mark whether the Registrant is an accelerated filer as defined in Rule 12b-2 of
the Exchange Act. Yes þ     No o As of April 29, 2005, 30,735,957 shares of the Registrants $0.01 par value Common Stock were
outstanding.




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##### Table of Contents



TABLE OF CONTENTS PART I. FINANCIAL INFORMATIONItem 1. Financial Statements
    
    
    1Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    14Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    26Item 4. Controls and Procedures
    
    
    26PART II.* OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    27Item 2. Changes in Securities and Use of Proceeds
    
    
    27Item 3. Defaults Upon Senior Securities
    
    
    27Item 4.
Submission of Matters to a Vote of Security Holders
    
    
    27Item 6. Exhibits and Reports on Form 8-K
    
    
    28SIGNATURESEXHIBITSSection 302 Certification of CEOSection 302 Certification of CFOSection 906 Certification of CEOSection 906 Certification of CFO




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##### Table of Contents



PART I: FINANCIAL INFORMATION 
 Item 1. Financial Statements CYBERGUARD CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Amounts in thousands) (Unaudited)March 31,
    
    
    June 30,2005
    
    
    2004ASSETSCash and cash equivalents
    
    $
    12,882
    
    
    $
    12,447Restricted cash
    
    
    208
    
    
    
    197Accounts receivable, less allowance for uncollectible accounts
of $1,068 at Mar 31, 2005 and $365 at June 30, 2004
    
    
    16,258
    
    
    
    9,461Inventories
    
    
    1,947
    
    
    
    2,063Other current assets
    
    
    2,941
    
    
    
    2,790Total current assets
    
    
    34,236
    
    
    
    26,958Property and equipment at cost, less accumulated
depreciation of $5,455 at Mar 31, 2005 and
$4,619 at June 30, 2004
    
    
    2,651
    
    
    
    1,673Capitalized software, less accumulated amortization
of $2,417 at Mar 31, 2005 and $2,166 at June 30, 2004
    
    
    2,139
    
    
    
    1,530Intangible assets, less accumulated amortization of
$5,245 at Mar 31, 2005 and $2,055 at June 30, 2004
    
    
    20,772
    
    
    
    20,262Other assets
    
    
    958
    
    
    
    104Goodwill
    
    
    43,274
    
    
    
    40,625Deferred tax asset, net
    
    
    5,575
    
    
    
    5,575Total assets
    
    $
    109,605
    
    
    $
    96,727LIABILITIES AND SHAREHOLDERS EQUITYAccounts payable
    
    $
    2,800
    
    
    $
    2,951Deferred revenue, current portion
    
    
    15,012
    
    
    
    10,760Note payable
    
    
    1,500
    
    
    
    Accrued expenses and other liabilities
    
    
    5,636
    
    
    
    5,750Total current liabilities
    
    
    24,948
    
    
    
    19,461Deferred tax liability
    
    
    7,466
    
    
    
    7,466Deferred revenue, less current portion
    
    
    4,221
    
    
    
    3,758Total long-term liabilities
    
    
    11,687
    
    
    
    11,224Total liabilities
    
    
    36,635
    
    
    
    30,685Commitments and Contingencies
    
    
    
    
    
    
    Shareholders equityPreferred stock par value $0.01; authorized 5,000 shares; none
issued
    
    
    
    
    
    
    Common stock par value $0.01; authorized 50,000 shares;
issued and outstanding 30,712 at Mar 31, 2005
and 28,528 at June 30, 2004
    
    
    307
    
    
    
    285Additional paid-in capital
    
    
    150,810
    
    
    
    144,569Accumulated deficit
    
    
    (77,547
    )
    
    
    (78,772
    )Accumulated other comprehensive income
    
    
    (600
    )
    
    
    (40
    )Total shareholders equity
    
    
    72,970
    
    
    
    66,042Total liabilities and shareholders equity
    
    $
    109,605
    
    
    $
    96,727
 The accompanying Notes to Condensed Consolidated Financial Statements are an
integral part of these financial statements. 1




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CYBERGUARD CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(Amounts in thousands, except per share data) Three Months Ended
    
    
    Nine Months EndedMarch 31,
    
    
    March 31,
    
    
    March 31,
    
    
    March 31,2005
    
    
    2004
    
    
    2005
    
    
    2004RevenuesProducts
    
    $
    12,645
    
    
    $
    10,113
    
    
    $
    38,307
    
    
    $
    24,497Services
    
    
    4,059
    
    
    
    2,923
    
    
    
    10,581
    
    
    
    8,795Total revenues
    
    
    16,704
    
    
    
    13,036
    
    
    
    48,888
    
    
    
    33,292Cost of revenuesProducts
    
    
    4,321
    
    
    
    3,671
    
    
    
    12,730
    
    
    
    7,651Services
    
    
    1,029
    
    
    
    947
    
    
    
    2,992
    
    
    
    2,716Total cost of revenues
    
    
    5,350
    
    
    
    4,618
    
    
    
    15,722
    
    
    
    10,367Gross profit
    
    
    11,354
    
    
    
    8,418
    
    
    
    33,166
    
    
    
    22,925Operating expensesResearch and development
    
    
    2,406
    
    
    
    1,714
    
    
    
    7,510
    
    
    
    5,109Selling, general and administrative
    
    
    8,190
    
    
    
    5,432
    
    
    
    24,442
    
    
    
    13,853Compensation expense related to unearned restricted
stock in the SnapGear acquisition
    
    
    
    
    
    
    4,113
    
    
    
    
    
    
    
    4,387Total operating expenses
    
    
    10,596
    
    
    
    11,259
    
    
    
    31,952
    
    
    
    23,349Operating income / (loss)
    
    
    758
    
    
    
    (2,841
    )
    
    
    1,214
    
    
    
    (424
    )Other incomeInterest income, net
    
    
    84
    
    
    
    45
    
    
    
    151
    
    
    
    113Other (expense) / income
    
    
    (285
    )
    
    
    206
    
    
    
    (17
    )
    
    
    358Total other (expense) / income
    
    
    (201
    )
    
    
    251
    
    
    
    134
    
    
    
    471Income / (loss) before income taxes
    
    
    557
    
    
    
    (2,590
    )
    
    
    1,348
    
    
    
    47Income tax (expense) / benefit
    
    
    (84
    )
    
    
    481
    
    
    
    (123
    )
    
    
    1,348Net income / (loss)
    
    $
    473
    
    
    $
    (2,109
    )
    
    $
    1,225
    
    
    $
    1,395Basic (loss) earnings per common share
    
    $
    0.02
    
    
    $
    (0.09
    )
    
    $
    0.04
    
    
    $
    0.06Weighted average number of common shares outstanding
    
    
    30,666
    
    
    
    23,757
    
    
    
    30,056
    
    
    
    22,431Diluted (loss) earnings per common share
    
    $
    0.01
    
    
    $
    (0.09
    )
    
    $
    0.04
    
    
    $
    0.05Weighted average number of common shares outstanding
    
    
    32,511
    
    
    
    23,757
    
    
    
    31,871
    
    
    
    28,110
 The accompanying Notes to Condensed Consolidated Financial Statements are an
integral part of these financial statements. 2




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CYBERGUARD CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Amounts in thousands) Nine Months EndedMarch 31,
    
    
    March 31,2005
    
    
    2004Cash flows from operating activities:Net income
    
    $
    1,225
    
    
    $
    1,395Adjustments to reconcile net income to net cash provided by
operating activities:Depreciation
    
    
    836
    
    
    
    1,113Amortization
    
    
    3,441
    
    
    
    959Compensation expense related to unearned restricted stock in the SnapGear
acquisition
    
    
    
    
    
    
    4,387Provision for inventory
    
    
    127
    
    
    
    Deferred tax benefit
    
    
    
    
    
    
    (1,348
    )Provision for uncollectible accounts receivable
    
    
    703
    
    
    
    269Stock based compensation expense
    
    
    573
    
    
    
    494Changes in assets and liabilities (excluding the effect of acquisitions)Increase in accounts receivable
    
    
    (7,500
    )
    
    
    (1,860
    )Increase in other current assets
    
    
    (62
    )
    
    
    (268
    )(Increase) / decrease in inventories
    
    
    (11
    )
    
    
    804Increase in other, net
    
    
    (854
    )
    
    
    (16
    )Decrease in accounts payable
    
    
    (149
    )
    
    
    (657
    )Increase in accrued expenses and other liabilities
    
    
    687
    
    
    
    1,015Increase in deferred revenue
    
    
    3,208
    
    
    
    1,713Decrease in litigation receivable
    
    
    
    
    
    
    6,500Decrease in litigation payable
    
    
    
    
    
    
    (10,400
    )Net cash provided by operating activities
    
    
    2,224
    
    
    
    4,100Cash flows used in investing activitiesIncrease in restricted cash
    
    
    (11
    )
    
    
    (21
    )Acquisition of SnapGear, net of cash acquired
    
    
    
    
    
    
    91Acquisition of certain assets of Zix Corporation
    
    
    (2,126
    )
    
    
    Capitalized software costs
    
    
    (860
    )
    
    
    (1,139
    )Purchase of property & equipment
    
    
    (1,782
    )
    
    
    (522
    )Net cash used in investing activities
    
    
    (4,779
    )
    
    
    (1,591
    )Cash flows provided by financing activities:Proceeds from stock options exercised
    
    
    381
    
    
    
    4,599Proceeds from warrants exercised
    
    
    3,169
    
    
    
    145Net cash provided by financing activities
    
    
    3,550
    
    
    
    4,744Effect of exchange rate changes on cash
    
    
    (560
    )
    
    
    12Net increase in cash
    
    
    435
    
    
    
    7,265Cash and cash equivalents at beginning of period
    
    
    12,447
    
    
    
    12,095Cash and cash equivalents at end of period
    
    $
    12,882
    
    
    $
    19,360Supplemental disclosure of cash flow informationCash paid for interest
    
    $
    
    
    
    $
    Cash paid for income taxes
    
    $
    
    
    
    $
    28
 3




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Supplemental disclosure of non-cash informationIn connection with the acquisition of certain assets from Zix
Corporation, the Company paid Zix $2,126 in cash and signed a promissory
note for $1,500. The following assets and liabilities were acquired:Current assetsOther current assets
    
    
    
    
    
    $
    142Total current assets
    
    
    
    
    
    
    142Non-current assetsProperty and equipment
    
    
    
    
    
    
    32Customer base
    
    
    
    
    
    
    3,700Goodwill
    
    
    
    
    
    
    1,259Total non-current assets
    
    
    
    
    
    
    4,991Current
liabilitiesDeferred revenue
    
    
    
    
    
    
    1,317Total current liabilities
    
    
    
    
    
    
    1,317Deferred revenue, less current portion
    
    
    
    
    
    
    190Total assets acquired
    
    
    
    
    
    $
    3,626
 In connection with the acquisition of SnapGear, 1,651 shares valued at
$14,414 were issued and a contingent purchase consideration of $800 was
accrued for during the quarter ended December 31, 2003. During the quarter ended December 31, 2004, 342 shares valued at $2,137
(which includes the $800 of contingent consideration previously recorded),
were issued based on the attainment of revenues during the 12 months
following the acquisition. 4




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CYBERGUARD CORPORATION
Notes to Condensed Consolidated Financial Statements
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) 1. Business and Basis of Presentation Business CyberGuard Corporation and its subsidiaries (CyberGuard or the Company) is a leading
provider of network security solutions designed to protect enterprises that use the Internet for
electronic commerce and secure communication (customers include Global 2000 companies, major
financial institutions, and government agencies worldwide). The Companys products include
firewall, VPN (Virtual Private Network), secure content management and security management
technologies. Through a combination of proprietary technology and a highly secure operating system,
the Company provides a full suite of products and services that are designed to protect the
integrity of electronic data and customer applications from unauthorized individuals and digital
thieves. The products and services are sold to end-users directly and indirectly by direct sales and
resellers worldwide in over thirty countries. Basis of Presentation CyberGuard has prepared the condensed consolidated financial statements included herein,
without audit, pursuant to the rules and regulations of the Securities and Exchange Commission with
respect to Form 10-Q. Certain information and footnote disclosures normally included in financial
statements prepared in accordance with accounting principles generally accepted in the United
States of America have been condensed or omitted pursuant to such rules and regulations, although
the Company believes that the disclosures made are adequate so as to make the information contained
herein not misleading. These consolidated interim financial statements and the notes should be
read in conjunction with the consolidated financial statements and the notes included in the
Companys 10-K for the year ended June 30, 2004 and the risk factors set forth in the Companys
annual report on Form 10-K, including, without limitation, risk related to the factors listed in
Managements Discussion and Analysis. In the Companys opinion, all adjustments (consisting only
of normal recurring adjustments) necessary for fair presentation of the information shown, have
been included. The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make estimates and
assumptions that affect the amounts reported in the consolidated financial statements and
accompanying notes. On an on-going basis, we evaluate significant estimates used in preparing our
consolidated financial statements, including revenue recognition, bad debt, software development
costs, inventory valuation, and deferred tax valuation allowances. We base our estimates on
historical experience and 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 value of
assets and liabilities that are not readily apparent from other sources. Actual results may differ
from these estimates under different assumptions or conditions. The results of operations
for the nine months ended March 31, 2005 are not necessarily indicative of the results of
operations that may be expected for the year ending June 30, 2005. Revenue Recognition 5




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CYBERGUARD CORPORATION
Notes to Condensed Consolidated Financial Statements
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) The Company recognizes revenue in accordance with Statement of Position (SOP) 97-2 Software
Revenue Recognition, Statement of Position (SOP) 98-9 Modification of SOP 97-2 and Staff
Accounting Bulletin (SAB) 104, Revenue Recognition. Revenue recognition in accordance with
these pronouncements can be complex due to the nature and variability of the Companys sales
transactions. The Companys revenue is primarily from the following sources:  (i)
    Product sales of firewall appliances and software licenses which include the sale
of subscription licenses to resellers and end users;(ii)
    Product sales with customer-specific acceptance provisions to original equipment
manufacturer (OEM) customers; and(iii)
    Service revenue which is primarily maintenance which provides for customer
support. Revenues from product sales are recognized only when a contract or agreement has been
executed, delivery of the appliance has occurred or for software licenses an authorization code or
subscription activation has been delivered to the customer, the fee is fixed and determinable and
we believe collection is probable. Product revenue is generally recognized on product shipment,
provided that no significant obligations remain. There is no product right of return available to
the customer. For software licenses, revenue is generally recognized on the delivery of the
authorization code for perpetual licenses or upon the activation of subscription licenses.
Subscription license revenue is recognized ratably over the life of the subscription. We defer
revenues on product sales for new value added resellers where we are unable to determine the
ability of the reseller to honor a commitment to make fixed or determinable payment. Revenue will
be deferred until the resellers demonstrate consistency of payment within terms and there are no
instances where we have to take back the product because of non-payment for a three-month period.
No resellers were reclassified from cash basis to accrual for the quarter ended March 31, 2005 and
three resellers were reclassified for the quarter ended March 31, 2004. For the nine-months ended
March 31, 2005, three resellers were reclassified from cash basis to accrual, based on a reasonable
assurance of collectibility from evaluating their payment history and no product returns. Eight
resellers were reclassified for the nine-months ended March 31, 2004. The impact of the
reclassifications did not have a material effect on revenue in any of the periods. Service revenues consist primarily of the annual fee for maintenance (post-contract customer
support) and maintenance renewals from our existing customers and are recognized ratably on a
monthly basis over the service contract term. These services provide our customers access to our
worldwide support organization for technical support, unspecified product updates/enhancements on a
when and if available basis, and general security information. The updates are considered minor
enhancements to the software that are not separately marketable or considered a competitive feature
or major upgrade. All products and services are separately priced. The Company also provides other professional support services, such as training and
consulting, which are available under service agreements and charged for separately. These
services are generally provided under time and materials contracts and revenue is recognized as the
service is provided. Reclassifications Certain amounts in the March 31, 2004 and June 30, 2004 financial statements have been reclassified
to conform to the March 31, 2005 presentation. 6




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CYBERGUARD CORPORATION
Notes to Condensed Consolidated Financial Statements
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) 2. Earnings Per Share (EPS) Basic EPS is computed by dividing net income available to common shareholders by the
weighted-average number of common shares outstanding for the period. Diluted EPS reflects the
potential dilution that could occur assuming stock options, warrants or other contracts to issue
common stock were exercised, using the treasury stock method. When the effects of the outstanding
stock options, warrants and/or convertible securities are anti-dilutive, they are not included in
the calculation of diluted EPS. Three months ended
    
    
    Three months ended
    
    
    Nine months ended
    
    
    Nine months endedMarch 31, 2005
    
    
    March 31, 2004
    
    
    March 31, 2005
    
    
    March 31, 2004Net Income/(Loss)
    
    $
    473
    
    
    $
    (2,109
    )
    
    $
    1,225
    
    
    $
    1,395Weighted average number of
common shares outstanding
    
    
    30,666
    
    
    
    23,757
    
    
    
    30,056
    
    
    
    22,431Dilutive effect of:Employee stock options
    
    
    1,639
    
    
    
    
    
    
    
    1,614
    
    
    
    3,344Unearned restricted stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    522Warrants
    
    
    206
    
    
    
    
    
    
    
    201
    
    
    
    1,813Diluted weighted average
number of common shares
outstanding
    
    
    32,511
    
    
    
    23,757
    
    
    
    31,871
    
    
    
    28,110Earnings / (loss) per share
Basic
    
    $
    0.02
    
    
    $
    (0.09
    )
    
    $
    0.04
    
    
    $
    0.06Diluted
    
    $
    0.01
    
    
    $
    (0.09
    )
    
    $
    0.04
    
    
    $
    0.05Shares subject to
anti-dilutive options
excluded from
calculation(1)
    
    
    1,045
    
    
    
    61
    
    
    
    1,096
    
    
    
    66
   (1)
    
    These weighted average shares relate to anti-dilutive stock options and could be dilutive in the future. 3. Stock-Based Compensation The Company has adopted the disclosure provisions of Statement of Financial Accounting Standard
(SFAS) No. 148, Accounting for Stock Based Compensation  Transition and Disclosure, which
amended SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 148 allows for continued
use of recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25
and related interpretations in accounting for stock based compensation. All options granted under
those plans had an exercise price equal to the market value of the underlying common stock on the
date of grant. For the three and nine months ended March 31, 2005 there was no stock based
compensation included in net income for the issuance of options during the period. The following
table illustrates the effect on net income and earnings per share if the Company had applied the
fair value recognition provisions to stock-based compensation. Such disclosure is not necessarily
indicative of the 7




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CYBERGUARD CORPORATION
Notes to Condensed Consolidated Financial Statements
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) fair value of stock options that could be granted by the Company in future
periods or of the value of all options currently outstanding. Three months ended
    
    
    Nine months endedMarch 31,
    
    
    March 31,2005
    
    
    2004
    
    
    2005
    
    
    2004Net income (loss) as reported
    
    $
    473
    
    
    $
    (2,109
    )
    
    $
    1,225
    
    
    $
    1,395Add: Stock-based employee
compensation expense
included in reported net
income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11Deduct: Total stock-based
employee compensation
expense determined under
fair value based method for
all awards
    
    
    363
    
    
    
    606
    
    
    
    1,909
    
    
    
    1,372Pro forma net income / (loss)
    
    $
    110
    
    
    $
    (2,715
    )
    
    
    ($684
    )
    
    $
    34Earnings / (loss) per share:Basicas reported
    
    $
    0.02
    
    
    $
    (0.09
    )
    
    $
    0.04
    
    
    $
    0.06Basicpro forma
    
    $
    0.00
    
    
    $
    (0.11
    )
    
    
    ($0.02
    )
    
    $
    0.00Dilutedas reported
    
    $
    0.01
    
    
    $
    (0.09
    )
    
    $
    0.04
    
    
    $
    0.05Dilutedpro forma
    
    $
    0.00
    
    
    $
    (0.11
    )
    
    
    ($0.02
    )
    
    $
    0.00
 The fair value method for these options was estimated at the date of grant using the
Black-Scholes option pricing model with the following weighted average assumptions for the three
and nine month period ended March 31, 2005 and 2004: risk-free interest rates were 4.00% and 2.13%;
the volatility factor of the expected market price of the Companys common stock was 92% and 89%,
and the weighted average expected life of the option was 6 years and 3 years for each period,
respectively. No dividend yield was used as the Company does not currently pay dividends. Results may vary depending on the assumptions applied within the Black-Scholes option-pricing
model. 4. Software Development Costs The Company capitalizes costs related to the development of certain software products on a
product by product basis in accordance with Statement of Financial Accounting Standards (SFAS)
No. 86, Accounting For the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed
which requires capitalization to begin when technological feasibility has been established and ends
when the product is available for general release to customers. Software development costs incurred
prior to technological feasibility, defined by the Company as implementation of a beta project, are
considered research and development costs and are expensed as incurred. Capitalized costs are
amortized on a straight-line basis over two to five years based on the products estimated economic
life. The Company changed the amortization period for certain software development costs during the quarter
ended December 31, 2004 from two to five years as a result of the actual lives of historical
products exceeding previous estimates. This change in estimate resulted in amortization expense
being $240 lower than what 8




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CYBERGUARD CORPORATION
Notes to Condensed Consolidated Financial Statements
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) would previously have been recorded in the nine months ended March 31,
2005. The amount amortized, is the greater of the two amounts calculated using the methods noted in
SFAS 86. Amortization starts when the product is available for general release to customers.
Unamortized capitalized software cost is evaluated at each balance sheet date and compared to the
net realizable value. Any excess capitalized cost above net realizable value will be written off.
No such impairment existed at March 31, 2005. The Company capitalized $507 and $632 in software
development costs for the three months ended March 31, 2005 and 2004, respectively. The Company
capitalized $860 and $1,139 in software development costs for the nine months ended March 31, 2005
and 2004, respectively. 5. Recent Accounting Pronouncements In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of Accounting
Research Bulletin (ARB) No. 43, Chapter 4. SFAS No. 151 amends the guidance in ARB No. 43,
Chapter 4, Inventory Pricing, to clarify the accounting of abnormal amounts of idle facility
expense, freight, handling costs, and wasted material. The guidance is effective for inventory
costs incurred during fiscal years beginning after June 15, 2005 and earlier application is
permitted for inventory costs incurred during fiscal years beginning after November 23, 2004. The
provisions of SFAS No. 151 are to be applied prospectively. The Company has not determined the
impact, if any, that the adoption of SFAS No. 151 may have on the Companys future consolidated
financial position and results of operations. In December 2004, the FASB issued Staff Position No. 109-2 (FSP No. 109-2) Accounting and
Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs
Creation Act of 2004, that provides guidance for implementing the repatriation of earnings
provisions of the American Jobs Creation Act of 2004 (the Jobs Act) and the impact on the
Companys income tax and deferred tax liabilities. Even though the Jobs Act was enacted in October
2004, FSP No. 109-2 allows additional time beyond the period of enactment to allow the Company to
evaluate the effects of the Jobs Act on the Companys plan for reinvestment or repatriation of
foreign earnings. The Company is in the process of analyzing the law in order to determine its
effects, if any, on the Companys consolidated financial position and results of operations. On December 16, 2004, the FASB issued Statement No. 123 (revised 2004), Share-Based Payment.
Statement 123(R) which requires us to measure all employee stock-based compensation awards using a
fair value method and record such expense in our consolidated financial statements. In addition,
the adoption of Statement 123(R) will require additional accounting related to the income tax
effects and additional disclosure regarding the cash flow effects resulting from share-based
payment arrangements. Statement 123(R) is effective for fiscal periods beginning after June 15,
2005 and, thus, will be effective for us beginning with the first quarter of fiscal 2006. The
adoption of Statement 123(R) could have a material impact on our consolidated financial position,
results of operations and cash flows. In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary AssetsAn Amendment
of ABP Opinion No. 29, Accounting for Nonmonetary Transactions (SFAS No. 153). SFAS No 153
eliminates the exception from fair value measurement for nonmonetary exchanges of similar
productive assets in paragraph 21(b) of APB Opinion No. 29, Accounting for Nonmonetary
Transactions, and replaces it with an exception for exchanges that do not have commercial
substance. SFAS No. 153 specifies that a nonmonetary exchange has commercial substance if future
cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is
effective for the fiscal periods beginning after June 15, 2005 and is required to be adopted by the
Company beginning 9




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CYBERGUARD CORPORATION
Notes to Condensed Consolidated Financial Statements
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) on July 1, 2005.The Company is currently evaluating the effect that the adoption
of SFAS No. 153 will have, if any, on its consolidated results of operations and financial
position. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 ( SAB 107),
Share-Based Payment, which provides interpretive guidance related to the interaction between SFAS
123R and certain SEC rules and regulations, as well as provides the SEC staffs views regarding the
valuation of share-based payment arrangements. The Company is currently assessing the impact of SAB
107 on our implementation and adoption of SFAS 123R. 6. Acquisitions On November 26, 2003, the Company completed the acquisition of SnapGear, Inc., a Delaware
corporation (SnapGear), pursuant to an Agreement and Plan of Merger dated November 12, 2003
(Agreement). On April 29, 2004, the Company completed the acquisition of German high-end content
security vendor webwasher AG (webwasher). The following unaudited pro-forma financial information was prepared in accordance with SFAS
No. 141 and assumes the acquisitions occurred at the beginning of the periods presented. The
unaudited pro forma financial information is provided for informational purposes only. These
pro-forma results are based upon the respective historical financial statements of the respective
companies, and do not incorporate, nor do they assume, any benefits from cost savings or synergies
of operations of the combined company. Unaudited pro-forma results of operations are presented
after giving effect to certain adjustments for acquisition related amortization expense on
intangibles resulting from the acquisitions of $818 and $2,855 for the three and nine months ended
March 31, 2004. The unaudited combined results of continuing operations are as follows: For the Three Months
    
    
    For the Nine Monthsended March 31,
    
    
    ended March 31,2004
    
    
    2004Proforma revenues
    
    $
    15,020
    
    
    $
    43,074Proforma net loss
    
    $
    (3,952
    )
    
    $
    (4,969
    )Loss per share-basic-proforma
    
    $
    (0.15
    )
    
    $
    (0.18
    )Loss per share-diluted-proforma
    
    $
    (0.15
    )
    
    $
    (0.18
    )
 10




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CYBERGUARD CORPORATION
Notes to Condensed Consolidated Financial Statements
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) On March 11, 2005, the Company completed the acquisition of certain assets of Zix Corporation,
a Texas corporation. The Company paid Zix Corporation $2,126 in cash, executed a promissory note
for $1,500 and acquired the following assets and liabilities. The terms of this note require the
Company to make three equal payments to Zix Corporation of $500 each on June 15, September 15, and
December 15, 2005. Current assetsOther current assets
    
    $
    142Total current assets
    
    
    142Non-current assetsProperty and equipment
    
    
    32Customer base
    
    
    3,700Goodwill
    
    
    1,259Total non-current assets
    
    
    4,991Current liabilitiesDeferred revenue
    
    
    1,317Total current liabilities
    
    
    1,317Deferred revenue, less current portion
    
    
    190Total assets acquired
    
    $
    3,626
 7. Goodwill and Other Intangible Assets The Company accounts for goodwill and other intangible assets in accordance with SFAS No. 142,
Goodwill and Other Intangible Assets. SFAS No. 142 revised the standards of accounting for
goodwill and indefinite-lived intangible assets by replacing the amortization of these assets with
the requirement that they are reviewed annually for possible impairment, or more frequently if
impairment indicators arise. This testing includes the determination of each reporting units fair
value using market multiples and discounted cash flows modeling. If the carrying amount of the
reporting unit exceeds its fair value, goodwill is considered to be impaired and a second test is
performed to measure the amount of the impairment loss, if any. No impairment indicators have been
identified at March 31, 2005. Separable intangible assets that have finite lives continue to be
amortized over their estimated useful lives. The changes in the carrying amount of goodwill for the three and nine months ended March 31, 2005
are as follows: Balance as of June 30, 2004
    
    $
    40,625Goodwill acquired during the period
    
    
    Adjustments to previously recorded purchase price
    
    
    1,390Balance as of December 31, 2004
    
    
    42,015Goodwill acquired during the period
    
    
    1,259Adjustments to previously recorded purchase price
    
    
    Balance as of March 31, 2005
    
    $
    43,274
 11




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CYBERGUARD CORPORATION
Notes to Condensed Consolidated Financial Statements
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) The adjustment to previously recorded purchase price in the quarter ended December 31, 2004
relates to the achievement of revenue targets, as specified in the SnapGear Agreement and Plan of
Merger. The earnout period for the attainment of revenue targets, ended on November 30, 2004. The components of intangible assets are: March 31, 2005
    
    
    June 30, 2004Unamortizable Trade Name
    
    $
    5,100
    
    
    $
    5,100Amortizable:Developed Technology
    
    
    6,762
    
    
    
    6,758Customer Base
    
    
    14,155
    
    
    
    10,459Total Gross Intangible Assets
    
    
    26,017
    
    
    
    22,317Accumulated Amortization:Developed Technology
    
    
    (2,887
    )
    
    
    (1,305
    )Customer Base
    
    
    (2,358
    )
    
    
    (750
    )Total Accumulated Amortization
    
    
    (5,245
    )
    
    
    (2,055
    )Total Net Book Value
    
    $
    20,772
    
    
    $
    20,262
 Amortization expense is computed by the straight-line method using the estimated
useful lives of the assets, which range from 2 1/2 to 5 years. Amortization expense for the three
months ended March 31, 2005 and 2004 amounted to $1,083 and $451, respectively. Amortization
expense for the nine months ended March 31, 2005 and 2004 amounted to $3,190 and $820,
respectively. Estimated amortization expense of currently capitalized costs for the remainder of
fiscal year 2005 and the next five fiscal years thereafter is as follows: Fiscal year2005 (remainder)
    
    $
    1,2072006
    
    
    4,7902007
    
    
    4,1362008
    
    
    2,7812009
    
    
    2,2652010
    
    
    493Thereafter
    
    $
    
 8. Comprehensive Income Comprehensive income is defined as the change in equity (net assets) of a business enterprise
during a period from transactions and other events and circumstances from non-owner sources, and is
comprised of net income and other comprehensive income. The Companys other comprehensive income
is comprised exclusively of changes in the Companys Cumulative Translation Adjustment (CTA)
account. Comprehensive income, for the three and nine months ended March 31, 2005 and 2004, was as
follows: 12




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CYBERGUARD CORPORATION
Notes to Condensed Consolidated Financial Statements
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) Three months ended
    
    
    Three months ended
    
    
    Nine months ended
    
    
    Nine months endedMarch 31, 2005
    
    
    March 31, 2004
    
    
    March 31, 2005
    
    
    March 31, 2004Net income
    
    $
    473
    
    
    $
    (2,109
    )
    
    $
    1,225
    
    
    $
    1,395Change in CTA
    
    
    436
    
    
    
    17
    
    
    
    (560
    )
    
    
    13Total
    
    $
    909
    
    
    $
    (2,092
    )
    
    $
    665
    
    
    $
    1,408
 9. Segment Information The Company views its operations and manages its business as one segment, enterprise security
solutions. Major foreign markets for our products and services include Europe, Japan, the Pacific
Rim, and Latin America. In each market, we have independent channel partners who are responsible
for marketing, selling and supporting our products and services to resellers and end-users within
their defined territories. International sales accounted for 62% and 44% of total revenues for the
three months ended March 31, 2005 and 2004, respectively. International sales accounted for 57% and
49% of total revenues for the nine months ended March 31, 2005 and 2004, respectively. 10. Commitments and Contingencies The Company expects to spend approximately $1,500 for the implementation of new financial
software over the next year. The Company is involved from time to time, in the ordinary course of its business, in various
litigation matters relating to the conduct of its business. The Company believes that these
litigation matters will not have a material adverse effect on its consolidated financial position,
results of operations or cash flows. 13




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CYBERGUARD CORPORATION
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) 
 Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations This Quarterly Report on Form 10-Q, including this Managements Discussion and Analysis of the
Financial Condition and Results of Operations, contains forwarding-looking statements, as described
in the safe harbor provision of the Private Securities Litigation Reform act of 1995. These
statements involve a number of risks and uncertainties and actual results could differ materially
from those projected. These forward-looking statements regarding future events and future results
of CyberGuard Corporation are based on current expectation, estimates, forecast, and projections
about the industry in which we operate and the beliefs and assumptions of our management. Words
such as expects, anticipates, target, goal, project, intend, plans, believes,
seeks, estimates, variations of such words, and similar expressions are intended to identify
such forward-looking statements. Statements regarding future growth, future products and product
development, including the anticipated dates for introducing such products, future prospects,
trends in our business, future profitability, business plans and strategies, future revenues and
revenue sources, future liquidity and capital resources, future computer network security market
directions, future acceptance of the Companys products and possible growth in markets, future
acquisitions, and increases in our sales force, as well as all other statements contained in this
report that are not purely historical, are forward-looking statements. Readers are cautioned that
these forward-looking statements are predictions and are subject to risk, uncertainties, and
assumptions that are difficult to predict. Therefore, actual results may vary materially and
adversely from those expressed in any forward-looking statement. Readers are referred to the
cautionary statements and important risk factors discussed elsewhere in this report and in our
other reports and filings with the SEC. Some of the factors that might cause future actual events
to differ from those predicted or assumed include: future advances in technologies and computer
security; the Companys history of annual net operating losses and the financing of future losses
through the sale of assets and newly issued Company securities; the Companys ability to execute on
its business plans; the Companys dependence on outside parties such as its key customers and
alliance partners; competition from major computer hardware, software, and networking companies;
risk and expense of governmental regulation and effects of changes in regulation; uncertainties
associated with product performance liability; risks associated with growth and expansion; global
economic conditions; changes in customer needs resulting from economic conditions; dependence on
information systems; risks associated with obtaining and maintaining patent and intellectual
property right protection; uncertainties in availability of expansion capital in the future and
other risks associated with capital markets; and the ability of the Company to integrate
successfully any businesses it acquires. We undertake no obligation to revise or update publicly
any forward-looking statements for any reason. The risks and uncertainties described below are not the only ones facing our company.
Additional risks and uncertainties not presently known to us or that we currently consider
immaterial may also impair our operations. If any of the following risks, or any additional risks
and uncertainties, were to materialize, our business, financial condition or results of operations
could be materially adversely affected. Were that to occur, the trading price of our common stock
could decline. Factors that could cause actual results to differ materially include the following:  
    Intense competition both domestically and internationally
    Decrease in profit margins
    Inventory risk due to shifts in market demands
    Dependence on information systems
    Upgrading our information and internal control systems 14




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CYBERGUARD CORPORATION
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data)  
    Credit exposure due to the deterioration of the financial condition of our customers
    Inability to obtain required capital
    Fluctuations in interest rates
    Potential adverse effects of acquisitions
    Foreign currency exchange rates and exposure to foreign markets
    The impact of changes of income tax and other regulatory legislation
    Changes in accounting rules
    Product supply and availability
    Changes in vendor terms and conditions
    Changes in general economic conditions
    Exposure to natural disaster, war and terrorism
    Volatility of common stock
    Accuracy of forecast data
    Expansion into new geographic markets
    Expansion into new product markets
    The ability to sustain profitability in the future
    Seasonality and concentration of revenues at the end of the quarter
    Dependence on third party channel partners to distribute products
    Decrease in the price of our products
    Dependence on one primary manufacturer and assembly house
    Resource constraints caused by growth
    Changes in technology and industry standards could affect our products and services
    Litigation in connection with the alleged or actual failure of our products and services
    A breach in security could harm public perception of our products
    Cost of customizing products for foreign countries
    Export and import restrictions, including those affecting encryption commodities and software
    Regional economic and political conditions
    Intellectual property claims and litigation
    Governmental controls over the export or import of encryption technology
    Changes in federal regulations and future rules of the Securities and Exchange Commission
    Lack of resources compared to our competitors
    Limited products or product types
    Downturns in the technology sector in the US and key foreign economies
    Fluctuations in quarterly operating results 15




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CYBERGUARD CORPORATION
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) Additional discussion of these and other factors affecting our business and prospects is contained
in our periodic filings with the SEC, copies which can be obtained at the Investor Relations
section of our website at www.cyberguard.com. CRITICAL ACCOUNTING POLICIES Our discussion and analysis of financial conditions and results of operations is based on our
condensed consolidated financial statements, which have been prepared in accordance with generally
accepted accounting principles 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 on-going basis, we evaluate significant estimates used in preparing our
financial
statements, including revenue recognition, bad debt, software development cost, inventory
valuation, and deferred tax valuation allowances. We base our estimates on historical experience
and 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 value of assets and liabilities
that are not readily apparent from other sources. Actual results may differ from these estimates
under different assumptions or conditions. We believe the following critical accounting policies affect the more significant judgments
and estimates used in preparing our consolidated financial statements: Revenue RecognitionThe Company recognizes revenue in accordance with Statement of Position
(SOP) 97-2 Software Revenue Recognition, Statement of Position (SOP) 98-9 Modification of
SOP 97-2 and Staff Accounting Bulletin (SAB) 104, Revenue Recognition. Revenue recognition in
accordance with these pronouncements can be complex due to the nature and variability of the
Companys sales transactions. The Companys revenue is primarily from the following sources:  (i)
    Product sales of firewall appliances and software licenses which include the sale
of subscription licenses to resellers and end users;(ii)
    Product sales with customer-specific acceptance provisions to original equipment
manufacturer (OEM) customers; and(iii)
    Service revenue which is primarily maintenance which provides for customer
support. Revenues from product sales are recognized only when a contract or agreement has been
executed, delivery of the appliance has occurred or for software licenses an authorization code or
subscription activation has been delivered to the customer, the fee is fixed and determinable and
we believe collection is probable. Product revenue is generally recognized on product shipment,
provided that no significant obligations remain. There is no product right of return available to
the customer. For software licenses, revenue is generally recognized on the delivery of the
authorization code for perpetual licenses or upon the activation of subscription licenses.
Subscription license revenue is recognized ratably over the life of the subscription. We defer
revenues on product sales for new value added resellers where we are unable to determine the
ability of the reseller to honor a commitment to make fixed or determinable payment. Revenue will
be deferred until the resellers demonstrate consistency of payment within terms and there are no
instances where we have to take back the product because of non-payment for a three-month period.
No resellers were reclassified from cash basis to accrual for the quarter ended March 31, 2005 and
three resellers were reclassified for the quarter ended March 31, 2004. For the nine-months ended
March 31, 2005, three resellers were reclassified from cash basis to accrual, based on a reasonable
assurance of collectibility from evaluating their payment history and no product returns. Eight
resellers were reclassified for the nine-months ended March 31, 2004. The impact of the
reclassifications did not have a material effect on revenue in any of the periods. Service revenues consist primarily of the annual fee for maintenance (post-contract customer
support) and maintenance renewals from our existing customers and are recognized ratably on a
monthly basis over the service contract term. These services provide our customers access to our
worldwide support organization for technical support, unspecified product updates/enhancements on a
when and if available basis, and general security information. The updates are considered minor
enhancements to the software that are not separately marketable or considered a competitive feature
or major upgrade. All products and services are separately priced. The Company also provides other professional support services, such as training and
consulting, which are available under service agreements and charged for separately. These
services are generally provided under time and materials contracts and revenue is recognized as the
service is provided. 16




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CYBERGUARD CORPORATION
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) Bad Debts.We maintain allowances for doubtful accounts for estimated losses resulting from
the inability of our customers to make required payments. Significant judgment is required when we
assess the ultimate realization of receivables, including the probability of collection and the
credit-worthiness of each customer. In estimating the allowance for doubtful accounts, we analyze
our accounts receivable aging, historical bad debts, customer credit-worthiness, current economic
trends and other factors. If the financial condition of our customers were to deteriorate,
resulting in an impairment of their ability to make payments, additional allowance might be
required. Goodwill In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, the
Company will perform its test of goodwill on an annual basis to determine if impairment has
occurred. Testing will be done on a more frequent basis if impairment indicators arise. Any
impairment would be charged to expense in the period identified. No impairment indicators have been
identified during the nine months ended March 31, 2005. Intangible Assets Intangible assets are primarily an allocation of a portion of the purchase
price in connection with the SnapGear and webwasher acquisitions and to the acquisition of certain
assets of Zix Corporation to the following separate and identifiable intangible assets: Developed
Technology, Trade Name and Customer Base. Amortization is computed by the straight-line method
using the estimated useful lives of the assets, which range from 2 1/2 to 5 years. Software Development Costs- The Company capitalizes costs related to the development of
certain software products on a product by product basis in accordance with Statement of Financial
Accounting Standards (SFAS) No. 86, Accounting For the Costs of Computer Software to be Sold,
Leased, or Otherwise Marketed which requires capitalization to begin when technological
feasibility has been established and ends when the product is available for general release to
customers. Software development costs incurred prior to technological feasibility, defined by
implementation of a beta project, are considered research and development costs and are expensed as
incurred. Capitalized costs are amortized on a straight-line method over two to five years, based
on the products estimated economic life. The Company changed the amortization period for certain
software development costs during the previous quarter from two to five years as a result of the
actual lives of historical products exceeding previous estimates. The amount amortized, is the
greater of the two amounts calculated using the methods noted in SFAS 86. Amortization starts when
the product is available for general release to customers. Unamortized capitalized software cost is
evaluated at each balance sheet date and compared to the net realizable value. Any excess
capitalized cost above net realizable value will be written off. No such impairment existed at
March 31, 2005. The Company capitalized $507 and $632 in software development costs for the three
months ended March 31, 2005 and 2004, respectively. The Company capitalized $860 and $1,139 in
software development costs for the nine months ended March 31, 2005 and 2004, respectively. Inventory Valuation Inventories consist primarily of component parts and computer hardware
and are carried at the lower of cost, determined by the First-In-First-Out method, or market. We
write our inventories down to estimated market value based on assumptions of our future demand,
based on projected product releases and market conditions. Variation in market trends, customer
preferences, introduction of new products (replacing existing products) or technological advances
could, however, significantly affect these estimates and result in additional inventory
write-downs. Evaluation inventory older than six-months is transferred to fixed assets and
depreciated over 12 months. Deferred Taxes We provide a valuation allowance for that portion of deferred tax assets,
which is not likely to be recognized due to the Companys cumulative losses and the uncertainty as
to future 17




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CYBERGUARD CORPORATION
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) recoverability. Any reversal of the deferred tax valuation allowance is made when we believe
that it is more likely than not that this portion of the deferred tax asset will be realized. The
computation of our deferred tax assets and related valuation allowance is based on taxable income
we expect to earn over the next two years which will include the utilization of previously
accumulated net operating tax losses. We will continue to evaluate each quarter the amount, if any,
of additional reduction or increase of the valuation allowance that should be made. This will be
based on managements estimate and conclusions regarding the ultimate realization of the deferred
tax assets, including but not limited to, the companys recent positive financial results as well
as projected earnings over a two-year period. The impact of further reductions of the valuation
allowance will be to record a tax benefit, which will increase net income in the period the
determination is made. While we have considered future taxable income and ongoing prudent and
feasible tax planning strategies in assessing the need for the deferred tax valuation allowance, in
the event we were to determine that we would be able to realize the deferred tax assets, in the
future, a reduction in the deferred tax asset valuation allowance would increase income in the
period the determination was made. Recent Accounting Pronouncements and Legislation See Note 5 of Notes to Condensed Consolidated Financial Statements for the discussion on
recent accounting pronouncements and legislation. Results of Operations The quarter ended March 31, 2005 compared to the quarter ended March 31, 2004 Total Revenues Total revenues consist of product sales and maintenance and professional services related to
the sale of products. For the quarter ended March 31, 2005, total revenues increased by $3,668 to
$16,704 compared to $13,036 for the quarter ended March 31, 2004. The increase was comprised of an
increase in product sales of $2,532 and an increase in services of $1,136. International revenue
represented approximately 62% of total revenues for the three months ended March 31, 2005 and 44%
of total revenues for the three months ended March 31, 2004. The increase in product revenue is
primarily the result of the inclusion of revenue from the webwasher acquisition for a full quarter
in the current year. The increase in product and service revenue is the result of an increase in
the number of units and products shipped and not from an increase in product prices. The increase
in international sales from 44% to 62% is primarily the result of the inclusion of webwasher
revenues, who for the quarter ended March 31, 2005, derived 78% of their total revenue from
international customers. Network security product revenue accounted for 76% of revenue during the quarter ended March
31, 2005 compared to 78% of revenues during the quarter ended March 31, 2004. Revenues are expected
to increase in the fourth quarter of this year compared to last year in part due to of the
inclusion of the results of the webwasher acquisition for a full quarter. Additionally, the
Company expects that the incorporation of the customer base acquired from Zix Corporation into
webwasher will favorably impact revenues in the fourth quarter of this year. Service revenue includes maintenance contracts related to new product sales, renewal
maintenance contracts for products previously deployed, training and consulting services. Support
services for network security products accounted for 24% of revenues during the quarter ended March
31, 2005, compared to 22% of revenues during the quarter ended March 31, 2004. Approximately 9% of
SnapGear 18




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CYBERGUARD CORPORATION
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) and webwasher total sales were service revenue. The increase in service revenue when
compared to the prior year is the result of the inclusion of the results of webwasher. Gross Profit Gross profit as a percentage of revenues was 68% for the quarter ended March 31, 2005 and 65%
for the quarter ended March 31, 2004. The increase in the gross profit percentage is due, in part,
to a decrease in the Companys OEM business in the current quarter, which have lower gross margins
than the Companys other product lines. The higher gross margin is the direct result of the inclusion of the webwasher product range,
which have higher gross margins than the CyberGuard and SnapGear product ranges. The gross margin was positively impacted during the current quarter by 1 percentage point as a
result of managements change in estimate for the remaining useful life of certain capitalized
software costs. These costs are now amortized to cost of goods sold over a five year period to better
reflect the useful life of the software, where they were previously amortized over a two year period. The Companys gross margin has been, and will continue to be, affected by a variety of factors
including, competition, the product mix and average selling prices of products, new product
introductions and enhancements, and the fluctuations in manufacturing volumes. We must continue to
manage each of these factors effectively for our gross margins to move back toward prior levels. Operating Expenses and Net Income Research and development expense includes salaries, non-capitalized equipment, software,
software tools, and depreciation from capital equipment. Research and development expense
increased by $692 to $2,406 for the quarter ended March 31, 2005, compared to $1,714 for the
quarter ended March 31, 2004. The increase is net of research and development costs capitalized
during the quarter ended March 31, 2005 of $507 compared to $632 of research and development costs
capitalized during the quarter ended March 31, 2004. The net increase in cost is the result of the
acquisition of webwasher which accounted for $440 of the increase. As a percentage of total
revenue, gross research and development expense was 17% for the quarters ended March 31, 2005 and
2004. We expect to increase our research and development costs in total dollars to enhance and
expand our current product offerings and develop new products. We plan to continue to make the
necessary investment in research and development to keep our products at a competitive advantage. Selling, general and administrative expense includes salaries, commissions, costs associated
with the executive, human resource, finance and administrative support functions, legal and
accounting professional services, and depreciation and amortization expense. Selling, general and
administrative expense increased by $2,758 to $8,190 for the quarter ended March 31, 2005, from
$5,432 for the quarter ended March 31, 2004. The increase in selling, general and administrative expenses for the quarter ended March 31,
2005, is in part attributable to increases in headcount across all functional areas as a result of
the webwasher acquisition. The additional payroll related costs as a result of the additional
headcount described above, accounted for 70% of the increase. Amortization and depreciation
expense accounted for 12% of the increase in selling, general and administrative expense for the
quarter when compared to the prior year, primarily as a result of the webwasher acquisition and
related amortization of acquisition related intangible assets. The remaining portion of the
increase was primarily due to an increase in professional services related to Sarbanes-Oxley 404
compliance and an increase in marketing expenses. 19




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##### Table of Contents



CYBERGUARD CORPORATION
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) The Company recorded an income tax expense of $84 as of March 31, 2005, and an income tax
benefit of $481 as of March 31, 2004. As a result of the factors described above, net income for the quarter ended March 31, 2005
was $473 or $0.01 per diluted share compared to a net loss of $2,109 or $0.09 per diluted share for
the quarter ended March 31, 2004. The net loss in the March 31, 2004 quarter included a charge of
$4,113 related to the acquisition of SnapGear. The nine-month period ended March 31, 2005 compared to the nine-month period ended March 31,
2004 Total Revenues Total revenues consist of product sales and maintenance and professional services related to
the sale of products. For the nine-month period ended March 31, 2005, total revenues increased by
$15,596 to $48,888 compared to $33,292 for the nine-month period ended March 31, 2004. The
increase was comprised of an increase in product sales of $13,810 and an increase in services of
$1,786. International revenue represented approximately 57% of total revenues for the nine months
ended March 31, 2005 and 49% of total revenues for the nine months ended March 31, 2004. The
increase in product revenue is primarily the result of inclusion of revenue from the SnapGear and
webwasher acquisitions for the full period in the current year. The increase in product and service
revenue is the result of an increase in the number of units and products shipped and not from an
increase in product prices. The increase in international sales from 49% to 57% is primarily the
result of the inclusion of webwasher revenues, who for the nine-month period ended March 31, 2005,
derived 76% of their total revenue from international customers. Network security product revenue accounted for 78% of revenue during the nine months ended
March 31, 2005 compared to 74% of revenues during the same period in the prior year. The increase
in the contribution of product revenue as a percentage of total revenue is a result of the
inclusion of the results of SnapGear and webwasher, both of which derive their revenues primarily
from the sale of product. Revenues are expected to increase for the full year compared to last
year as a result of the acquisitions. Additionally, the Company expects that the incorporation of
the customer base acquired from Zix Corporation into webwasher will favorably impact revenues in
the fourth quarter of this year. Service revenue includes maintenance contracts related to new product sales, renewal
maintenance contracts for products previously deployed, training and consulting services. Support
services for network security products accounted for 22% of revenues during the nine-month period
ended March 31, 2005, compared to 26% of revenues during the same period in 2004. The decrease in
service revenue as a percentage of total revenue corresponds to the growth in product revenue
related to product sales from the acquisition of SnapGear and webwasher. Approximately 6 % of
SnapGear and webwasher total sales were service revenue. The increase in services revenue when
compared to the prior year is the result of the inclusion of the results of SnapGear and webwasher. Gross Profit Gross profit as a percentage of revenues was 68% for the nine-month period ended March 31,
2005 and 69% for the nine-month period ended March 31, 2004. The lower gross margin is the direct result of the inclusion of the SnapGear product range in
the current year, which tend to have lower gross margins than the CyberGuard product range due to
the significant OEM revenue in the first and second quarter of the current fiscal year. OEM refers
to 20




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CYBERGUARD CORPORATION
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) contracts the Company has with large individual customers to manufacture a custom firewall
appliance. These relationships normally result in lower product margins. The gross margin was positively impacted during the nine months ended March 31, 2005 by 1
percentage point as a result of managements change in estimate for the remaining useful life of
certain capitalized software costs. These costs are now amortized to cost of goods sold over a five year period, where they were previously amortized over a two year period. The Companys gross margin has been, and will continue to be, affected by a variety of factors
including, competition, the product mix and average selling prices of products, new product
introductions and enhancements, and the fluctuations in manufacturing volumes. We must continue to
manage each of these factors effectively for our gross margins to move back toward prior levels. Operating Expenses and Net Income Research and development expense includes salaries, non-capitalized equipment, software,
software tools, and depreciation from capital equipment. Research and development expense
increased by $2,401 to $7,510 compared to $5,109 for the nine-month period ended March 31, 2005 and
2004. The increase is net of research and development costs capitalized during the nine-month
period ended March 31, 2005 of $860 compared to $1,139 of research and development costs
capitalized during the nine-month period ended March 31, 2004. The net increase in cost is the
result of the acquisition of SnapGear and webwasher with SnapGear accounting for $1,427 and
webwasher accounting for $1,085 of the increase. As a percentage of total revenue, gross research
and development expense was 17% and 18% for the nine-month periods ended March 31, 2005 and 2004,
respectively. We expect to increase our research and development costs in total dollars to enhance and
expand our current product offerings and develop new products. We plan to continue to make the
necessary investment in research and development to keep our products at a competitive advantage. Selling, general and administrative expense includes salaries, commissions, costs associated
with the executive, human resource, finance and administrative support functions, legal and
accounting professional services, and depreciation and amortization expense. Selling, general and
administrative expense increased by $10,589 to $24,442 for the nine-month period ended March 31,
2005, from $13,853 for the nine-month period ended March 31, 2004. The increase in selling, general and administrative expenses for the nine-month period ended
March 31, 2005, is in part attributable to increases in headcount across all functional areas as a
result of the SnapGear and webwasher acquisitions. The additional payroll related costs as a
result of the additional headcount described above, accounted for 62% of the increase. An increase
in marketing expense accounted for 13% of the increase and an increase in professional fees,
primarily related to Sarbanes-Oxley 404 compliance, accounted for 9% of the increase. Amortization
and depreciation expense accounted for 10% of the increase in selling, general and administrative
expense for the quarter when compared to the prior year, primarily as a result of the SnapGear and
webwasher acquisitions and related amortization of acquisition related intangible assets.
Additionally, an increase in the allowance for doubtful accounts accounted for 5% of the increase. The Company recorded an income tax expense of $123 as of March 31, 2005, and an income tax
benefit of $1,348 as of March 31, 2004. As a result of the factors described above, net income for the nine-month period ended March
31, 2005 was $1,225 or $0.04 per diluted share compared to net income of $1,395 or $0.05 per
diluted for the nine-month period ended March 31, 2004. 21




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##### Table of Contents



CYBERGUARD CORPORATION
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) Liquidity and Capital Resources The following table summarizes the Companys consolidated statements of cash flows for the
first nine months of fiscal 2005 and 2004: For the nine months endedMarch 31,2005
    
    
    2004Net cash flow (used in) provided by:Operating activities
    
    $
    2,224
    
    
    $
    4,100Investing activities
    
    
    (4,779
    )
    
    
    (1,591
    )Financing activities
    
    
    3,550
    
    
    
    4,744Effect of exchange rate changes on cash
    
    
    (560
    )
    
    
    12Net increase in cash
    
    $
    435
    
    
    $
    7,265
 Cash flow provided by operating activities in the nine months ended March 31, 2005 was $2,224.
The Company reported net income of $1,225 for the nine-month period ended March 31, 2005. In
addition, the Company reported adjustments to reconcile net income of $5,680 for the nine months
ended March 31, 2005. The primary components of these adjustments for the nine months ended March
31, 2005 were amortization expense of $3,441 primarily attributable to the Snapgear and webwasher
acquisitions, depreciation expense of $836, a provision for uncollectible accounts receivable of
$703 and stock based compensation expense of $573. The primary change in assets and liabilities
that negatively impacted cash flow from operating activities was a $7,500 increase in accounts
receivable offset by an increase in deferred revenue of $3,208. The increase in accounts receivable
is as a result of the concentration of revenue at the end of the quarter as well as a slower
collection cycle with certain large customers. Net cash used in investing activities during the nine-month period ended March 31, 2005 of
$4,779 related primarily to the acquisition of certain assets of Zix Corporation and the purchase
of property and equipment. Cash provided by financing activities of $3,550 during the nine-month period ended March 31,
2005 reflects the proceeds from stock options exercised and the proceeds from stock purchase
warrants exercised. For the nine months ended March 31, 2005 and 2004, the effect of exchange rate changes on cash
were ($560) and $12, respectively. At March 31, 2005, the Company had cash and cash equivalents on hand of $12,882 representing
an increase of $435 from $12,447 as of June 30, 2004. The Companys principal sources of liquidity
at March 31, 2005, consisted of cash, accounts receivable, and vendor trade credit. We believe our existing cash, cash equivalents and short-term investments will be sufficient
to meet our operating cash requirements through at least the next twelve months, except for
acquisition related needs. The Company purchased an enterprise software solution the cost of which
is approximately $1,500 over the next twelve months. Our future capital requirements will depend on
many factors, including our rate of revenue growth, the timing and extent of spending on support,
product development efforts, expansion of sales and marketing, the timing of introductions of new
products and enhancement to existing products, and market acceptance of our products. Other recent
and possible future events that 22




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CYBERGUARD CORPORATION
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) could also materially impact the Companys ability to successfully execute on its business
plans are described in Information Relating to Forward Looking Statements of this Item on Form
10-Q. Other than as described above, we are not aware of any known demands, commitments, events or
uncertainties that will result or that are reasonably likely to result in our liquidity increasing
or decreasing in a material way. We have no other agreements or arrangements for third parties to provide us with sources of
liquidity and capital resources, including off balance sheet arrangements. Information Relating to Forward Looking Statements Statements regarding future products, prospects, profitability, business plans and strategies,
future revenues and revenue sources, future liquidity and capital resources, future computer
network security market directions, future acceptance of the Companys products and possible growth
in markets, as well as all other statements contained in this Report on Form 10-Q that are not
purely historical are forward-looking statements. Forward-looking statements are based upon assumptions and analyses made by the Company in
light of current conditions, future developments and other factors the Company believes are
appropriate in the circumstances, or information obtained from third parties and are subject to a
number of assumptions, risks and uncertainties. Readers are cautioned that forward-looking
statements are not guarantees of future performance and that the actual results might differ
materially from those suggested or projected in the forward-looking statements. Accordingly, there
can be no assurance that the forward-looking statements will occur or that results will not vary
significantly from those described in the forward-looking statements. Some of the factors that
might cause future actual events to differ from those predicted or assumed include: future advances
in technologies and computer security; the Companys history of annual net operating losses and the
financing of these losses through the sale of assets and newly issued Company securities; the
Companys ability to execute on its business plans; the Companys ability to effectively integrate
newly acquired operations; the Companys dependence on outside parties such as its key customers
and alliance partners; competition from major computer hardware, software, and networking
companies; risk and expense of government regulation and effects on changes in regulation; the
limited experience of the Company in marketing its products; uncertainties associated with product
performance liability; risks associated with growth and expansion; the completion of the numerous
organizational changes and the assembly of a new management team for the Company; global economic
conditions, overall network security spending, risks associated with obtaining and maintaining
patent and intellectual property right protection, uncertainties in availability of expansion
capital in the future and other risks associated with capital markets. In addition, the
forward-looking statements herein involve assumptions, risks and uncertainties, including, but not
limited to economic, competitive, operational, management, governmental, regulatory, litigation and
technological factors affecting the Companys operations, liquidity, capital resources, markets,
strategies, products, prices and other factors discussed elsewhere herein and in the other
documents filed by the Company with the Securities and Exchange Commission. Copies of these filings
can be obtained at the Investor Relations section of our website at
www.cyberguard.com. We provide
our annual and quarterly reports free of charge on
www.cyberguard.com, as soon as reasonably
practicable after they are electronically filed, or furnished to the SEC. Many of the foregoing
factors are beyond the Companys control. The Companys future success is based largely on its ability to develop and sell increasingly
technologically advanced network security solutions in sufficient volume and at sufficient prices
to become profitable on a consistent basis. In addition, the network security market is
characterized by extremely rapid technological change, requiring rapid product development. The
velocity of technological change has accelerated, and the Company believes that it is important to
its future that it 23




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CYBERGUARD CORPORATION
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) keeps pace with these changes. The Company believes that competition will continue to
intensify in the rapidly evolving markets in which the Company is involved, and that the continued
development of technologically advanced products will be necessary to keep our products current.
The Company believes that its ability to generate adequate cash flow from operations will be
critical to its future. Non-GAAP Financial Information The following table details the difference between results calculated using Generally
Accepted Accounting Principles (GAAP) and the same results reported excluding certain charges
(non-GAAP information). The non-GAAP information is included with the intention of providing
investors a more complete understanding of our underlying operational results and trends, but
should only be used in conjunction with results reported in accordance with GAAP. The Company
believes that the non-GAAP disclosures set forth below provide useful information to show the
effect on net income when all acquisition-related costs are excluded. CYBERGUARD CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Amounts in thousands, except per share data) Three Months EndedMarch 31, 2005
    
    
    March 31, 2004GAAP
    
    
    Proforma
    
    
    Proforma
    
    
    GAAP
    
    
    Proforma
    
    
    ProformaPresentation
    
    
    Adjustments
    
    
    Presentation
    
    
    Presentation
    
    
    Adjustments
    
    
    PresentationRevenues:Products
    
    $
    12,645
    
    
    $
    
    
    
    $
    12,645
    
    
    $
    10,113
    
    
    $
    
    
    
    $
    10,113Services
    
    
    4,059
    
    
    
    
    
    
    
    4,059
    
    
    
    2,923
    
    
    
    
    
    
    
    2,923Total revenues
    
    
    16,704
    
    
    
    
    
    
    
    16,704
    
    
    
    13,036
    
    
    
    
    
    
    
    13,036Cost of revenues:Products
    
    
    4,321
    
    
    
    (508
    )1
    
    
    3,813
    
    
    
    3,671
    
    
    
    (241
    )1
    
    
    3,430Services
    
    
    1,029
    
    
    
    
    
    
    
    1,029
    
    
    
    947
    
    
    
    
    
    
    
    947Total cost of revenues
    
    
    5,350
    
    
    
    (508
    )
    
    
    4,842
    
    
    
    4,618
    
    
    
    (241
    )
    
    
    4,377Gross profit
    
    
    11,354
    
    
    
    508
    
    
    
    11,862
    
    
    
    8,418
    
    
    
    241
    
    
    
    8,659Operating expenses:Research and development
    
    
    2,406
    
    
    
    
    
    
    
    2,406
    
    
    
    1,714
    
    
    
    
    
    
    
    1,714Selling, general and administrative
    
    
    8,190
    
    
    
    (572
    )1
    
    
    7,618
    
    
    
    5,432
    
    
    
    (177
    )1
    
    
    5,255Compensation expense related to unearned restricted stock
in the SnapGear Acquisition
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,113
    
    
    
    (4,113
    )
    
    
    Total operating expenses
    
    
    10,596
    
    
    
    (572
    )
    
    
    10,024
    
    
    
    11,259
    
    
    
    (4,290
    )
    
    
    6,969Operating income / (loss)
    
    
    758
    
    
    
    1,080
    
    
    
    1,838
    
    
    
    (2,841
    )
    
    
    4,531
    
    
    
    1,690Other incomeInterest income, net
    
    
    84
    
    
    
    
    
    
    
    84
    
    
    
    45
    
    
    
    
    
    
    
    45Other (expense) / income
    
    
    (285
    )
    
    
    
    
    
    
    (285
    )
    
    
    206
    
    
    
    
    
    
    
    206Total other (expense) / income
    
    
    (201
    )
    
    
    
    
    
    
    (201
    )
    
    
    251
    
    
    
    
    
    
    
    251Income / (loss) before income taxes
    
    
    557
    
    
    
    1,080
    
    
    
    1,637
    
    
    
    (2,590
    )
    
    
    4,531
    
    
    
    1,941Income tax (expense) / benefit
    
    
    (84
    )
    
    
    
    
    
    
    (84
    )
    
    
    481
    
    
    
    (481
    )
    
    
    Net income / (loss)
    
    $
    473
    
    
    $
    1,080
    
    
    $
    1,553
    
    
    $
    (2,109
    )
    
    $
    4,050
    
    
    $
    1,941Basic earnings per common share
    
    $
    0.02
    
    
    
    
    
    
    $
    0.05
    
    
    $
    (0.09
    )
    
    
    
    
    
    $
    0.08Basic weighted average number of common shares outstanding
    
    
    30,666
    
    
    
    
    
    
    
    30,666
    
    
    
    23,757
    
    
    
    
    
    
    
    23,757Diluted earnings per common share
    
    $
    0.01
    
    
    
    
    
    
    $
    0.05
    
    
    $
    (0.09
    )
    
    
    
    
    
    $
    0.07Diluted weighted average number of common shares outstanding
    
    
    32,511
    
    
    
    
    
    
    
    32,511
    
    
    
    23,757
    
    
    
    
    
    
    
    28,878
   Note 1  The proforma adjustment relates to amortization of acquisition related intangible assets. 24




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CYBERGUARD CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Amounts in thousands, except per share data) Nine Months EndedMarch 31, 2005
    
    
    March 31, 2004GAAP
    
    
    Proforma
    
    
    Proforma
    
    
    GAAP
    
    
    Proforma
    
    
    ProformaPresentation
    
    
    Adjustments
    
    
    Presentation
    
    
    Presentation
    
    
    Adjustments
    
    
    PresentationRevenues:Products
    
    $
    38,307
    
    
    $
    
    
    
    $
    38,307
    
    
    $
    24,497
    
    
    $
    
    
    
    $
    24,497Services
    
    
    10,581
    
    
    
    
    
    
    
    10,581
    
    
    
    8,795
    
    
    
    
    
    
    
    8,795Total revenues
    
    
    48,888
    
    
    
    
    
    
    
    48,888
    
    
    
    33,292
    
    
    
    
    
    
    
    33,292Cost of revenues:Products
    
    
    12,730
    
    
    
    (1,572
    )1
    
    
    11,158
    
    
    
    7,651
    
    
    
    (557
    )1
    
    
    7,094Services
    
    
    2,992
    
    
    
    
    
    
    
    2,992
    
    
    
    2,716
    
    
    
    
    
    
    
    2,716Total cost of revenues
    
    
    15,722
    
    
    
    (1,572
    )
    
    
    14,150
    
    
    
    10,367
    
    
    
    (557
    )
    
    
    9,810Gross profit
    
    
    33,166
    
    
    
    1,572
    
    
    
    34,738
    
    
    
    22,925
    
    
    
    557
    
    
    
    23,482Operating expenses:Research and development
    
    
    7,510
    
    
    
    
    
    
    
    7,510
    
    
    
    5,109
    
    
    
    
    
    
    
    5,109Selling, general and administrative
    
    
    24,442
    
    
    
    (1,606
    )1
    
    
    22,836
    
    
    
    13,853
    
    
    
    (264
    )1
    
    
    13,589Compensation expense related to unearned
restricted stock in the SnapGear acquisition
    
    
    
    
    
    
    
    
    
    
    4,387
    
    
    
    (4,387
    )
    
    
    Total operating expenses
    
    
    31,952
    
    
    
    (1,606
    )
    
    
    30,346
    
    
    
    23,349
    
    
    
    (4,651
    )
    
    
    18,698Operating income / (loss)
    
    
    1,214
    
    
    
    3,178
    
    
    
    4,392
    
    
    
    (424
    )
    
    
    5,208
    
    
    
    4,784Other incomeInterest income, net
    
    
    151
    
    
    
    
    
    
    
    151
    
    
    
    113
    
    
    
    
    
    
    
    113Other (expense) / income
    
    
    (17
    )
    
    
    
    
    
    
    (17
    )
    
    
    358
    
    
    
    
    
    
    
    358Total other (expense) / income
    
    
    134
    
    
    
    
    
    
    
    134
    
    
    
    471
    
    
    
    
    
    
    
    471Income / (loss) before income taxes
    
    
    1,348
    
    
    
    3,178
    
    
    
    4,526
    
    
    
    47
    
    
    
    5,208
    
    
    
    5,255Income tax (expense) / benefit
    
    
    (123
    )
    
    
    
    
    
    
    (123
    )
    
    
    1,348
    
    
    
    (1,348
    )
    
    
    Net income / (loss)
    
    $
    1,225
    
    
    $
    3,178
    
    
    $
    4,403
    
    
    $
    1,395
    
    
    $
    3,860
    
    
    $
    5,255Basic earnings per common share
    
    $
    0.04
    
    
    
    
    
    
    $
    0.15
    
    
    $
    0.06
    
    
    
    
    
    
    $
    0.23Basic weighted average number of common
shares outstanding
    
    
    30,056
    
    
    
    
    
    
    
    30,056
    
    
    
    22,431
    
    
    
    
    
    
    
    22,431Diluted earnings per common share
    
    $
    0.04
    
    
    
    
    
    
    $
    0.14
    
    
    $
    0.05
    
    
    
    
    
    
    $
    0.19Diluted weighted average number of common
shares outstanding
    
    
    31,871
    
    
    
    
    
    
    
    31,871
    
    
    
    28,110
    
    
    
    
    
    
    
    28,110
   Note 1  The proforma adjustment relates to amortization of acquisition related intangible assets. 25




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##### Table of Contents



CYBERGUARD CORPORATION
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) 
 Item 3. Quantitative and Qualitative Disclosures Concerning Market Risk We have limited exposure to financial market risks, including changes in interest rates. The
fair value of our investments 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 investments. The Company uses the U.S. Dollar as its reporting currency for financial statement purposes.
The Company conducts business in numerous countries around the world through its foreign
subsidiaries which use the local currencies to denominate their transactions. Therefore, the
Company is subject to certain risks associated with fluctuating foreign currencies. Due to the long-term nature of the Companys investment in its subsidiaries, the translation
adjustments resulting from these exchange rate fluctuations are excluded from the results of
operations and recorded in a separate component of consolidated stockholders equity. The Company
monitors its currency exposure but does not hedge its exposure due to the high economic costs of
such a program and the long-term nature of its investment in its subsidiaries. 
 Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures The Company maintains disclosure controls and procedures designed to ensure that information
required to be disclosed in reports filed under the Securities Exchange Act of 1934, as amended,
(the Exchange Act) is recorded, processed, summarized and reported within the specified time
periods. In designing and evaluating our disclosure controls and procedures, management recognized
that disclosure controls and procedures, no matter how well conceived and operated, can provide
only reasonable, not absolute, assurance that the objectives of the disclosure controls and
procedures are met. Further, the design of a control system must reflect the fact that there are
resource constraints, and the benefits of controls must be considered relative to their costs.
Because of the inherent limitations in all control systems, no evaluation of controls can provide
absolute assurance that all control issues and instances of fraud, if any, within the Company have
been detected. These inherent limitations include the realities that judgments in decision-making
can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally,
controls can be circumvented by the individual acts of some persons, by collusion of two or more
people, or by management override of the controls. The design of any system of controls also is
based in part upon certain assumptions about the likelihood of future events, and there can be no
assurance that any design will succeed in achieving its stated goals under all potential future
conditions. Over time, controls may become inadequate because of changes in conditions, or the
degree of compliance with the policies or procedures may deteriorate. Because of the inherent
limitations in a cost-effective control system, misstatements due to error or fraud may occur and
not be detected. The Company is currently in the process of completing its documentation, evaluation and
testing of internal controls over financial reporting, as required by the Sarbanes-Oxley Act of
2002. The Company has engaged extensive outside resources to assist with activities related to
Section 404 of Sarbanes-Oxley Act. As part of this evaluation, we have identified certain
deficiencies in the design and / or operating effectiveness of internal controls. During the
current quarter the Company identified a cost that should have been recorded in the prior quarter
and subsequently restated the December 31, 2004 10 Q. While the error did result in a restatement,
it was the Companys control system that identified the error that led to the subsequent
restatement. The Company believes while the control that detected this error was operating
effectively, the control was not operating with enough frequency to detect the error. 26




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CYBERGUARD CORPORATION
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) Accordingly, the Company believes a material weakness in the design of its internal control
system existed at December 31, 2004. The Company considers the error that resulted in the
restatement of the December 31, 2004 quarterly results to be an isolated event. During the current
quarter, management corrected the design of its internal control system by increasing the frequency
of the control that detected the error. Further, management has implemented additional controls to
identify and correct any potential reoccurrence of such an error. These matters have been
discussed with the Companys audit committee and independent auditors and the Company is in the
process of making necessary improvements to enhance the reliability of its internal controls over
financial reporting. The Company has not fully completed its evaluation and testing nor have all
the control enhancements been completed. Although we do not foresee being unable to complete our
evaluation and remediation activities, there can be no assurances that all such control
deficiencies will be fully remediated and successfully tested prior to June 30, 2005. The Company is in the process of upgrading its computer systems used for operations at the
corporate location as well as all subsidiaries. The upgrade process will take place over the next
several quarters. As we believe is the case in most system changes, the implementation of these
systems will necessitate changes in operating policies and procedures and the related internal
controls and their method of application. Thus far throughout this implementation, there have been
no changes in the Companys internal controls over financial reporting that have materially
affected, or are reasonably likely to materially affect, the Companys internal controls over
financial reporting. As of the end of the period covered by this report, the Companys Chief Executive Officer and
Chief Financial Officer evaluated, with the participation of the Companys management, the
effectiveness of the Companys disclosure controls and procedures (as defined in rules 13a-15(e)
AND 15(d)-15(e) under the Exchange Act). Based on the evaluation, the Companys Chief Executive
Officer and Chief Financial Officer concluded that the Companys disclosure controls and procedures
are effective. 
 PART II: OTHER INFORMATION 
 Item 1. Legal Proceedings Litigation The Company is involved from time to time, in the ordinary course of its business, in various
litigation relating to the conduct of its business. The Company believes that these litigation
matters will not have a material adverse effect on its consolidated financial position, results of
operations or cash flows. 
 Item 2. Changes in Securities and Use of Proceeds None 
 Item 3. Defaults upon Senior Securities None 
 Item 4. Other Information 27




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CYBERGUARD CORPORATION
March 31, 2005
(Unaudited)
(Dollars in thousands, except per share data) None. 
 Item 6. Exhibits and Reports on Form 8-K (a) Exhibits: Exhibit No.
    
    Exhibit Description31.01
    
    Certification by Patrick J. Clawson, Chief Executive Officer, pursuant to Exchange Act Rules 13a-14 and 15d-15.31.02
    
    Certification by Michael D. Matte, Chief Financial Officer, pursuant to Exchange Act Rules 13a-14 and 15d-15.32.01
    
    Certification by Patrick J. Clawson, Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.02
    
    Certification by Michael D. Matte, Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 (b) Reports filed on Form 8-K during the quarter ended March 31, 2005: During the quarter ended March 31, 2005, the Company filed 2 Current Reports on Form 8-K. On
January 25, 2005, Items 2.02 and 9.01 in connection with the results of operations for the second
quarter of fiscal 2005 were filed. On March 15, 2005, Items 8.01 and 9.01 were filed in connection
with the acquisition of certain assets of Zix Corporation. 28




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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. Date: May 6, 2005
    
    CYBERGUARD CORPORATIONBy:
    
    /s/Patrick J. ClawsonChairman and Chief Executive OfficerBy:
    
    /s/Michael D. MatteChief Financial Officer
(Principal Financial and Accounting Officer)
 29