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UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, D.C. 20549


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FORM 10-K


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(Mark
One)





xANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE


SECURITIES EXCHANGE ACT OF 1934





For the Fiscal Year Ended September 30, 2002





OR





 ̈ TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934





For the transition period from
             to


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Commission File Number 0-33387


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NETSCREEN TECHNOLOGIES,
INC.


(Exact Name of Registrant as Specified in Its Charter)





Delaware

77-0469208(State or Other Jurisdiction of Incorporation or Organization)

(I.R.S. Employer Identification No.)350 Oakmead Parkway, Sunnyvale, California

94085(Address of Principal Executive Offices)

(Zip Code)





(408) 730-6000


(Registrants Telephone Number, Including Area Code)


Securities registered pursuant to Section
12(b) of the Act: None


Securities registered pursuant to Section 12(g) of the Act:


Common Stock, $0.001 Par Value Per Share


(Title of Class)


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





Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of
Registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x





Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act


Rule 12b-2).    Yes  ̈ No x





The aggregate market value of the voting and non-voting common equity held by
non-affiliates of the Registrant (based upon the closing price of the Registrants common stock on March 28, 2002 of $16.65 per share) was $649,429,800.





The number of shares of the Registrants common stock outstanding as of December 13, 2002 was 78,914,583.


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DOCUMENTS INCORPORATED BY REFERENCE





Portions of Registrants definitive proxy statement to be delivered to stockholders in connection with the Registrants 2003 Annual Meeting of Stockholders, which is required
to be filed within 120 days of Registrants fiscal year end, are incorporated by reference into Part II and Part III of this Form 10-K.


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NETSCREEN TECHNOLOGIES, INC.





ANNUAL REPORT ON FORM 10-K





FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2002





TABLE OF CONTENTS





PART I

PageITEM 1:

Business

4ITEM 2:

Properties

13ITEM 3:

Legal Proceedings

14ITEM 4:

Submission of Matters to a Vote of Security Holders

14PART IIITEM 5:

Market for the Registrants Common Equity and Related Stockholder Matters

14ITEM 6:

Selected Consolidated Financial Data

15ITEM 7:

Managements Discussion and Analysis of Financial Conditionand Results of Operations

16ITEM 7A:

Quantitative and Qualitative Disclosures About Market Risk

40ITEM 8:

Financial Statements and Supplementary Data

40ITEM 9:

Changes In and Disagreements with Accountants on Accounting and Financial Disclosure

41PART IIIITEM 10:

Directors and Executive Officers of the Registrant

41ITEM 11:

Executive Compensation

41ITEM 12:

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

41ITEM 13:

Certain Relationships and Related Transactions

41ITEM 14:

Controls and Procedures

41PART IVITEM 15:

Exhibits, Financial Statement Schedules, and Reports of Form 8-K

42Signatures

46Financial Statements

49Schedule IIValuation and Qualifying Accounts

78





NetScreen, the NetScreen logo, NetScreen Technologies, GigaScreen
and our product names are trademarks or registered trademarks of NetScreen Technologies, Inc. in the United States and other countries. Each trademark, trade name or service mark of any other company appearing herein belongs to its holder.




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FORWARD-LOOKING STATEMENTS





This annual report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934. These forward-looking statements may be identified by the use of words such as expect, anticipate, intend, believe, estimate, will,
may, continue and similar terms. These forward-looking statements include our expectations about revenue, cost of revenues and various operating expenses. Our actual results may differ significantly from those projected in
the forward-looking statements as a result of many factors, such as risks and uncertainties regarding our anticipated costs, expenses, revenue channel and revenue mix. Factors that might cause or contribute to these differences include, but are not
limited to, those discussed in the section Managements Discussion and Analysis of Financial Condition and Results of Operations, and the section entitled Factors That May Affect Our Business and Future Results of Operations
and Financial Condition and elsewhere in this report. You should also carefully review the risks described in other documents we file from time to time with the Securities and Exchange Commission, including the quarterly reports on Form 10-Q
or current reports on Form 8-K that we will file in 2003. You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this report. We undertake no obligation to update any forward-looking
statements for any reason, except as required by law, even if new information becomes available or other events occur in the future.




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PART I





Item 1.Business.





Overview





NetScreen develops, markets and sells a broad family of integrated network security solutions. Our security solutions provide key security
technologies such as virtual private networking, denial of service protection, firewall and intrusion detection and prevention, in a line of easy-to-manage security systems and appliances.





Virtual private networks, called VPNs, allow access to an internal network through the Internet or other untrusted network to securely connect two or more locations as well
as remote users. VPNs protect against malicious eavesdropping and/or data manipulation by encrypting data to provide confidentiality and authenticating data to provide data integrity. Firewalls help prevent unauthorized network access by
establishing a perimeter defense between two networks, such as an enterprises network and the Internet. Firewalls enable users to establish security policies designed to permit only authorized traffic into and out of a connected network.
Intrusion detection and prevention, called IDP, appliances detect network attacks using sophisticated detection methods and, once an attack is identified, can alert internal IT staff or drop the packets or connection associated with the attack.





Our firewall and VPN systems and appliances deliver integrated firewall, VPN and denial of service protection
capabilities in a single device using our proprietary application specific integrated circuits, which we refer to as the GigaScreen and GigaScreen-II ASICs, and our proprietary security operating system and applications, which we refer to as
ScreenOS. Our IDP appliances run a secure version of the Linux operating system and use proprietary software and multiple detection methods to identify network and application attacks and prevent them from reaching mission-critical resources. Our
products are based on industry standard communication protocols so they can be integrated easily into networks and will interoperate with other security devices and software applications. Our security systems and appliances can be centrally managed
with flexible management software. For our firewall and VPN systems and appliances, our NetScreen Global-PRO and Global-PRO Express enable secure, scalable monitoring of devices, network traffic and security events and policy administration. For our
IDP appliances, our NetScreen-IDP Manager gives administrators control over which traffic the IDP appliance should examine and how it should respond when intrusions are detected.





Our end customers are a broad range of enterprises, large communication service providers, called carriers, and government entities. Our products are deployed in a wide
range of networks from single user environments to large-scale, carrier class network deployments. Our family of products enables our end customers to cost-effectively address their network security needs across the network using firewall, VPN,
denial of service protection and IDP solutions from a single vendor.





The NetScreen Solution





We provide a broad family of network security solutions that deliver high performance, cost-effective security for enterprises, carriers
and government entities. We offer firewall and VPN systems and appliances, as well as a new line of intrusion detection and prevention appliances.





Our firewall and VPN systems and appliances deliver integrated firewall, VPN and denial of service protection capabilities in a single device. Each device is standards-based for easy integration into
customer networks, interoperability with other IP security protocol, or IPSec, devices, and secure management and monitoring via a wide range of industry standard interfaces. Our IDP appliances incorporate multiple methods of detection, such as
attack pattern matching, protocol anomaly detection and backdoor detection, in a single device. These detection methodologies monitor the data traffic and connection requests on a network, identify and stop attacks based on known patterns of attack,
suspicious traffic or connection requests, and the likely means of attack. Using our products, enterprises, carriers and government entities can facilitate secure communication over the Internet, while accommodating sudden surges in network traffic
and protecting against denial of service attacks as well as sophisticated intrusion attempts by hackers.




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We provide two classes of firewall and VPN products: high performance
chassis-based systems and fixed configuration appliances. Our firewall and VPN system products include the NetScreen-5400, NetScreen-5200, NetScreen-1000 and NetScreen-500. These products are high capacity, high availability, flexible configuration,
network security platforms. These chassis-based systems allow users to deploy multiple configurations that best suit their network environment. Our firewall and VPN appliance products include the NetScreen-208, NetScreen-204, NetScreen-100,
NetScreen-50, NetScreen-25, NetScreen-5XT and NetScreen-5XP. These appliances provide a fixed configuration solution that greatly simplifies customer installation and can be deployed to address specific network requirements. All of our firewall and
VPN systems and appliances use our ScreenOS operating system and applications, enabling flexible security and network configurations to meet the needs of a wide variety of network environments.





We provide two IDP appliances: the NetScreen IDP-500 and NetScreen IDP-100. These products detect attacks and prevent intrusions to reduce or eliminate the impact of a
broad range of sophisticated network attacks. These IDP appliances provide efficient attack detection, reducing the number of false alarms and missed attacks, and attack prevention, by dropping the packets or connection associated with the attack.
These IDP appliances can be deployed as an enforcement point, or in-line, in the network to stop attacks that may have otherwise been missed by other security systems or otherwise have reached their intended network targets.





We also provide management software products that are deployed in connection with our network security solutions. Together with our
firewall and VPN systems and appliances, NetScreen-Global PRO security management software permits our customers to enable VPN connections with the personal computers of remote users and to manage security policies and monitor network security from
a single management application. NetScreen-IDP Manager provides centralized, rule-based management that simplifies how administrators and managers deploy, configure and respond to attacks using our IDP appliances.





Key benefits of our network security solutions are:





Broad Security Solution.    Our broad product line allows us to provide solutions that meet a range of enterprise, carrier and government entity
requirements for firewall, VPN, denial of service protection and IDP capabilities. We believe our breadth of product offerings allows our customers to deploy broad security solutions to meet their connectivity, application and network requirements.
Our breadth of product offerings allows us to address the needs of a wide range of customers and networks from single user environments to large-scale, carrier class network deployments. We believe we offer our customers the most comprehensive and
effective network security solutions available.





Integrated, Cost-effective Network Security
Solutions.    Each of our firewall and VPN systems and appliances integrates firewall, VPN and denial of service protection capabilities into a single device. Each of our IDP appliances integrates multiple detection
technologies and prevention capabilities into a single device. This integrated approach reduces the complexity and expense of purchasing and integrating separate single-function products from multiple vendors.





Industry Leading High Performance Security Systems.    Our high performance firewall and VPN security systems
can be deployed in mission-critical environments such as enterprise central sites, corporate extranets, major e-business Web sites and carrier network infrastructures and can be used to deliver managed security services. Using our high performance
firewall and VPN systems, enterprises, carriers and government entities are able to deploy integrated VPN and firewall capabilities at up to 12 Gbps of throughput for firewall and 6 Gbps of throughput for VPN. Large numbers of VPN tunnels, sessions
and policies can be added to the NetScreen-5400, NetScreen-5200, NetScreen-1000 and NetScreen-500, with minimal degradation in network performance.





Secure Operating Environment.    Our firewall and VPN systems and appliances are based on a proprietary operating system that we refer to as ScreenOS. Our ScreenOS
operating system and applications were developed specifically to perform processing-intensive network security functions. ScreenOS includes a suite of




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applications supporting firewall, VPN, network traffic management and denial of service blocking capabilities. Our IDP appliances are based on a secure version of the Linux operating system,
which we refer to as IDP OS, on top of which custom features have been developed to provide IDP capabilities.





High Performance.    Our firewall and VPN systems and appliances are designed to maximize performance across the network. Each of our firewall and VPN systems and appliances uses either our
GigaScreen or GigaScreen-II ASIC, which we believe are the fastest security ASICs in the industry and the first ASICs to combine both firewall and VPN capabilities.





Ease of Implementation and Manageability.    Our firewall and VPN systems and appliances and IDP appliances are easily managed and require
minimal configuration. As a result, they can be deployed quickly and cost-effectively in a network. In addition, the applications in ScreenOS and IDP OS implement industry standard protocols and management interfaces enabling interoperability with a
broad range of third-party products.





Products





Firewall and VPN Systems and Appliances





Our family of firewall and VPN systems and appliances consists of the following products:





Throughput

IPSec Tunnels(1)

TCP Sessions(2)

List Price(3)Product

Firewall

VPNSecurity Systems NetScreen-5400

12 Gbps

6 Gbps

25,000

1,000,000

$99,000$310,000NetScreen-5200

4 Gbps

2 Gbps

25,000

1,000,000

$69,000$269,000NetScreen-1000

2 Gbps

1 Gbps

25,000

500,000

$65,000$245,700NetScreen-500

700 Mbps

250 Mbps

10,000

250,000

$22,500$84,600Security Appliances NetScreen-208

550 Mbps

200 Mbps

1,000

128,000

$14,995$20,800NetScreen-204

400 Mbps

200 Mbps

1,000

128,000

$9,995$14,300NetScreen-100

200 Mbps

200 Mbps

1,000

128,000

$9,995$14,300NetScreen-50

170 Mbps

50 Mbps

100

8,000

$5,995$7,795NetScreen-25

100 Mbps

20 Mbps

25

4,000

$3,495$4,500NetScreen-5XT

70 Mbps

20 Mbps

10

2,000

$695$1,500NetScreen-5XP

10 Mbps

10 Mbps

10

2,000

$495$1,300


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|(1) |  | A tunnel is an encrypted link between two devices.
|--- |  | --------------------------------------------------

|(2) |  | A session is a communication channel between two networked devices utilizing the transmission control protocol, or TCP.
|--- |  | -----------------------------------------------------------------------------------------------------------------------

|(3) |  | Price depends on configuration and customer location.
|--- |  | -----------------------------------------------------




Firewall and VPN Systems.    The NetScreen-5400, NetScreen-5200, NetScreen-1000 and NetScreen-500 products are high performance security systems designed to provide
integrated firewall, VPN and denial of service protection capabilities for enterprise environments and carrier network infrastructures. Each can be deployed in high bandwidth environments and can be used to deliver managed security services. Our
firewall and VPN systems allow unique security policies to be enforced for multiple virtual local area networks, or VLANs, allowing a single system to secure multiple networks. Our security systems also allow for the creation of multiple Virtual
Systems, each providing a unique security domain with its own virtual firewall and VPN and dedicated management interface. These features enable enterprises, carriers and government entities to use a single security system to secure multiple
networks and enable carriers to deliver security services to multiple customers. For example, the NetScreen-5000 product family supports 4,000 VLANs and 500 Virtual Systems. The NetScreen-500 supports 100 VLANs and 25 Virtual Systems.







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Firewall and VPN Appliances.    The NetScreen-208, NetScreen-204, NetScreen-100, NetScreen-50,
NetScreen-25, NetScreen-5XT and NetScreen-5XP security appliances are fixed configuration products of varying performance characteristics that offer integrated firewall, VPN and denial of service protection capabilities. Our security appliances are
designed to maximize security and performance while using less physical space than competing products. Our security appliances can be deployed to provide small to medium-sized businesses and enterprise remote locations with secure Internet access
and communication.





Intrusion Detection and Prevention Appliances





Our IDP family of products consists of the following appliances:





Product

Throughput

TCP Sessions(1)

List Price(2)NetScreen-IDP 500

500 Mbps

200,000

$34,995-$45,495NetScreen-IDP 100

200 Mbps

50,000

$16,495-$21,450


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|(1) |  | A session is a communication channel between two networked devices utilizing TCP.
|--- |  | ---------------------------------------------------------------------------------

|(2) |  | Price depends on configuration and customer location.
|--- |  | -----------------------------------------------------




Our IDP appliances detect attacks and prevent intrusions using Multi-Method Detection, or MMD, which utilizes eight intrusion detection methods to increase the attack detection accuracy and provide the broadest attack
detection coverage available. These attack detection mechanisms include protocol anomaly, backdoor, traffic anomaly, IP spoofing, Layer 2 and SYN-flood detection, a network honeypot and a technique called Stateful Signature Detection. Stateful
Signature Detection uses signatures that look for attack pattern matches only in the relevant portions of the traffic where an intrusion can be perpetrated. Our IDP appliances provide fast and efficient traffic processing and alarm collection,
presentation and forwarding. Once an attack is detected, our IDP appliances prevent the intrusion by dropping the packets or connection associated with the attack, reducing or eliminating the effects of the attack. Our IDP appliances can also alert
the IT staff to respond to the attack. Our IDP appliances can be clustered to provide high availability and reduce risk associated with a single point of failure.





Software





NetScreen-Global
PRO.    NetScreen-Global PRO is a centralized management application that enables enterprises, carriers and government entities to manage and control security for large-scale networks from a single location. NetScreen-Global
PRO is designed to allow for multi-customer and role-based device configuration, policy management, real-time monitoring and historical reporting of network traffic and security logs for multiple firewall and VPN security systems and appliances.
NetScreen-Global PRO manages all of our firewall and VPN systems and appliances and can be delivered as a pre-installed software application on a third party server to simplify deployment. NetScreen-Global PRO also enables centralized policy
management for NetScreen-Remote VPN client software. The list price for NetScreen-Global PRO management software and the server is between $16,995 and $72,800 depending on the number of devices to be managed and customer location.





NetScreen-Global PRO Express.    NetScreen-Global PRO Express is an entry-level version of our
management software that enables configuration, policy management and real-time monitoring for up to 100 firewall and VPN security systems and appliances. NetScreen-Global PRO Express also enables centralized policy management for
NetScreen-Remote VPN client software. NetScreen-Global PRO Express manages all of our firewall and VPN systems and appliances and is delivered as a pre-installed software application on a third- party server to simplify deployment. The list price
for the NetScreen-Global PRO Express management software and the server is between $5,995 and $19,500 depending on the number of devices to be managed and customer location.




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NetScreen-IDP Manager.    NetScreen-IDP Manager
provides centralized, policy-based management for all of our IDP appliances. Using the NetScreen-IDP Manager, customers can manage up to 100 IDP appliances from a single management console. Administrators create individual rules to establish a
security policy. This gives administrators control over which traffic the IDP appliance should examine and how it should respond when attacks or intrusions are detected. NetScreen-IDP Manager capabilities include a policy editor, log viewer,
integrated security incident management and reports to provide our customers useful tools to manage security by using our IDP application. Customers can manage up to 10 IDP appliances using NetScreen-IDP Manager at no cost. The list price for an
upgrade to the NetScreen-IDP Manager management software and the server is between $8,495 and $22,795 depending on the number of devices to be managed and customer location.





NetScreen-Remote Client software.    NetScreen-Remote is a line of two client software products that enable mobile or remote users with security
capabilities. NetScreen-Remote VPN Client is used to establish VPN connections from personal computers. It is based on IPSec client software licensed from a third party. The list price for NetScreen-Remote VPN Client is up to $9.50 per license.
NetScreen-Remote Security Client is used to establish VPN connections as well as integrated client-based firewall capabilities. It uses software licensed from a third party. The list price for NetScreen-Remote Security Client is up to $44.50 per
license.





Services





Product Support Offerings





We provide a range of hardware and software
support options for our firewall and VPN systems and appliances, IDP appliances and for our NetScreen-Global PRO, NetScreen-Global PRO Express and NetScreen-IDP Manager applications. These options include extended hardware maintenance, faster
hardware replacement for defective units, software maintenance, as well as world-wide technical support with access 24 hours a day, seven days a week. These service offerings can be purchased as a bundle to provide complete service and support for
the covered product or as separate support offerings. The software maintenance provides our end customers with updates and upgrades during the period of coverage purchased by the customer.





Professional Services and Training Offerings





To facilitate the sale, customer installation and use of our security products, we provide our customers with fee-based, hands-on training classes, testing and certification, and professional services such as network design,
product installation and configuration, and security assessments. These services can be sold by our resellers and can be delivered directly by our personnel or by authorized training and service partners.





Alliances





We have
established formal and informal commercial relationships with networking, security and application development companies to provide low cost, high performance network security solutions to our customers. We expect these alliances to verify and
demonstrate the interoperability of our security products with other networking equipment and technologies. We also expect these alliances to help facilitate the introduction of new features and enhancements allowing our products to work with other
security technologies such as anti-virus and authentication products and to facilitate our products compatibility with new technologies such as mobile data services, including GPRS.





Through our Global Security Alliance program, end customers can select scalable and comprehensive network security solutions to secure their networks. Solutions offered
through this program combine the features of our systems and appliances, such as firewall, VPN, denial of service protection and intrusion detection and prevention, with the features of our alliance members products, that provide additional
complementary technologies and services, to provide comprehensive end-to-end security for an end customers network infrastructure. The joint solutions are certified in an alliance integration lab and then made available to customers with
integration documentation and other tools for successful implementation. Joint solutions currently include monitoring and reporting tools, content filtering, route optimization and application security.




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Our Global Security Alliance currently includes the following members: Ericsson
AB, Extreme Networks, Inc., Foundry Networks, Inc., Funk Software, Inc., Internet Security Systems, Inc., Juniper Networks, Inc., Micromuse, Inc., Network Security, Inc., netIQ Corporation, Radware Ltd., RouteScience Technologies, Inc., RSA Security
Inc., SafeNet, Inc., SafeWeb, Inc., SilentRunner, Inc., Smartpipes, Inc., Solsoft, Inc., Stratum8 Networks, Inc., SurfControl, Inc., Sygate Technologies, Inc., TrendMicro, Inc., and Websense, Inc. Of the foregoing, Radware Ltd., RouteScience
Technologies, Inc., SilentRunner, Inc., Stratum8 Networks, Inc. and SurfControl Inc. have certified solutions.





Customers





Distributors, Resellers and Carriers





Domestically, we sell directly to major carriers and, through value-added resellers and a distributor, to end customers. Internationally, we sell primarily through
distributors, who, in turn, sell to value-added resellers. Sales through distributors and value-added resellers represented approximately 86.9% of our total revenues in the year ended September 30, 2002.





End Customers





Our products are sold to end customers, such as established companies and large carriers including traditional local and long distance telephone companies, Internet carriers, managed security service providers, Internet data
center operators, metropolitan area network carriers and government entities. In 2002, 2001 and 2000, no customer accounted for more than 10% of our total revenues.





Technology





Each of our firewall and VPN security systems
and appliances is built on a technology core that consists of our proprietary GigaScreen or GigaScreen-II ASICs, and our ScreenOS, which integrates a security operating system and other software applications. Our ASICs and ScreenOS have been
designed specifically for the unique requirements of high performance security processing. The NetScreen-5000 series of systems uses GigaScreen-II ASICs and an innovative system architecture to deliver high performance security processing. We
incorporate our Virtual Systems capability and high availability technology into the NetScreen-5400, NetScreen-5200, NetScreen-1000 and NetScreen-500. We incorporate our high availability technology into the NetScreen-208, NetScreen-204,
NetScreen-100, the NetScreen-50 and the NetScreen-IDP appliances. The NetScreen-IDP 500 and NetScreen-IDP 100 appliances offer Multi-Method Detection, or MMD, which utilizes eight intrusion detection methods for efficient attack detection and
intrusion protection, making it capable of dropping an attack to reduce or eliminate its impact on the network. We have also developed scalable, centralized management software to allow our end customers to manage large numbers of security devices.





GigaScreen-II ASIC and NetScreen-5000 Series Hardware Architecture





The NetScreen-5000 series of systems use up to six GigaScreen-II ASICs and a distributed system architecture for high performance security
processing. The GigaScreen-II ASIC contains multiple, small, yet powerful, processing engines, each responsible for a portion of data flow processing. Examples of these processing functions include packet parsing, classification, fragmentation,
reassembly, encryption, decryption, network address translation and session lookup. The GigaScreen-II ASICs high performance packet input-output capability and controls are designed to integrate with modern hardware packet switching
technology.





Each GigaScreen-II ASIC is capable of supporting 2 Gbps of firewall traffic and 1 Gbps of VPN
traffic. The NetScreen-5000 series of systems can utilize multiple GigaScreen-II ASIC processors for security flow processing and a RISC processor for management and control processes. This architecture contains three primary components:





| |  |  | Secure Port (Flow Processing) Modulesare based around the GigaScreen-II ASIC and a programmable front-end processor. The programmable element provides
flexibility to improve future performance and facilitate scalability. These modules handle every packet as it enters and exits the system, providing
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | packet parsing, classification and flow-level processing for packets of established sessions. Packets requiring processing beyond that provided by the secure port module are handed off to the
management module for further attention.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | The Management Moduleis based around a powerful combination of a RISC processor and GigaScreen ASICs. It handles tasks not supported by the secure port
module such as session setup and tear down, IKE negotiation, all management access, and dedicated inter-system, high availability and management interfaces.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | The High Performance Backplaneinterconnects all the internal system components. Using a multi-bus architecture and a switched fabric, it provides an
efficient communication path for control information, data exchange and packet forwarding between modules.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




GigaScreen ASIC and Multi-bus Architecture





NetScreens other firewall and VPN
products use our GigaScreen ASIC and innovative hardware designs to relieve the performance bottleneck that has been associated with both software-based security products running on general-purpose computers and first generation hardware-based
security appliances. Our GigaScreen ASIC provides hardware-based acceleration for firewall and VPN functions, such as encryption, authentication, public key acceleration, security policy search engine and network address translation acceleration.
Each GigaScreen ASIC performs data encryption using the data encryption standard, or DES, which is an industry standard encryption algorithm, at speeds of up to 1.2 Gbps, or up to 400 Mbps using 3DES encryption. Each GigaScreen ASIC also supports
industry standard authentication algorithms, such as MD-5 and SHA-1. The NetScreen-1000, NetScreen-500, NetScreen-208, NetScreen-204 and NetScreen-100 are based on system-level designs that incorporate a GigaScreen ASIC connected to a reduced
instruction set computing, or RISC, processor through a multi-bus architecture to accelerate processing-intensive security functions. This multi-bus architecture uses two independent buses to connect our GigaScreen ASIC and host processor to the
packet memory. Our multi-bus architecture increases performance by reducing the bandwidth burden on the packet memory bus.





ScreenOS





Our ScreenOS is a security operating system integrated with a suite of
applications designed to offer high levels of security and performance that we have incorporated into all of our security systems and appliances. We have developed ScreenOS to deliver a complete suite of tightly integrated high performance network
security functions including firewall, VPN, and denial of service protection. ScreenOS is designed to eliminate traditional performance bottlenecks and known security flaws. It cannot be easily analyzed for vulnerabilities by hackers since the
source code is not generally publicly available. In addition to providing a secure operating system and key security applications, ScreenOS delivers a robust set of technologies based on industry standard protocols designed to allow our security
systems and appliances to be integrated easily into our end customers existing networks.





To facilitate
network integration, ScreenOS allows our security systems and appliances to be configured to work in one of three modes of operation, route mode, network address translation, or NAT, mode, and transparent mode. In route mode, the network is
configured to have different IP networks on each interface of the security product, and our system or appliance enforces security policies as it routes traffic between different networks. In NAT mode, IP addresses on one interface can be translated
into different IP addresses as the traffic traverses the device, allowing IP addresses to be hidden from outside view for increased security as well as allowing addresses to be conserved. NetScreens transparent mode enables the security device
to be integrated easily into a network without any changes to IP addressing of the network. In transparent mode, the device will not be assigned an IP address, which makes it harder for a hacker to detect or attack the security system or appliance.





ScreenOS supports a number of industry standard and specialized protocols to allow our devices to be integrated
into existing networks, security environments and network management environments. ScreenOS




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supports dynamic routing protocols including OSPF, BGP and RIPv2. ScreenOS supports and is compatible with authentication mechanisms including Radius servers, Secured token-based authentication
and digital certificates and certificate authorities from VeriSign, Inc., Entrust, Inc., Baltimore Technologies plc, Microsoft Corporation, Netscape Communications Corp. and RSA Security Inc. ScreenOS supports industry standard management protocols
including simple network management protocol, or SNMP, syslog, telnet and secure shell, or ssh, protocol, as well as proprietary management interfaces to our central management software and to NetIQs WebTrends monitoring application.





High Availability Technology





The NetScreen-5400, NetScreen-5200, NetScreen-1000, NetScreen-500, NetScreen-208, NetScreen-204, NetScreen-100 and NetScreen-50 incorporate our ScreenOS high availability
capabilities, which are based on version 2 of the NetScreen Redundancy Protocol, or NSRPv2. NSRPv2 enables a redundant pair of our security systems to be integrated into a high availability network architecture, with redundant physical connections
between the systems and the adjacent network switches. These systems can simultaneously process network traffic, called an active-active configuration, and can synchronize system configurations, session states and IPSec tunnel states between the
systems using redundant, high availability connections between the two systems. This system synchronization allows a redundant system to take over network traffic processing typically in less than one second after a system or network failure to
ensure that network traffic can continue to be forwarded. The NetScreen-50 provides for synchronization of system configuration, session states and IPSec tunnel states between an active appliance and a standby appliance, called an active-passive
configuration.





Virtual Systems Capability





The NetScreen-5400, NetScreen-5200, NetScreen-1000 and NetScreen-500 also incorporate our patent pending ScreenOS Virtual Systems capability. Used in conjunction with
multiple physical interfaces or industry standard VLAN technology, this architecture allows end customers to use a single system to create up to 500 virtual firewalls and VPN gateways, each able to protect a unique security domain. Each Virtual
System can have its own address book, policies and management set based on the end customers requirements. As a result, our Virtual Systems capability allows enterprises and government entities to implement multiple departmental security
systems on a single platform, and it enables Internet data center operators and carriers to deliver managed security services to numerous individual users easily and cost effectively.





IDP MMD Attack Detection





The NetScreen-IDP 500 and NetScreen-IDP 100 appliances offer MMD which utilizes eight intrusion detection methods to increase the attack detection accuracy and provide the broadest attack detection coverage available. These intrusion
detection mechanisms include protocol anomaly, backdoor, traffic anomaly, IP spoofing, Layer 2 and SYN-flood detection, a network honeypot and a technique called Stateful Signature Detection. Stateful Signature Detection uses signatures that look
for attack pattern matches only in the relevant portions of the traffic where an intrusion can be perpetrated.





Scalable Central Management Software





We have developed our NetScreen-Global PRO and
NetScreen-IDP Manager applications and scalable central management software to enable secure, scalable monitoring of devices, network traffic and security events, and device configuration and policy administration. The NetScreen-Global PRO
management software incorporates at three-tier system architecture for scalable network monitoring. Devices forward log information to a layer of data collector software that aggregates network traffic logs from hundreds of devices. The data
collector software, in turn, forwards log information to a master controller that stores log information in a relational database and enables sophisticated network monitoring and reporting of security information, and interfaces into third-party
management applications. Multiple customer administrators and multiple customer domains can be supported, enabling service providers to deliver managed security services to multiple customers.




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Research and Development





We have assembled a team of engineers with experience in the fields of computing, network system design, Internet routing protocols, Internet security standards, embedded
software and network management software. In addition to having the ability to build complex hardware and software systems, our engineering team has experience in developing and delivering large, highly integrated ASICs and scalable security
software.





We believe that strong product development capabilities are essential to our strategy of enhancing our
core technology, developing and incorporating additional functions, and maintaining the competitiveness of our product offerings. We are building on our proprietary GigaScreen and GigaScreen-II ASICs and continuing to develop next generation
technology to support the anticipated growth in network bandwidth requirements. We continue to develop new releases of our ScreenOS, IDP OS and management software to improve functionality, performance, scalability and the user interface.





Our research and development expenses, excluding stock-based compensation, were $25.2 million for the year ended
September 30, 2002, $19.2 million for the year ended September 30, 2001 and $10.3 million for the year ended September 30, 2000.





Manufacturing





We outsource the manufacturing of our systems and appliances. We subcontract
our manufacturing requirements to Flash Electronics, Inc. and Solectron Corporation. This subcontracting activity extends from prototypes to full production and includes material procurement, assembly, test, control and shipment to our customers. We
design, specify and monitor all of the tests that are required to meet internal and external quality standards. Our subcontracting arrangements provide us with the ability to deliver products quickly to customers by using Flash Electronics and
Solectrons turnkey manufacturing and drop shipment capabilities. In addition, we can adjust manufacturing volumes rapidly to meet changes in demand. Neither the Flash Electronics agreement nor the Solectron agreement provides for a fixed term
of service. In addition, our proprietary ASICs are fabricated by foundries operated by Toshiba America Electronic Components, Inc.





Competition





The market for network security products is highly competitive, and we expect
competition to intensify in the future. Competitors may gain market share and introduce new competitive products for the same markets and customers currently served by our products. We currently compete principally on the basis of product security,
performance, reliability, scalability, manageability and cost-effectiveness. We believe that we compete favorably on the basis of these factors.





Current and potential competitors in our market include the following, all of which sell worldwide or have a presence in most of the major geographical markets for their products:





| |  |  | firewall and VPN software vendors, such as Check Point Software Technologies Ltd. and Symantec Corporation;
| | - |  | -----------------------------------------------------------------------------------------------------------




| |  |  | network equipment manufacturers, such as Cisco Systems, Inc., Lucent Technologies Inc., Nokia Corporation and Nortel Networks Corporation;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | security appliance suppliers, such as SonicWALL, Inc., WatchGuard Technologies, Inc. and Symantec Corporation;
| | - |  | --------------------------------------------------------------------------------------------------------------




| |  |  | Intrusion detection system vendors including Internet Security Systems, Inc., Cisco Systems, Inc., Enterasys Networks, Inc. and emerging startups;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | computer and network component manufacturers;
| | - |  | ---------------------------------------------



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##### Table of Contents




| |  |  | low-cost Internet hardware suppliers with products that include network security functionality; and
| | - |  | ---------------------------------------------------------------------------------------------------




| |  |  | emerging intrusion detection and other security companies that may position their systems as replacements for our products.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------




Intellectual Property





Our success and ability to compete are substantially dependent upon our internally developed technology and know-how. We have seven patent applications pending in the United States relating to our technologies and the design of our
products. We have elected to extend three of these patent applications to other countries. Our engineering teams have significant expertise in ASIC design. Our ScreenOS operating system and applications and our NetScreen-Global PRO, NetScreen-Global
PRO Express, NetScreen-Global Manager and NetScreen-IDP Manager software were developed internally and are protected by United States and international copyright laws.





While we rely on patent, copyright, trade secret and trademark law to protect our technology, we also believe that factors such as the technological and creative skills of
our personnel, new product developments, frequent product enhancements and reliable product maintenance are essential to establishing and maintaining our position. Other companies may develop technologies that are similar or superior to our
technology.





Our success depends in part upon our ability to obtain necessary intellectual property rights and
protect our intellectual property rights. We may not be able to obtain the necessary intellectual property rights, and other parties may contest our intellectual property rights.





Employees





As of September 30, 2002, we had 493 full-time
employees, 149 of whom were engaged in research and development, 225 in sales and marketing, 35 in customer service and support and 84 in administration and operations. None of our employees is represented by a labor union. We have not experienced
any work stoppages and we consider our relations with our employees to be good.





Acquisitions





On September 18, 2002, we completed the acquisition of OneSecure, Inc, a provider of network intrusion detection and prevention solutions.
We issued 3.2 million shares of our common stock for all the outstanding stock of OneSecure. We also assumed all of the outstanding stock options of OneSecure, which were converted into options to purchase approximately 349,000 shares of our common
stock, and issued options to purchase 1.4 million shares of our common stock in connection with the transaction. Through the acquisition of OneSecure, Inc., we added IDP appliances to our broad family of integrated network security solutions.





Corporate Information





We were incorporated in Delaware in October 1997. Our principal executive offices are located at 350 Oakmead Parkway, Sunnyvale, California 94085, and our telephone number at this location is
(408) 730-6000. Our common stock is traded on the Nasdaq National Market under the ticker symbol NSCN. Our primary Web site address is www.netscreen.com. The information on our Web site is not incorporated by reference into this annual report.





Item 2.Properties.





We are currently
occupying approximately 51,000 square feet of office space in Sunnyvale, California pursuant to a lease that will expire on February 14, 2003. Effective February 2003, we will occupy approximately 156,000 square feet of office space in Sunnyvale,
California pursuant to a lease that will expire on May 13, 2008. We may lease an additional 22,000 square feet in this facility, exercisable at our option anytime through February 14, 2004. We believe that these facilities are adequate to meet our
needs for the foreseeable future.




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##### Table of Contents




Item 3.Legal Proceedings.





We are subject
to legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, we do not expect that the ultimate costs to resolve these matters will have a material adverse
effect on our consolidated financial position, results of operations or cash flows.





Item 4.Submission of Matters to a Vote of Security Holders.





Not applicable.





PART II





Item 5.Market for Registrants Common Stock and Related Stockholder Matters.





Price Range of Common Stock





Our common stock has traded on the Nasdaq National Market
under the symbol NSCN since our initial public offering of stock on December 12, 2001. Prior to this time, there was no public market for our common stock. The following table presents the high and low sales price per share of our common
stock for the period indicated, as reported on the Nasdaq National Market:





High

LowFiscal Year ended September 30, 2002First Quarter (beginning December 12, 2001)

$
24.69

$
20.95Second Quarter

$
27.95

$
12.90Third Quarter

$
16.46

$
7.76Fourth Quarter

$
14.00

$
8.29





The market price of our common stock has been volatile. See
Managements Discussion and Analysis of Financial Condition and Results of OperationsFactors That May Affect Our Business and Future Results of Operations and Financial Condition.





On December 13, 2002, we had 78,914,583 shares of our common stock outstanding held by 358 stockholders of record. Because brokers
and other institutions hold many of the shares on behalf of stockholders, we believe the total number of beneficial holders is greater than that represented by these record holders.





Dividend Policy





We have never declared or paid any cash
dividends on our capital stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any dividends in the foreseeable future.





Securities Authorized for Issuance Under Equity Compensation Plans





Information relating to securities authorized for issuance under equity compensation plans will be presented under the caption Securities Authorized for Issuance Under Equity Compensation
Plans in our definitive proxy statement. That information is incorporated into this report by reference.




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##### Table of Contents




Item 6.Selected Consolidated Financial Data.





The selected consolidated financial data presented below should be read in conjunction with Managements Discussion and Analysis of Financial Condition and Results of Operations, our consolidated financial statements
and the related notes appearing elsewhere in this report. The consolidated statement of operations data presented below for the years ended September 30, 2002, 2001 and 2000, and the consolidated balance sheet data as of September 30, 2002 and 2001,
have been derived from our audited consolidated financial statements appearing elsewhere in this report. The consolidated statement of operations data for the year ended September 30, 1999 and for the period October 30, 1997 (inception) to
September 30, 1998, and the consolidated balance sheet data as of September 30, 2000, 1999 and 1998 have been derived from audited consolidated financial statements not appearing in this report. The historical results are not necessarily indicative
of the operating results to be expected in the future.





Year Ended September 30,


October 30, 1997 (Inception) to September 30 19982002


2001


2000


1999(in thousands, except per share amounts)Consolidated Statement of Operations Data:Revenues:Product

$
113,943


$
71,197


$
23,438


$
5,669


$
648Maintenance and service


24,539



14,366



3,146



202



17Total revenues


138,482



85,563



26,584



5,871



665Cost of revenues:Product (1) (2)


28,729



22,128



6,578



1,538



189Maintenance and service (1)


7,872



3,668



1,797



150



Total cost of revenues


36,601



25,796



8,375



1,688



189Gross margin


101,881



59,767



18,209



4,183



476Operating expenses:Research and development (1) (2)


32,845



25,595



14,365



15,840



2,318Sales and marketing (1) (2)


63,914



54,784



27,536



6,713



1,505General and administrative (1)


16,796



11,611



9,786



1,440



475Total operating expenses


113,555



91,990



51,687



23,993



4,298Loss from operations


(11,674
)


(32,223
)


(33,478
)


(19,810
)


(3,822
)Interest and other income, net


3,361



1,086



457



80



64Loss before taxes


(8,313
)


(31,137
)


(33,021
)


(19,730
)


(3,758
)Provision for income taxes


(4,058
)


(168
)










Net loss


(12,371
)


(31,305
)


(33,021
)


(19,730
)


(3,758
)Deemed dividend on Series E and Series F redeemable convertible preferred stock


(28,743
)


(2,923
)


(699
)






Net loss applicable to common stockholders

$
(41,114
)

$
(34,228
)

$
(33,720
)

$
(19,730
)

$
(3,758
)Basic and diluted net loss per share applicable to common stockholders

$
(0.68
)

$
(2.05
)

$
(2.82
)

$
(2.99
)

$
(1.22
)Shares used in computing basic and diluted net loss per share applicable to common stockholders


60,564



16,696



11,954



6,598



3,079(1)  Includes stock-based compensation of the
following:Cost of product revenues

$
1,644


$
1,405


$
991


$
Cost of maintenance and service revenues


1,017



1,210



671



Research and development


7,665



6,376



4,082



75Sales and marketing


11,116



9,348



5,993



236General and administrative


2,817



704



3,003



21Total stock-based compensation

$
24,259


$
19,043


$
14,740


$
332(2)  Includes amortization of intangible assets of the following:Cost of product revenues

$
31Research and development


4Sales and marketing


6Total amortization of intangible assets

$
41




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##### Table of Contents




September 30,2002

2001


2000


1999


1998(in thousands)Consolidated Balance Sheet Data:Cash, cash equivalents and short-term investments

$
249,864

$
17,655


$
31,869


$
5,947


$
1,463Working capital


223,296


8,330



23,964



4,177



1,730Total assets


346,684


50,201



48,115



10,390



3,522Total long-term obligations, less current portion


4,090


2,663



673



580



183Redeemable convertible preferred stock





56,542



53,629



16,497



5,679Total stockholders equity (net capital deficiency)


288,889


(42,611
)


(27,683
)


(11,693
)


(3,327
)





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





Forward-Looking Statements





This Managements
Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Selected Consolidated Financial Data and our consolidated financial statements and related notes appearing elsewhere in this
report. In many cases, you can identify forward-looking statements by terms such as may, will, should, expect, plan, anticipate, believe, estimate,
potential, intend or continue, or comparable terminology. Our forward-looking statements include our expectations about revenue, revenue mix, channel mix, cost of revenues and various operating expenses. Our
actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including, but not limited to, those presented below, under the caption Factors That May Affect Our Business and
Future Results of Operations and Financial Condition, and elsewhere in this report. We undertake no obligation to update any forward-looking statements for any reason, except as required by law, even if new information becomes available or
other events occur in the future.





Overview





We develop, market and sell a broad family of integrated network security solutions for enterprises, carriers and government entities. Our security solutions provide key
technologies such as firewall, virtual private networking, denial of service and intrusion detection and prevention in a line of easy-to-manage security systems and appliances. Our firewall and VPN systems and appliances deliver integrated firewall,
virtual private networking and denial of service capabilities in single device using our proprietary application specific integrated circuits, which we refer to as GigaScreen and GigaScreen-II ASICs, and our proprietary security operating system,
ScreenOS. Our intrusion detection and prevention appliances run a secure version of the Linux operating system and use proprietary software and multiple detection methods to identify network attacks. Our products are based on industry standard
communication protocols and can be combined with our management software so that they can be easily integrated into networks, easily managed and will interoperate with other security devices and applications.





On September 18, 2002, we completed our acquisition of OneSecure, Inc., a provider of network intrusion detection and prevention
solutions. We issued 3.2 million shares of our common stock for all the outstanding stock of OneSecure. We also assumed all of the outstanding stock options of OneSecure, which were converted into options to purchase approximately 349,000 shares of
our common stock, and issued options to purchase 1.4 million shares of our common stock in connection with the transaction. The acquisition has been accounted for as a purchase and, accordingly, the total purchase price of $60.3 million has
been allocated to the tangible and intangible assets acquired and the liabilities assumed based on their respective fair values on the acquisition date. OneSecures results of operations have been included in the consolidated results of
operations from the date of acquisition. As a result of the acquisition, we recorded goodwill of $56.8 million and other intangible assets of




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$5.8 million. In accordance with provisions of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, goodwill resulting from the
acquisition will not be amortized, but will be reviewed periodically for impairment. The other intangible assets will be amortized on a straight-line basis over estimated useful lives of three to ten years. Achieving the anticipated benefits
of the merger will depend in part upon whether the operations, products and technology of OneSecure can be integrated with our operations, products and technology in a timely and cost-effective manner. The process of combining the two companies is a
complex, expensive and time-consuming process and may cause an interruption of, or loss of momentum in, the development and sales activities and operations of both companies. We cannot assure you that any part or all of the integration will be
accomplished on a timely basis, or at all.





We introduced and began shipping several new products since the end of
our last fiscal year, which are as follows:





Product

First ShipmentNetScreen-25

November 2001NetScreen-50

November 2001NetScreen-204

January 2002NetScreen-208

January 2002NetScreen-5200

April 2002NetScreen-Remote

August 2002NetScreen-5400

October 2002NetScreen-IDP 100

September 2002NetScreen-IDP 500

November 2002





The revenue and income potential of our newest products is unproven and the markets
addressed by these products are volatile. Likewise, we may not be able to effectively combine OneSecures technologies into our own products, successfully market or enhance OneSecures line of intrusion detection and prevention products,
or offer a viable combined hardware or management product that addresses the needs of our customers. As a result of this limited history, it may be difficult to plan operating expenses or forecast our revenues accurately. If our newer products are
not successful, our operating results could be below our expectations and the expectations of investors and market analysts, which would likely cause the price of our common stock to decline.





We derive a substantial portion of our revenues from outside the Americas. Revenues from outside the Americas were 55.3% in the year ended September 30, 2002, compared
to 46.8% in the year ended September 30, 2001 and 23.5% in the year ended September 30, 2000. Specifically, revenues from Asia and the Pacific Rim (APAC) accounted for approximately 33.7%, 29.5% and 13.3% of our total revenues in the years
ended September 30, 2002, 2001 and 2000, respectively. Revenues from Europe, the Middle East and Africa (EMEA) accounted for approximately 21.6%, 17.3% and 10.2% of our total revenues in the years ended September 30, 2002, 2001 and 2000,
respectively. The increases in revenues from outside the Americas as a percentage of total revenues was primarily attributable to increasing demand for our products in international markets as we continued to expand our presence around the world.
There can be no assurance that we will be able to maintain or increase the demand for our products in international markets.





We derive revenues primarily from sales of our hardware-based security systems and appliances and maintenance arrangements, and, to a lesser extent, from sales of software products and services. We have incurred significant losses in
each fiscal period since our inception and, as of September 30, 2002, we had an accumulated deficit of $132.6 million. We experienced consecutive improvements in revenues and net loss before deemed dividend in each quarter of fiscal 2002. In the
first through fourth quarters of fiscal 2002, our revenues were $29.0 million, $32.0 million, $36.4 million and $41.1 million, and our net loss before deemed dividend was $5.7 million, $3.3 million, $2.4 million and approximately $925,000,
respectively. There can be no assurance that our revenues will continue to grow at the same rate as in the past, at the rate expected or that we will achieve similar results in future periods. There can also be no assurance that our net loss will
continue to decline or that we will reach or maintain profitability in future periods.




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We recorded a deemed dividend of $27.6 million in the year ended September 30,
2002 related to our October 2001 issuance of Series F preferred stock at a price subsequently deemed to be below its fair value. The deemed dividend was calculated based on the difference between the assumed fair market value at the time of our IPO
and the purchase price of the Series F preferred stock. We also recorded deemed dividends of $1.1 million, $2.9 million and approximately $699,000 in the years ended September 30, 2002, 2001 and 2000, respectively, to account for cumulative dividend
rights attributable to our Series E and F preferred stock. At the time of our IPO, all outstanding preferred stock converted to common stock and all dividend rights, as well as voting and liquidation rights, attributable to the preferred stock
terminated.





Cost of product revenues consists of the costs associated with manufacturing, assembling and testing
our products, related overhead costs, compensation and other costs related to manufacturing support and logistics. We rely on contract manufacturers to manufacture our hardware products. Accordingly, a significant portion of our cost of product
revenues consists of payments to these contract manufacturers. Cost of maintenance and service revenues consists of customer support costs, training and professional service expenses and warranty-related costs.





Our gross margin has been and will continue to be affected by a variety of factors, including competition, the mix and average selling
prices of products, maintenance and services, new product introductions and enhancements, the cost of components and manufacturing labor, fluctuations in manufacturing volumes, component shortages, and the mix of distribution channels through which
our products are sold. Our gross margin will be adversely affected by price declines if we are unable to reduce costs on existing products and do not continue to introduce new products with higher margins.





Research and development expenses consist of salaries and related expenses for development and engineering personnel, fees paid to
consultants, license fees paid to third parties and prototype costs related to the design, development, testing and enhancement of our ASICs, security systems and appliances, ScreenOS, management applications and VPN client software. We expense our
research and development costs as they are incurred. Several components of our research and development effort require significant expenditures, the timing of which can cause significant quarterly variability in our expenses. We are devoting
substantial resources to the continued development of new products. To meet the changing requirements of our customers, we will need to fund investments in several development projects in parallel. As a result, we expect our research and development
expenses to increase in absolute dollars in the future.





Sales and marketing expenses consist of salaries,
commissions and related expenses for personnel engaged in marketing, sales and sales support functions and costs associated with promotional and other marketing activities. We intend to expand our sales operations substantially, both domestically
and internationally, in order to increase sales of our products. In addition, we believe part of our future success will be dependent upon establishing successful relationships with a variety of additional resellers in other countries. We expect
that sales and marketing expenses will increase in absolute dollars as we expand our sales efforts in additional domestic and international locations, hire additional sales and marketing personnel and initiate additional marketing programs.





General and administrative expenses consist of salaries and related expenses for executive, finance, accounting,
legal and human resources personnel, professional fees and corporate expenses. We expect general and administrative expenses to increase in absolute dollars as we employ additional personnel, and incur additional costs related to the growth of our
business and our operation as a public company, including new corporate governance requirements.





We account for
stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25). Expenses associated with stock-based
compensation are being amortized ratably over the vesting periods of the individual awards consistent with the method described in FASB Interpretation No. 28. During the years ended




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September 30, 2002, 2001 and 2000, in connection with the grant of stock options to employees, we recorded deferred stock compensation of $13.5 million, $6.8 million and $101.1 million,
respectively, representing the difference between the exercise price and the deemed fair value for financial reporting purposes of the common stock on the date these stock options were granted. We also recorded deferred stock compensation of
approximately $587,000, representing the intrinsic value of unvested stock options assumed in connection with the acquisition of OneSecure. Restricted stock acquired through the exercise of unvested stock options is subject to our right to
repurchase the unvested stock at the price paid, which right lapses over time. Deferred stock compensation is included as a reduction of stockholders equity and is amortized ratably over the vesting period of the individual award, generally
four years, consistent with the method described in FASB Interpretation No. 28. During the years ended September 30, 2002, 2001 and 2000, we recorded amortization of deferred stock compensation of $24.3 million, $19.0 million and $14.7 million,
respectively. This deferred stock compensation expense relates to stock options granted to individuals in all cost of revenues and operating expense categories, and has been included in those categories. At September 30, 2002, $42.2 million of
deferred stock compensation related to employee stock options remained unamortized. This amount will be amortized as follows (in thousands):





Year ending September 30:2003

$
24,8292004


12,3022005


4,7382006


293Total deferred stock compensation

$
42,162





The provision for income taxes is primarily related to federal
income taxes and income taxes generated on income in tax jurisdictions outside the United States.





Critical Accounting Policies





The methods, estimates and judgments we use in applying our accounting policies have a significant impact on
the results we report in our financial statements. Some of our accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Our most critical
accounting estimates include: the assessment of technical complexity and market acceptance of technically complex products, which impact revenue recognition; deferral of revenue for distributors and value-added resellers and revenue reserves, which
impact revenue recognition; potential return rates and probability of collections, which impact account receivable and warranty reserves; the valuation of inventory, which impacts cost of sales and gross margin; the assessment of recoverability of
goodwill and other intangible assets, which impacts write-offs of goodwill and identified intangible assets; and, the assessment of our realization of deferred tax assets, which impacts income taxes.





Revenue recognitiongeneral





We derive our revenues primarily from sales of our hardware-based security systems and appliances and maintenance arrangements, and, to a lesser extent, from sales of software products and services. We
generally recognize revenue when persuasive evidence of an arrangement exists, delivery or customer acceptance, where applicable, has occurred, the fee is fixed or determinable, and collectibility is probable. We defer a portion of product revenues
based on the value of basic maintenance services bundled with each product sale. For these bundled arrangements, revenue is allocated among each element of the bundle at the time of sale based on the fair value of each element of the bundle. The
fair value of each element is determined by reference to the prices we charge when each element is sold separately. Maintenance revenue is deferred and recognized over the applicable maintenance period. We also derive a portion of our revenues from
sales of separate extended maintenance arrangements.




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For newly introduced technically complex products, we defer recognition of
revenues from the sale of these products until they have successfully performed in the marketplace and sales returns are not unusually high. Determining which products are sufficiently technically complex to merit this revenue deferral requires us
to exercise judgment, as does the determination of when products have achieved sufficient acceptance in the market so that deferral is no longer appropriate. The determination of which products are complex, and the timing of the end of deferral for
particular products, can be expected to vary. If we define technically complex products too broadly, we will defer revenue unnecessarily; if we define these products too narrowly, revenue will be recognized earlier but product returns and warranty
claims will be higher in future periods.





Revenue recognitiondistributors and value-added resellers





We sell to value-added resellers and distributors. We derived approximately 86.9% of our total revenues
from value-added resellers and distributors in the year ended September 30, 2002. We defer revenue on sales to our distributors until the distributor has sold our products to its customers. Our agreements with distributors provide for limited stock
rotation and price protection rights. Stock rotation rights provide distributors with the right to exchange unsold inventory for alternate products of equal or greater value. Price protection rights grant distributors the right to credit on future
purchases in the event of decreases in the prices of our products. Our agreements with value-added resellers typically do not include stock rotation or price protection rights. At the time of shipment to value-added resellers, we reserve for
estimated returns and exchanges. These revenue reserves are estimated and adjusted periodically based on historical rates of returns and allowances, inventory levels for value-added resellers that submit inventory or sell-through reports, the volume
of sales to value-added resellers that we ship directly to end customers, and for sales to value-added resellers that do not submit inventory or sell-through reports, accounts receivable balances, payment history and other related factors. These
reserves require the exercise of our judgment in determining if historical experience applies to new products, and to new distributors and value-added resellers. If our estimate of returns and exchanges is too low, additional charges will be
incurred in future periods, and these additional charges could have a material adverse effect on our financial position and results of operations.





Sales Return and Warranty Reserves





We record sales
return and warranty reserves based on estimates of expected future returns and allowances and expected future repair and replacement costs. We record a sales return reserve that approximates the aggregate amount of expected future returns and
allowances. Our sales return reserve is based on past return history, product mix, channel mix and, in some cases, allowances for specific customers based on several factors such as return rights included in our agreements with customers. Our
warranty reserve approximates the aggregate amount of future repair and replacement costs for our products. Our warranty reserve is based on historical product repair and replacement information. In the event we determine that our current or future
sales returns and allowances and product repair and replacement costs exceed our estimates, an adjustment to these reserves would be charged to earnings in the period such determination is made.





Allowance for Doubtful Accounts





We have a large, diversified customer base, which includes customers located in foreign countries. We monitor the creditworthiness of our customers but have experienced losses related to our accounts receivable in the past. We record
an allowance for doubtful accounts based on past history, current economic conditions and the composition of our accounts receivable aging and, in some cases, make allowances for specific customers based on several factors, such as the
creditworthiness of those customers and payment history. These allowances require our subjective judgment. Actual write-offs may differ from the allowances for doubtful accounts, and this difference may have a material effect on our financial
position and results of operations.





Inventory





Given the volatility of the networking market, the rapid obsolescence of technology and short product life cycles, we write down inventories to net realizable value
based on backlog and forecasted demand. However,




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backlog is subject to revisions, cancellations and rescheduling. If actual demand is lower than our forecasted demand, and we fail to reduce manufacturing output accordingly, we could be required
to record additional inventory write-downs, which would have a negative effect on our gross margin.





Valuation of Long-Lived Assets Including Goodwill and Other Intangible Assets





We
review property, plant and equipment, goodwill and other intangible assets for impairment whenever events or circumstances indicate the carrying amount of the assets may not be recoverable. Our review of goodwill and other intangible assets is based
on the estimated future cash flows the assets are expected to generate. Our review is based on our best estimate of a variety of factors, including future market growth, forecasted revenues and costs and a strategic review of our business and
operations. In the event we determine that an asset is impaired in the future, an adjustment to the value of the asset would be charged to earnings in the period such determination is made.





Income Taxes





We record
a valuation allowance to reduce our deferred tax assets to an amount that we estimate is more likely than not to be realized. We consider estimated future taxable income and prudent tax planning strategies in determining the valuation allowance. In
the event we were to determine that we would be able to realize deferred tax assets in the future in excess of the net recorded deferred tax asset, an adjustment to the net deferred tax asset would decrease the net loss (or increase net income) in
the period such determination was made. Likewise, should we determine that we are not able to realize all or part of our deferred tax assets in the future, an adjustment to deferred tax assets would be charged to earnings in the period such
determination was made.





Results of Operations for the Years Ended September 30, 2002 and 2001





Revenues





Product Revenues.    Revenues from sales of our products increased 60.0% to $113.9 million in the year ended September 30, 2002 from $71.2 million in the year ended September 30, 2001. This
increase was attributable to a higher volume of product shipments that were recognized as revenue during the year as well as an increase in the amount of deferred revenue recognized from sales to our customers. Increased product shipments consisted
primarily of new products, and reflected generally higher selling prices. Hardware revenue units increased to approximately 74,000 units in the year ended September 30, 2002 from approximately 42,000 units in the year ended September 30, 2001. No
single customer accounted for 10% or more of our total revenues in either year.





Maintenance and Service
Revenues.    Revenues from maintenance and services increased 70.8% to $24.5 million in the year ended September 30, 2002 from $14.4 million in the year ended September 30, 2001. This increase was a result of the
higher volume of products shipped and the related recognition of revenues associated with the portion of product revenues attributable to maintenance and services over the applicable maintenance period, as well as increased maintenance renewals on a
larger installed base of customers.





There can be no assurance that our revenues will continue to increase in
absolute dollars or at the rate at which they have grown in recent periods.





Cost of Revenues; Gross Margin





Product Cost of Revenues.    Cost of product revenues, including stock
compensation, increased 29.8% to $28.7 million in the year ended September 30, 2002 from $22.1 million in the year ended September 30, 2001. Excluding stock-based compensation of $1.6 million and $1.4 million in the years ended September 30, 2002
and 2001, respectively, and amortization of intangible assets of approximately $31,000 in the year ended September 30,




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2002, cost of product revenues increased 30.6% to $27.1 million in the year ended September 30, 2002 from $20.7 million in the year ended September 30, 2001. This increase, excluding
stock-based compensation, was related primarily to the increase in our revenues and, to a lesser extent, write downs taken against our inventories. These increases were partially offset by reductions in the prices at which we purchase our products
from our manufacturers.





Product Gross Margin.    Product gross margin,
excluding stock-based compensation and amortization of intangible assets, as a percentage of total revenues was 76.3% in the year ended September 30, 2002 compared to 70.9% in the year ended September 30, 2001. The increase in gross margin
percentage was primarily attributable to the increased sales of our higher-margin, mid-range products and increased sales, along with improved margins, of our low-range products. We expect our product gross margin percentage to decline over time.





Maintenance and Service Cost of Revenues.    Maintenance and service cost of
revenues, including stock-based compensation, increased 114.6% to $7.9 million in the year ended September 30, 2002 from $3.7 million in the year ended September 30, 2001. Excluding stock-based compensation of $1.0 million and $1.2 million in the
years ended September 30, 2002 and 2001, respectively, cost of maintenance and service revenues increased 178.9% to $6.9 million in the year ended September 30, 2002 from $2.5 million in the year ended September 30, 2001. This increase, excluding
stock-based compensation, was primarily related to increases in costs related to the expansion of our customer support infrastructure and larger installed base of products for which we provide service.





Maintenance and Service Gross Margin.    Maintenance and service gross margin, excluding stock-based
compensation, as a percentage of total revenues was 72.1% in the year ended September 30, 2002 compared to 82.9% in the year ended September 30, 2001. The decrease in gross margin percentage was primarily attributable to increased costs as we
expanded our worldwide customer support infrastructure in order to grow that business. We expect our service and maintenance gross margin percentage to continue to decline over time.





Operating Expenses





Research and Development Expenses.    Research and development expenses, including stock-based compensation, increased 28.3% to $32.8 million in the year ended September 30, 2002 from $25.6 million
in the year ended September 30, 2001. Excluding stock-based compensation of $7.7 million and $6.4 million in the years ended September 30, 2002 and 2001, respectively, research and development expenses increased 31.0% to $25.2 million in the year
ended September 30, 2002 from $19.2 million in the year ended September 30, 2001. These expenses, excluding stock-based compensation, represented 18.2% and 22.5% of total revenues for these periods, respectively. The dollar increase was primarily
attributable to increased personnel costs as a result of increased headcount.





Sales and Marketing
Expenses.    Sales and marketing expenses, including stock-based compensation, increased 16.7% to $63.9 million in the year ended September 30, 2002 from $54.8 million in the year ended September 30, 2001. Excluding
stock-based compensation of $11.1 million and $9.3 million in the years ended September 30, 2002 and 2001, respectively, sales and marketing expenses increased 16.2% to $52.8 million in the year ended September 30, 2002 from $45.4 million in the
year ended September 30, 2001. These expenses, excluding stock-based compensation, represented 38.1% and 53.1% of total revenues for these periods, respectively. The dollar increase in sales and marketing expenses was primarily related to the
expansion of our sales and marketing organizations, including increased compensation-related expenses resulting from the growth of our sales force and higher commissions expense associated with increased revenues, increased marketing-related program
costs and, to a lesser extent, to increases in other sales office costs associated with the expansion of our sales force. These increases were partially offset by a reduction in direct advertising expenditures.





General and Administrative Expenses.    General and administrative expenses, including stock-based
compensation, increased 44.7% to $16.8 million in the year ended September 30, 2002 from $11.6 million in the




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year ended September 30, 2001. Excluding stock-based compensation of $2.8 million and approximately $704,000 in the years ended September 30, 2002 and 2001, respectively, general and
administrative expenses increased 28.2% to $14.0 million in the year ended September 30, 2002 from $10.9 million in the year ended September 30, 2001. These expenses, excluding stock-based compensation, represented 10.1% and 12.7% of total revenues
for these periods, respectively. The dollar increase was primarily related to increased personnel costs as a result of increased headcount from the expansion of our general and administrative staff and greater infrastructure requirements, including
those associated with being a public company. These increased costs were partially offset by a reduction in bad debt expense.





Stock-Based Compensation.    In connection with the grant of employee stock options in the year ended September 30, 2002, we recorded deferred stock compensation of $13.5 million. We recorded
deferred stock compensation of approximately $587,000 in connection with stock options assumed in the acquisition of OneSecure, Inc. During the year ended September 30, 2002, we recorded stock-based compensation expense of $24.3 million. As of
September 30, 2002, $42.2 million of deferred stock compensation remained unamortized. This amount will be amortized through the quarter ending December 31, 2005.





Interest and Other Income, Net





Interest and other income, net, was $3.4 million in the year ended September 30, 2002 compared to interest and other income, net, of $1.1 million in the year ended September 30, 2001. The increase in interest and other income was
primarily a result of increased interest earned on higher average cash, cash equivalent and short-term investment balances in the year ended September 30, 2002. The increased interest income was partially offset by foreign exchange losses arising
from the remeasurement of our international entities financial statements into U.S. dollars and higher interest expense in the year ended September 30, 2002 due to higher average levels of debt and capital lease obligation in that year.





Provision for Income Taxes





We recorded an income tax provision of $4.1 million for the year ended September 30, 2002, primarily related to federal income taxes and income taxes currently payable on
income generated in non-U.S. tax jurisdictions for which no U.S. tax benefit is currently recognizable. We recorded an income tax provision of approximately $168,000 for the year ended September 30, 2001, primarily related to income taxes currently
payable on income generated in non-U.S. tax jurisdictions for which no U.S. benefit is currently recognizable. We had gross deferred tax assets, net of liabilities, of $43.6 million as of September 30, 2002 and $25.3 million as of September 30,
2001. Realization of deferred tax assets is dependent on our ability to generate future taxable income, the timing and amount of which are uncertain. Accordingly, a valuation allowance, in an amount equal to the total gross deferred tax assets as of
September 30, 2002 and September 30, 2001, has been established to reflect those uncertainties. Our deferred tax assets primarily relate to net operating loss carryforwards and deferred compensation. As of September 30, 2002, we had federal and
state net operating loss carryforwards of $45.7 million and $37.6 million, respectively. We also had research and development tax credit carryforwards of $4.3 million. The net operating loss and tax credit carryforwards will expire at various dates
beginning in 2013, if not utilized. Utilization of the net operating loss and tax credit carryforwards may be subject to a substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code Section 382 and
Section 383 and similar state provisions. The annual limitation may result in the expiration of net operating loss and tax credit carryforwards before utilization.





Results of Operations for the Years Ended September 30, 2001 and 2000





Revenues





Product Revenues.    Revenues from sales
of our products increased to $71.2 million in the year ended September 30, 2001 from $23.4 million in the year ended September 30, 2000. This increase was attributable to a higher volume of products shipped, expansion of our distribution channels,
expansion of our product offerings to include the NetScreen-1000 and NetScreen-500, and increasing demand in our markets.




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Maintenance and Service Revenues.    Revenues
from maintenance and services increased to $14.4 million in the year ended September 30, 2001 from $3.1 million in the year ended September 30, 2000. This increase was a result of the higher volume of products shipped and the related
recognition of revenues associated with the allocated portion of product revenues attributable to maintenance and services over the applicable maintenance period.





No single customer accounted for 10% or more of our total revenues in either year. Revenues from the Americas accounted for approximately 53.2% of our total revenues in the
year ended September 30, 2001 and 76.5% of our total revenues in the year ended September 30, 2000. Revenues from Asia and the Pacific Rim (APAC) accounted for approximately 29.5% and 13.3% of our total revenues in the years ended September 30,
2001 and 2000, respectively. Revenues from Europe, the Middle East and Africa (EMEA) accounted for approximately 17.3% and 10.2% of our total revenues in the years ended September 30, 2001 and 2000, respectively.





Cost of Revenues; Gross Margin





Cost of revenues, including stock-based compensation, increased to $25.8 million in the year ended September 30, 2001 from $8.4 million in the year ended September 30, 2000. Excluding stock-based
compensation of $2.6 million and $1.7 million in the years ended September 30, 2001 and 2000, respectively, cost of revenues increased to $23.2 million in the year ended September 30, 2001 from $6.7 million in the year ended September 30, 2000. This
increase, excluding stock-based compensation, was related primarily to the increase in our revenues and increases in related product costs and, to a lesser extent, to increases in costs related to increased headcount in the manufacturing support and
customer support organizations. Gross margin, excluding stock-based compensation, as a percentage of total revenues was 72.9% in the year ended September 30, 2001 compared to 74.7% in the year ended September 30, 2000. The decrease in gross
margin percentage, despite our significant growth in revenues, was primarily attributable to the increase in product costs and to increased revenues from lower margin products, partially offset by increased higher margin maintenance and service
revenues.





Operating Expenses





Research and Development Expenses.    Research and development expenses, including stock-based compensation, increased 78.2% to $25.6 million in the year ended
September 30, 2001 from $14.4 million in the year ended September 30, 2000. Excluding stock-based compensation of $6.4 million and $4.1 million in the years ended September 30, 2001 and 2000, respectively, research and development expenses increased
86.9% to $19.2 million in the year ended September 30, 2001 from $10.3 million in the year ended September 30, 2000. These expenses, excluding stock-based compensation, represented 22.5% and 38.7% of total revenues for these periods,
respectively. The dollar increase was primarily attributable to increased personnel costs, the allocated portion of increased facility expenses related to a larger facility, increased prototype expenses associated with the development of new
products and increased product development efforts.





Sales and Marketing
Expenses.    Sales and marketing expenses, including stock-based compensation, increased 99.0% to $54.8 million in the year ended September 30, 2001 from $27.5 million in the year ended September 30, 2000. Excluding
stock-based compensation of $9.3 million and $6.0 million in the years ended September 30, 2001 and 2000, respectively, sales and marketing expenses increased 110.9% to $45.4 million in the year ended September 30, 2001 from $21.5 million in
the year ended September 30, 2000. These expenses, excluding stock-based compensation, were 53.1% and 81.0% of total revenues for these periods, respectively. The dollar increase was primarily related to the expansion of our sales and marketing
organizations, including growth in our domestic and international sales forces and the associated sales office expenses. The dollar increase was also due to increased salary, commission and bonus expenses related to higher sales volumes, increased
travel expenses, increased outside sales consultant fees and product demonstration unit costs. Marketing-related program costs designed to improve our market penetration also increased, mainly due to




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increased costs of marketing development, reseller incentive programs, advertising and trade shows. Allocated facility expenses, depreciation and amortization also increased due to our move to a
larger facility and to related leasehold improvements.





General and Administrative
Expenses.    General and administrative expenses, including stock-based compensation, increased 18.6% to $11.6 million in the year ended September 30, 2001 from $9.8 million in the year ended September 30, 2000. Excluding
stock-based compensation of approximately $704,000 and $3.0 million in the years ended September 30, 2001 and 2000, respectively, general and administrative expenses increased 60.8% to $10.9 million in the year ended September 30, 2001 from
$6.8 million in the year ended September 30, 2000. These expenses, excluding stock-based compensation, were 12.7% and 25.5% of total revenues for these periods, respectively. The dollar increase was primarily related to the expansion of our
general and administrative organization to support additional finance, human resource, legal and other administrative activities and greater infrastructure requirements, resulting in an increase in salaries and related personnel costs, and to
increased outside consulting costs, including legal, accounting and other professional services fees associated with our financial audit, information systems implementation and other consulting and, to a lesser extent, to an increased bad debt
provision due to increased accounts receivable.





Stock-based Compensation.    In
connection with the grant of employee stock options in the year ended September 30, 2001, we recorded deferred stock compensation of $6.8 million. During the year ended September 30, 2001, we recorded stock-based compensation expense of
$19.0 million.





Interest and Other Income, Net





Interest and other income, net, was approximately $1.1 million in the year ended September 30, 2001 compared to interest and other income, net of approximately
$457,000 in the year ended September 30, 2000. The increase in interest and other income was primarily a result of larger cash, cash equivalent and short-term investment balances in the year ended September 30, 2001.





Provision for Income Taxes





We recorded an income tax provision of approximately $168,000 for the year ended September 30, 2001, primarily related to income taxes currently payable on income generated in non-U.S. tax
jurisdictions for which no U.S. benefit is currently recognizable. Due to operating losses and our inability to recognize an income tax benefit from these losses, there was no provision for income taxes for the year ended September 30, 2000.





Liquidity and Capital Resources





Since our inception, we have financed our operations primarily through equity financing. In October 2001, we completed the sale of 5,762,502 shares of our Series F convertible preferred stock for net
proceeds of $29.7 million. Prior to our December 2001 initial public offering (IPO), we raised a total of $82.6 million through the private sale of convertible preferred stock.





In December 2001, we completed the sale of 11,500,000 shares of common stock in our IPO. We realized net proceeds of $168.6 million upon the close of the IPO. See Note
10, Stockholders Equity, of the Notes to Consolidated Financial Statements for additional information.





Net cash provided by operating activities was $31.7 million for the year ended September 30, 2002, compared to net cash used in operating activities of $6.9 million for the year ended September 30, 2001. Net cash provided by
operating activities for the year ended September 30, 2002 was primarily the result of cash generated from our net loss, after adjusting for noncash operating expenses, of $17.9 million and an increase in deferred revenue. The net cash used in
operating activities for the year ended September 30, 2001 was primarily the result of our net loss, after adjusting for noncash operating expenses of $10.1 million and an increase in accounts receivable due to higher revenues, partially offset by
an increase in deferred revenue.




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Net cash used in investing activities for the years ended September 30, 2002 and
2001 was $236.0 million and $6.0 million, respectively. Net cash used in investing activities for the year ended September 30, 2002 was almost entirely due to net purchases of short-term investments. Net cash used in investing activities for the
year ended September 30, 2001 was primarily due to purchases of property and equipment.





Net cash provided by
financing activities for the year ended September 30, 2002 was $204.0 million, compared to net cash used in financing activities of $1.8 million in the year ended September 30, 2001. Net cash provided by financing activities for the year ended
September 30, 2002 was primarily due to the net proceeds from our IPO and the net proceeds from the sale of our Series F convertible preferred stock. Net cash used in financing activities for the year ended September 30, 2001 was primarily due to an
increase in restricted cash, partially offset by proceeds from borrowing arrangements.





As of September 30, 2002,
our principal source of liquidity was $249.9 million of cash, cash equivalents and short-term investments. At that date, we had future minimum lease payments under non-cancelable operating leases of $2.7 million and long-term debt and restructuring
obligations, including the current portion, of $6.4 million. At September 30, 2002, we had no material commitments for capital expenditures, but we expect to spend between $10.0 million and $12.0 million on capital expenditures during the next
12 months.





In October 1998, we entered into a $318,000 (later adjusted to $404,000) equipment leasing
arrangement. During the year ended September 30, 2000, we expanded the equipment leasing arrangement by an additional $500,000. As of September 30, 2002, there was no availability for future purchases of equipment under this leasing arrangement and
approximately $176,000 was outstanding. In February 2001, we entered into an equipment leasing arrangement of $514,000. The lease is payable in monthly installments of principal and interest of approximately $15,000 through February 2004. As of
September 30, 2002, approximately $239,000 was outstanding under this arrangement.





In April 2001, we entered into
a loan and security agreement for $3.5 million. Under the agreement, we could borrow amounts to finance eligible equipment purchases. The lender has a security interest in the purchased equipment. Borrowings under the agreement bear interest at the
U.S. Treasury note rate for notes with a three-year maturity plus 3.75% and are payable in equal monthly installments over a three-year term. A final payment equal to 9% of the amount borrowed, due at the end of the three-year term, has been treated
as an additional finance charge and is being amortized over the term of the loan. We are not required to meet any financial covenants under this agreement. The commitment terminated on November 30, 2001. As of September 30, 2002, we had
borrowed $2.0 million at an annual interest rate of 8.2% under this agreement, of which $1.2 million was outstanding.





In August 2001, we entered into a loan and security agreement for $3.0 million. Under the agreement, we could borrow amounts to finance eligible equipment purchases. The lender has a security interest in the purchased equipment.
Borrowings under the agreement bear interest at the U.S. Treasury note rate for notes with a three-year maturity plus 9.5% and are payable in equal monthly installments over terms ranging from 33 to 36 months. We are required to maintain an
unrestricted domestic cash balance of $11.0 million while borrowings are outstanding under the agreement. The commitment terminated on November 30, 2001. As of September 30, 2002, we had borrowed $1.3 million at an annual interest rate of 13.8% and
approximately $944,000 at an annual rate of 13.3% under this arrangement. The total amount outstanding under this arrangement was $1.6 million as of September 30, 2002.





In August 2000, we entered into a lease for approximately 51,000 square feet of office space in Sunnyvale, California, which commenced on January 21, 2001 and will
terminate on February 14, 2003. The related cost of the lease is approximately $270,000 per month. The lease was secured by a $1.6 million standby letter of credit as of September 30, 2002.





We have entered into several leases for domestic and foreign sales office facilities. The leases expire at various dates through October 2004. The related cost of the
leases is approximately $173,000 per month.




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In October 2002, we entered into a lease for a new approximately 156,000 square
foot corporate headquarters in Sunnyvale, California. Rent payments under the lease are approximately $231,000 per month and commence February 14, 2003. The lease terminates on May 13, 2008. Under the terms of the lease, we may lease an additional
approximately 22,000 square feet in the facility at an additional monthly rent of approximately $32,000. We can exercise this option to lease the additional space at anytime through February 14, 2004.





We acquired OneSecure, Inc. in September 2002. In connection with the acquisition, we assumed noncancelable operating leases
for domestic sales offices that were not occupied by OneSecure and that will not be occupied by NetScreen. In addition, we assumed the noncancelable operating lease for OneSecures headquarters in Sunnyvale, California, which is a duplicate
facility. We have recorded a restructuring liability for the net present value of these leases, net of expected sublease income, for the periods these facilities will be unoccupied.





Flash Electronics, Inc. manufactures, assembles and tests the NetScreen-100, NetScreen-50, NetScreen-25, NetScreen-204 and NetScreen-208 products. Solectron Corporation
manufactures, assembles and tests the NetScreen-5200, NetScreen-5400, NetScreen-1000, NetScreen-500, NetScreen-5XP and NetScreen-5XT products. We purchase from these manufactures on a purchase order basis, and do not have long-term supply contracts.
At September 30, 2002, we had noncancelable purchase orders of $5.0 million to Flash Electronics, Inc. and Solectron Corporation.





A summary of our obligations and commitments are as follows (in thousands):





Payments Due by PeriodTotal

Less Than One Year

One to Three Years

Four to Five Years

After Five YearsDebt and capital lease obligations

$
3,274

$
1,761

$
1,513

$


$
Restructuring liabilities


3,118


541


1,210


923


444Noncancelable inventory purchase commitments


5,018


5,018








Operating leases


17,204


4,054


5,889


5,532


1,729Total contractual cash obligations

$
28,614

$
11,374

$
8,612

$
6,455

$
2,173





Recent Accounting Pronouncements





In July 2001, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards No. 141,
Business Combination, or SFAS 141. SFAS 141 established new standards for accounting and reporting for business combinations initiated after June 30, 2001. Use of the pooling-of-interests method is prohibited. We adopted this statement
during the first quarter of fiscal 2002. The adoption of this pronouncement did not have a material effect on our operating results or financial position.





In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, or SFAS 142, which supersedes APB Opinion No. 17, Intangible
Assets. SFAS 142 established new standards for goodwill, including the elimination of goodwill amortization, which is to be replaced with methods of periodically evaluating goodwill for impairment. We adopted this statement during the first
quarter of fiscal 2002. The adoption of this pronouncement did not have a material effect on our operating results or financial position.





In August 2001, the FASB issued Statement of Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144). SFAS 144 superseded Statement of Accounting
Standards No. 121, Accounting for the Impairment of Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions relating to the disposal of a segment of a business in Accounting Principles Board No. 30. We adopted
SFAS 144 during the second quarter of fiscal 2002. The adoption of this pronouncement did not have a material impact on our operating results or financial position.




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In November 2001, the Emerging Issues Task Force (EITF) released
Issue No. 01-09, Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendors Product, which applies to annual or interim financial statement periods beginning December 15, 2001. This release requires
that cash consideration (including sales incentives) that we give our customers or resellers should be accounted for as a reduction of revenue unless we receive a benefit that is identifiable and that can be reasonably estimated. We adopted this
release as of January 1, 2002. The adoption of this release did not have a material impact on our total revenues.





In July 2002, the FASB issued Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities (SFAS 146). SFAS 146 addresses financial accounting and
reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring). SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred rather than when the exit or disposal is approved. We will adopt this pronouncement on
January 1, 2003. The adoption of this pronouncement is not expected to have a material impact on our operating results or financial position.





Qualitative and Quantitative Disclosure about Market Risk





We develop products in the
United States and sell them worldwide. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. Since our sales are currently priced in U.S.
dollars and are translated to local currency amounts, a strengthening of the dollar could make our products less competitive in foreign markets.





As of September 30, 2002, our investment portfolio consisted of money market funds, corporate-backed debt obligations, municipal bonds and U.S. government discount notes and earned interest at an
average rate of 2.2%. We place investments with high quality issuers and limit the amount of credit exposure to any one issuer. These securities are subject to interest rate risks. Based on our portfolio content and our ability to hold investments
to maturity, we believe that a hypothetical 10% increase or decrease in interest rates would not materially affect our interest income, although there can be no assurance of this.




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FACTORS THAT MAY AFFECT OUR BUSINESS AND FUTURE RESULTS OF


OPERATIONS AND FINANCIAL CONDITION





In addition to other information in this report, the following risk factors should be carefully considered in evaluating us and our business because these factors may have a significant impact on our business, operating results or
financial condition. Actual results could differ materially from those projected in the forward-looking statements contained in this report as a result of the risk factors discussed below and elsewhere in this report.





Downturns in the Internet infrastructure, network security and related markets may decrease our revenues and margins.





The market for our products depends on economic conditions affecting the broader Internet infrastructure, network security and related
markets. Downturns in these markets may cause enterprises and carriers to delay or cancel security projects, reduce their overall or security-specific information technology budgets or reduce or cancel orders for our products. In this environment,
our customers such as distributors, value-added resellers and carriers may experience financial difficulty, cease operations and fail to budget or reduce budgets for the purchase of our products. This, in turn, may lead to longer sales cycles,
delays in purchase decisions, payment and collection, and may also result in price pressures, causing us to realize lower revenues, gross margins and operating margins. In addition, general economic uncertainty caused by potential hostilities
involving the United States, terrorist activities, the decline in specific markets such as the service provider market in the United States, and the general decline in the capital spending in the information technology sector make it difficult to
predict changes in the purchase and network requirements of our customers and the markets we serve. We believe that, in light of these events, some businesses may curtail or eliminate capital spending on information technology. If capital spending
in our markets declines, our revenues, gross margins and operating margins may decline and make it necessary for us to gain significant market share from our competitors in order to achieve our financial goals and achieve or maintain profitability.





Competition may decrease our revenues, market share and margins.





The market for network security products is highly competitive, and we expect competition to intensify in the future. Competitors may gain market share and introduce new
competitive products for the same markets and customers currently served by our products. These products may have better performance, lower prices and broader acceptance than our products.





Current and potential competitors in our market include the following, all of which sell worldwide or have a presence in most of the major geographical markets for their
products:





| |  |  | firewall and VPN software vendors, such as Check Point Software Technologies Ltd. and Symantec Corporation;
| | - |  | -----------------------------------------------------------------------------------------------------------




| |  |  | network equipment manufacturers, such as Cisco Systems, Inc., Lucent Technologies Inc., Nokia Corporation and Nortel Networks Corporation;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | security appliance suppliers, such as SonicWALL, Inc., WatchGuard Technologies, Inc. and Symantec Corporation;
| | - |  | --------------------------------------------------------------------------------------------------------------




| |  |  | intrusion detection system vendors, such as Internet Security Systems, Inc., Cisco Systems, Inc., Enterasys Networks, Inc. and emerging startups;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | computer and network component manufacturers;
| | - |  | ---------------------------------------------




| |  |  | low-cost Internet hardware suppliers with products that include network security functionality; and
| | - |  | ---------------------------------------------------------------------------------------------------




| |  |  | emerging intrusion detection and other security companies that may position their systems as replacements for our products.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------






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Many of our current or potential competitors have longer operating histories, greater name recognition, larger customer bases and significantly
greater financial, technical, sales, marketing and other resources than we do. In addition, some of our competitors currently combine their products with other companies networking and security products to compete with our products. These
competitors also often combine their sales and marketing efforts to compete with our products. This competition may result in reduced prices, lower gross and operating margins and longer sales cycles for our products. If any of our larger
competitors were to commit greater technical, sales, marketing and other resources to our markets, or reduce prices for their products over a sustained period of time, our ability to successfully sell our products, increase revenue or meet our or
market analysts expectations could be adversely affected.





We cannot assure you that we will be successful in integrating the
operations of OneSecure or any other future acquisitions.





On September 18, 2002, we completed the acquisition
of OneSecure, Inc. Achieving the anticipated benefits of the merger will depend in part upon whether the operations, products and technology of OneSecure can be integrated with our operations, products and technology in a timely and cost-effective
manner. The process of combining two companies is complex, expensive and time consuming and may cause an interruption of, or loss of momentum in, the development and sales activities and operations of both companies. We cannot assure you that any
part or all of the integration will be accomplished on a timely basis, or at all. Assimilating OneSecure, or any other companies we may seek to acquire in the future, involves a number of other risks, including, but not limited to:





| |  |  | adverse effects on existing customer relationships, such as cancellation of orders or the loss of key customers;
| | - |  | ----------------------------------------------------------------------------------------------------------------




| |  |  | difficulties in integrating or an inability to retain the employees of the acquired company;
| | - |  | --------------------------------------------------------------------------------------------




| |  |  | difficulties in integrating the operations of the acquired company, such as information technology resources, manufacturing processes, and financial and
operational data;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | unanticipated costs or the incurrence of unknown liabilities;
| | - |  | -------------------------------------------------------------




| |  |  | the potential incompatibility of business cultures;
| | - |  | ---------------------------------------------------




| |  |  | any perceived adverse changes in business focus;
| | - |  | ------------------------------------------------




| |  |  | entering into markets and acquiring technologies in areas in which we have little experience;
| | - |  | ---------------------------------------------------------------------------------------------




| |  |  | potential dilution to existing stockholders if we have to incur debt or issue equity securities to pay for any future acquisitions;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------




| |  |  | additional expenses associated with the amortization of intangible assets; and
| | - |  | ------------------------------------------------------------------------------




| |  |  | an inability to maintain uniform standards, controls, procedures and policies.
| | - |  | ------------------------------------------------------------------------------




In addition, the integration of certain operations following any merger will require the time and attention of our management, which may distract attention from the day-to-day business of
the combined company. Failure to effectively accomplish the integration of the operations of the two companies could have an adverse effect on our business, financial condition and results of operations.





Our limited history with our newer products makes it difficult to evaluate our business and prospects.





We introduced several new system and appliance products in 2002. As a result of our limited history with these products, it may be
difficult to plan operating expenses or forecast our revenues accurately. Our assumptions about customer or network requirements may be wrong. The revenue and income potential of these products is unproven. And, the markets addressed by these
products are volatile. Likewise, we may not be able to effectively combine OneSecures technologies into our own products, successfully market or enhance




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OneSecures line of IDP appliances, or offer a viable combined hardware or management product that addresses the needs of our customers. If such products are not successful, our operating
results could be below our expectations and the expectations of investors and market analysts, which would likely cause the price of our common stock to decline.





Failure to address evolving standards in the network security industry and successfully develop and introduce new products or product enhancements would cause our revenues to decline.





The market for network security products is characterized by rapid technological change, frequent new product introductions, changes in
customer requirements and evolving industry standards. We expect to introduce new products and enhancements to existing products to address current and evolving customer requirements and broader networking trends and vulnerabilities. We also expect
to develop products with strategic partners and incorporate third-party advanced security capabilities into our products. Some of these new products and enhancements may require us to develop new hardware architectures and ASICs that involve complex
and time consuming processes. In developing and introducing our products, we have made, and will continue to make, assumptions with respect to which features, security standards and performance criteria will be required by our customers. If we
implement features, security standards and performance criteria that are different from those required by our customers, market acceptance of our products may be significantly reduced or delayed, which would harm our ability to penetrate existing or
new markets.





Furthermore, we may not be able to develop new products or product enhancements in a timely manner, or at all. Any failure
to develop or introduce these new products and product enhancements might cause our existing products to be less competitive, may adversely effect our ability to sell solutions to address large customer deployments and, as a consequence, our
revenues may decline. In addition, the introduction of products embodying new technologies could render our existing products obsolete, which would have a direct, adverse effect on our market share and revenues. Any failure of our future products or
product enhancements to achieve market acceptance could cause our revenues to decline and our operating results to be below our expectations and the expectations of investors and market analysts, which would likely cause the price of our common
stock to decline.





The unpredictability of our quarterly results may cause the trading price of our common stock to decline.





Our quarterly revenues and operating results have varied in the past and will likely continue to vary in the
future due to a number of factors, many of which are outside of our control. Any of these factors could cause the price of our common stock to decline. The primary factors that may affect revenues and operating results include the following:





| |  |  | the demand for our products;
| | - |  | ----------------------------




| |  |  | the length of our sales cycle;
| | - |  | ------------------------------




| |  |  | the timing of recognizing revenues;
| | - |  | -----------------------------------




| |  |  | new product introductions by us or our competitors;
| | - |  | ---------------------------------------------------




| |  |  | changes in our pricing policies or the pricing policies of our competitors;
| | - |  | ---------------------------------------------------------------------------




| |  |  | variations in sales channels, product costs or mix of products sold;
| | - |  | --------------------------------------------------------------------




| |  |  | our ability to develop, introduce and ship in a timely manner new products and product enhancements that meet customer requirements;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------




| |  |  | our ability to obtain sufficient supplies of sole or limited source components, including ASICs, and power supplies, for our products;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------




| |  |  | variations in the prices of the components we purchase;
| | - |  | -------------------------------------------------------



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| |  |  | our ability to attain and maintain production volumes and quality levels for our products at reasonable prices at our third-party manufacturers;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | our ability to manage our customer base and credit risk and to collect our accounts receivable; and
| | - |  | ---------------------------------------------------------------------------------------------------




| |  |  | the financial strength of our value-added resellers and distributors.
| | - |  | ---------------------------------------------------------------------




Our operating expenses are largely based on anticipated revenues and a high percentage of our expenses are, and will continue to be, fixed in the short term. As a result,
lower than anticipated revenues for any reason could cause significant variations in our operating results from quarter to quarter and, because of our rapidly growing operating expenses, could result in substantial operating losses.





Due to the factors summarized above, we believe that quarter-to-quarter comparisons of our operating results are not a good
indication of our future performance. Also, it is likely that, in some future quarters, our operating results will be below the expectations of public market analysts and investors. In this event, the price of our common stock would likely decline.





We derive a substantial portion of our revenues from international customers, and our failure to address the difficulties associated
with marketing, selling and supporting our products outside the United States could cause our sales to decline.





Revenues from outside of the Americas were 55.3% of our total revenues for the year ended September 30, 2002, 46.8% of our total revenues for the year ended September 30, 2001 and 23.5% of our total revenues for the year ended
September 30, 2000. We expect revenues from outside of the Americas will continue to represent a substantial portion of our total revenues for the foreseeable future.





We may not be able to maintain or increase international market demand or international revenues from our products. For example, general economic conditions in
international markets can fluctuate and downturns in these markets could have a significant adverse impact on our ability to meet public market expectations and achieve profitability. Also, as agreements with international distributors expire, we
may be unable to favorably renew our distributor agreements or make alternative arrangements with other partners. If we are unable to maintain or increase international market demand and revenues from our products, our revenues may be below our
expectations and the expectations of investors and market analysts, which would likely cause the price of our common stock to decline.





We intend to continue expanding our existing international operations and to enter new international markets. This expansion will require significant management attention and financial resources. We currently have limited
experience in marketing and distributing our products internationally and in developing versions of our products that comply with local standards. In addition, international operations are subject to other inherent risks, including:





| |  |  | potential foreign government regulation of our technology or unexpected changes in regulatory requirements;
| | - |  | -----------------------------------------------------------------------------------------------------------




| |  |  | greater difficulty and delays in accounts receivable collection;
| | - |  | ----------------------------------------------------------------




| |  |  | difficulties in and costs of staffing and managing foreign operations;
| | - |  | ----------------------------------------------------------------------




| |  |  | reduced protection for intellectual property rights in some countries;
| | - |  | ----------------------------------------------------------------------




| |  |  | currency fluctuations; and
| | - |  | --------------------------




| |  |  | potentially adverse tax consequences.
| | - |  | -------------------------------------




Our international sales are currently denominated in U.S. dollars. As a result, an increase in the value of the U.S. dollar relative to foreign currencies could make our products less price competitive in international markets. In
the future, we may elect to invoice some of our international customers in local currency, which could subject us to fluctuations in exchange rates between the U.S. dollar and the local currency.




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The long sales and implementation cycles for our products may cause revenues and operating results to
vary significantly.





An end customers decision to purchase our products often involves a significant
commitment of its resources and a lengthy evaluation and product qualification process. Throughout the sales cycle, we often spend considerable time educating and providing information to prospective customers regarding the use and benefits of our
products. Budget constraints and the need for multiple approvals within enterprises, carriers and government entities may also delay the purchase decision. Failure to obtain the required approval for a particular project or purchase decision may
delay the purchase of our products. As a result, the sales cycle for our security systems is typically 60 to 90 days. Additionally, our security systems and intrusion detection and prevention products are complex systems designed for the enterprise
and service provider markets. These systems and products require us to maintain a sophisticated sales force, engage in extensive negotiations, and provide high-level engineering support to complete sales. If these systems and products are not
successful with enterprise and service provider customers, our operating results will be below our expectations and the expectations of investors and market analysts, which would likely cause the price of our common stock to decline.





Even after making the decision to purchase our products, our end customers may not deploy our products broadly within their
networks. The timing of implementation can vary widely and depends on the skill set of the end customer, the size of the network deployment, the complexity of the end customers network environment and the degree of hardware and software
configuration necessary to deploy our products. End customers with large networks usually expand their networks in large increments on a periodic basis. Large deployments and purchases of our security systems also require a significant outlay of
capital from end customers.





If we fail to develop or maintain relationships with value-added resellers or distribution partners, or
if our value-added resellers or distribution partners are not successful in their sales efforts, sales of our products may decrease and our operating results would suffer.





In the year ended September 30, 2002, we derived approximately 86.9% of our total revenues from value-added resellers and distributors. We expect our revenues to continue
to depend in large part on the performance of these third-party distributors and resellers. In addition, our value-added resellers and distributors may be unsuccessful in selling our products and services, may sell products and services that are
competitive with ours, may devote more resources to competitive products and may cease selling our products and services altogether. The loss of or reduction in sales to our value-added resellers or distributors could materially reduce our revenues.
If we fail to develop and maintain additional relationships with these distribution partners, or if these partners are not successful in their sales efforts, sales of our products may decrease and our operating results would suffer.





We may experience issues with our financial systems, controls and operations that could harm our financial condition and results of operations.





Our ability to sell our products and implement our business plan successfully in a volatile and growing
market requires effective management and financial systems and a system of financial processes and controls. Growth is likely to place a considerable strain on our systems, processes and controls. Our anticipated growth in future operations will
continue to place a strain on our management systems, controls and resources. To address these issues, we will need to continue to improve our financial and managerial controls, reporting systems and procedures, and will need to continue to expand,
train and manage our work force worldwide. If we are unable to maintain an adequate level of financial processes and controls, we may not be able to accurately report our financial performance on a timely basis and our business and stock price would
be harmed.





Our reliance on third parties to manufacture, assemble and test our products could cause a delay in our ability to fill
orders, which might cause us to lose sales.





Flash Electronics, Inc. manufactures, assembles and tests the
NetScreen-100, NetScreen-50, NetScreen-25, NetScreen-204, NetScreen-208, NetScreen IDP-500 and NetScreen IDP-100 products at its Fremont, California




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facility. Solectron Corporation manufactures, assembles and tests the NetScreen-5400, NetScreen-5200, NetScreen-1000, NetScreen-500 and NetScreen-5XT products at its San Jose, California facility
and the NetScreen-5XP product at its facility in China. We currently do not have a long-term supply contract with either Flash Electronics or Solectron, and we purchase from these manufacturers on a purchase order basis. If we should fail to manage
our relationship with Flash Electronics or Solectron effectively, or if either of these manufacturers experiences delays, disruptions or quality control problems in its manufacturing operations, our ability to ship products to our customers could be
delayed.





The absence of dedicated capacity with Flash Electronics and Solectron means that, with little or no
notice, they could refuse to continue manufacturing some or all of our products. Qualifying a new contract manufacturer and commencing volume production is expensive and time-consuming. If we are required or choose to change contract manufacturers,
we would lose revenues and damage our customer relationships.





Our proprietary GigaScreen and GigaScreen-II ASICs,
which are key to the functionality of our hardware-based products, are fabricated by foundries operated by Toshiba America Electronic Components, Inc. We have no long-term contract with Toshiba and purchase our ASICs on a purchase order basis. If
Toshiba materially delays its supply of ASICs to us, or requires us to find an alternate supplier and we are not able to do so on a timely and reasonable basis, our business would be harmed.





Our reliance on third-party manufacturers also exposes us to the following risks outside our control:





| |  |  | unexpected increases in manufacturing and repair costs;
| | - |  | -------------------------------------------------------




| |  |  | interruptions in shipments if one of our manufacturers is unable to complete production;
| | - |  | ----------------------------------------------------------------------------------------




| |  |  | inability to control quality of finished products;
| | - |  | --------------------------------------------------




| |  |  | inability to control delivery schedules;
| | - |  | ----------------------------------------




| |  |  | unpredictability of manufacturing yields;
| | - |  | -----------------------------------------




| |  |  | financial strength to meet procurement and manufacturing needs; and
| | - |  | -------------------------------------------------------------------




| |  |  | potential lack of adequate capacity to provide all or a part of the services we require.
| | - |  | ----------------------------------------------------------------------------------------




Our reliance on single or limited sources for key components may inhibit our ability to deliver products to our customers, which would negatively impact
present and future sales.





We currently purchase several key components, including semiconductors, from single
or limited sources. We carry very little inventory of some of our products and product components, and we rely on our suppliers to deliver necessary components to our contract manufacturers in a timely manner based on the forecasts we provide. Some
of the semiconductors we require are very complex, and we may not be able to develop an alternate source in a timely manner, which could hurt our ability to deliver our products to our customers. We also purchase power supplies from a single source
and purchase other custom components from other sole or limited sources. If we are unable to buy these components on a timely basis, we will not be able to deliver products to our customers, which would negatively impact present and future revenues
and, in turn, seriously harm our business.





At various times, some of the key components for our products, such as
flash memory, have been in short supply. Delays in receiving components would harm our ability to deliver our products on a timely basis. In addition, because we rely on purchase orders rather than long-term contracts with our suppliers, we cannot
predict with certainty our ability to procure components in the longer term. If we receive a smaller allocation of components than is necessary to manufacture products in quantities sufficient to meet customer demand, customers could choose to
purchase competing products.




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A breach of network security could harm public perception of our products, which could cause us to
lose revenues.





If an actual or perceived breach of network security occurs in one of our end customers
network systems, regardless of whether the breach is attributable to our products, the market perception of the effectiveness of our products could be harmed. This could cause us to lose current and potential end customers or cause us to lose
current and potential value-added resellers and distributors. Because the techniques used by computer hackers to access or sabotage networks change frequently and generally are not recognized until launched against a target, we may be unable to
anticipate these techniques.





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





We offer a warranty on all of our products, allowing the end customer to have any
defective unit repaired, or to receive a replacement product for it during the warranty period. Our products may contain undetected errors or defects. If there is a broad product failure across our customer base, we may decide to replace all
affected products or we may decide to refund the purchase price for defective units. Such defects and actions may adversely affect our ability to record revenue for units. Some errors are discovered only after a product has been installed and used
by end customers. Any errors discovered after commercial release could result in loss of revenues and claims against us.





If we are unable to fix errors or other problems that later are identified after full deployment, in addition to the consequence described above, we could experience:





| |  |  | failure to achieve market acceptance;
| | - |  | -------------------------------------




| |  |  | loss of customers;
| | - |  | ------------------




| |  |  | loss of or delay in revenues and loss of market share;
| | - |  | ------------------------------------------------------




| |  |  | diversion of development resources;
| | - |  | -----------------------------------




| |  |  | increased service and warranty costs;
| | - |  | -------------------------------------




| |  |  | legal actions by our customers; and
| | - |  | -----------------------------------




| |  |  | increased insurance costs.
| | - |  | --------------------------




If our products do not interoperate with our end customers networks, installations would be delayed or cancelled, which could significantly reduce our revenues.





Our products are designed to interface with our end customers existing networks, each of which has different specifications and utilizes multiple protocol standards.
Many of our end customers networks contain multiple generations of products that have been added over time as these networks have grown and evolved. Our products must interoperate with all of the products within these networks as well as with
future products that might be added to these networks in order to meet our end customers requirements. If we find errors in the existing software used in our end customers networks, we may elect to modify our software to fix or overcome
these errors so that our products will interoperate and scale with their existing software and hardware. If our products do not interoperate with those within our end customers networks, installations could be delayed or orders for our
products could be cancelled, which could significantly reduce our revenues.





If we fail to predict our manufacturing requirements
accurately, we could incur additional costs or experience manufacturing delays, which could reduce our gross margins or cause us to lose sales.





Because we currently do not have long-term supply contracts with our contract manufacturers, they are not obligated to supply products to us for any specific period, in any specific quantity or at any
certain price, except as may be provided in a particular purchase order. We provide forecasts of our demand to our contract




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manufacturers up to six months prior to scheduled delivery of products to our customers. If we overestimate our requirements, our contract manufacturers may have excess inventory, which would
increase our costs. If we underestimate our requirements, our contract manufacturers may have an inadequate component inventory, which could interrupt manufacturing of our products and result in delays in shipments and revenues. In addition, lead
times for materials and components that we order vary significantly and depend on factors such as the specific supplier, contract terms and demand for each component at a given time. We may also experience shortages of components from time to time,
which also could delay the manufacturing of our products.





We may experience losses and may not achieve profitability.





We have incurred significant losses since our inception in October 1997. We may incur losses in the future.
As of September 30, 2002, we had an accumulated deficit of $132.6 million. We had net losses applicable to common stockholders of $41.1 million for the year ended September 30, 2002, $34.2 million for the year ended September 30, 2001, and $33.7
million for the year ended September 30, 2000. We have large fixed expenses, and we expect to continue to incur significant and increasing sales and marketing, research and development and administrative expenses. As a result, we will need to
continue generating higher revenues to achieve profitability. Revenue growth depends on many factors, including those described elsewhere in these Factors That May Affect Our Business and Future Results of Operations and Financial
Condition. Our revenues may not grow, our gross margins and operating margins may decline and we may not achieve or maintain profitability. A failure to achieve profitability or a delay in any anticipated timing to achieve profitability could
cause our stock price to decline.





We depend on our key personnel to manage our business effectively in a rapidly changing market, and
if we are unable to hire additional personnel or retain existing personnel, our ability to execute our business strategy would be impaired.





Our future success depends upon the continued services of our executive officers, including in particular Robert D. Thomas, Feng Deng and Yan Ke and other key engineering, sales, marketing and support
personnel. None of our officers or key employees is bound by an employment agreement for any specific term, and no one is constrained from terminating his or her employment relationship with us at any time. In addition, since a number of our
long-standing employees have most of their stock options or restricted stock vested, their economic incentive to remain in our employ may be diminished. Further, we do not have key person life insurance policies covering any of our employees. We
also intend to hire a significant number of engineering, sales, marketing and support personnel in the future, and we believe our success depends, in large part, upon our ability to attract and retain these key employees. Competition for qualified
personnel is intense, especially in the San Francisco Bay Area. In particular, we have experienced difficulty in hiring ASIC, software, system and test, and customer support engineers, and we may not be successful in attracting and retaining these
individuals. The loss of the services of any of our key employees, the inability to attract or retain qualified personnel in the future, or delays in hiring required personnel, could delay the development and introduction of, and negatively impact
our ability to sell, our products.





We might have to defend lawsuits or pay damages in connection with any alleged or actual failure
of our products and services.





Because our products and services provide and monitor network security and may
protect valuable information, we could face claims for product liability, tort or breach of warranty. Anyone who circumvents our security measures could misappropriate the confidential information or other property of end customers using our
products, or interrupt their operations. If that happens, affected end customers or others may sue us. In addition, we may face liability for breaches caused by faulty installation of our products by our service and support organizations. Provisions
in our contracts relating to warranty disclaimers and liability limitations may be unenforceable. Some courts, for example, have found contractual limitations of liability in standard computer and software contracts to be unenforceable in some
circumstances. Defending a lawsuit, regardless of its merit, could




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be costly and could divert management attention. Our business liability insurance coverage may be inadequate or future coverage may be unavailable on acceptable terms or at all.





If we fail to protect our intellectual property rights, end customers or potential competitors might be able to use our technologies to develop
their own solutions, which could weaken our competitive position or reduce our revenues.





We rely on a
combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. As of September 30, 2002, we have seven patent applications pending in the United States relating to the
design of our products, three of which has been extended to other countries. Our pending patent applications may not result in the issuance of any patents. Even if we obtain such patents, that will not guarantee that our patent rights will be
valuable, create a competitive barrier or will be free from infringement. Furthermore, if any patent is issued, it might be invalidated or circumvented or otherwise fail to provide us any meaningful protection. We also enter into confidentiality
agreements with our employees, consultants and corporate partners, and control the use, access to and distribution of our software, documentation and other proprietary information. Unauthorized parties may attempt to copy or otherwise obtain and use
our products or technology. Monitoring unauthorized use of our products is difficult, and the steps we have taken may not prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary
rights as fully as in the United States.





We could become subject to litigation regarding intellectual property rights that could be
costly and result in the loss of significant rights.





In recent years, there has been significant litigation
in the United States involving patents and other intellectual property rights. We may become a party to litigation in the future to protect our intellectual property or as a result of an alleged infringement of another partys intellectual
property. Claims for alleged infringement and any resulting lawsuit, if successful, could subject us to significant liability for damages and invalidation of our proprietary rights. These lawsuits, regardless of their success, would likely be
time-consuming and expensive to resolve and would divert management time and attention. Any potential intellectual property litigation could also force us to do one or more of the following:





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




| |  |  | obtain from the owner of the infringed intellectual property right a license to sell or use the relevant technology, which license might not be available on
reasonable terms or at all; or
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | redesign the products that use that technology.
| | - |  | -----------------------------------------------




If we are forced to take any of these actions, our business might be seriously harmed. Our insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability
that could be imposed.





The inability to obtain any third-party license required to develop new products and product enhancements
could require us to obtain substitute technology of lower quality or performance standards or at greater cost, which could seriously harm our business, financial condition and results of operations.





From time to time, we may be required to license technology from third parties to develop new products or product enhancements.
Third-party licenses may not be available to us on commercially reasonable terms or at all. The inability to obtain any third-party license required to develop new products or product enhancements could require us to obtain substitute technology of
lower quality or performance standards or at greater cost, which could seriously harm our business, financial condition and results of operations.




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We will record substantial expenses related to our issuance of stock options that will have a
material negative impact on our financial condition and results of operations.





We have granted stock options
under our stock option plans since November 1997. We are required to recognize, as a reduction of stockholders equity, deferred stock compensation equal to the difference between the deemed fair market value of our common stock for financial
reporting purposes and the exercise price of these options at the date of grant. This deferred stock compensation is amortized over the vesting period of the applicable options, generally four years, using the straight-line vesting method. At
September 30, 2002, approximately $42.2 million of deferred stock compensation related to employee stock options remained unamortized. The resulting amortization expense will have a material negative impact on our results of operations in future
periods through the quarter ending December 31, 2005.





Governmental regulations affecting the import or export of products could
negatively affect our revenues.





Governmental regulation of imports or exports or failure to obtain required
export approval of our encryption technologies could harm our international and domestic sales. The United States and various foreign governments have imposed controls, export license requirements and restrictions on the import or export of some
technologies, especially encryption technology. In addition, from time to time, governmental agencies have proposed additional regulation of encryption technology, such as requiring the escrow and governmental recovery of private encryption keys.





In particular, in light of recent terrorist activity, governments could enact additional regulation or
restrictions on the use, import or export of encryption technology. Additional regulation of encryption technology could delay or prevent the acceptance and use of encryption products and public networks for secure communications. This might
decrease demand for our products and services. In addition, some foreign competitors are subject to less stringent controls on exporting their encryption technologies. As a result, they may be able to compete more effectively than we can in the
domestic and international network security market.





Earthquakes, other natural disasters and power shortages may damage our
facilities or the facilities of third parties on which we depend.





Our corporate headquarters and two of our
third-party manufacturers are located in Northern California near major earthquake faults that have experienced earthquakes in the past. An earthquake or other natural disaster near our headquarters or near one or more of the facilities of third
parties upon which we rely could disrupt our operations or the operations of those parties. None of these disruptions would be covered by insurance, so the supply of our products could be limited, our business could be hampered and our financial
condition and results of operations could be harmed.





The price of our common stock is likely to be volatile.





The market prices of the securities of technology-related companies have been extremely volatile. Thus, the market price of our
common stock is likely to be subject to wide fluctuations. If our revenues do not grow or grow more slowly than we anticipate, if operating or capital expenditures exceed our expectations and cannot be reduced appropriately, or if some other event
adversely affects us, the market price of our common stock could decline. In addition, if the market for technology-related stocks or the stock market in general experiences a continued or greater loss in investor confidence or otherwise fails, the
market price of our common stock could decline for reasons unrelated to our business, results of operations and financial condition. The market price of our stock also might decline in reaction to events that affect other companies in our industry
even if these events do not directly affect us. General political or economic conditions, such as an outbreak of war, a recession or interest rate or currency rate fluctuations, could also cause the market price of our common stock to decline. Our
common stock has experienced, and is likely to continue to experience, these fluctuations in price, regardless of our performance.




38




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##### Table of Contents




The concentration of our capital stock ownership with insiders is likely to limit ability of other
stockholders to influence corporate matters.





Our executive officers, our directors and entities affiliated
with any of them together beneficially own approximately 42% of our outstanding common stock. As a result, these stockholders may be able to exercise control over matters requiring approval by our stockholders, including the election of directors
and approval of significant corporate transactions. This concentration of ownership might also have the effect of delaying or preventing a change in our control that might be viewed as beneficial by other stockholders.





Management could invest or spend our cash or cash equivalents and investments in ways that might not enhance our results of operations or market share.





We have made no specific allocations of our cash or cash equivalents and investments. Consequently,
management will retain a significant amount of discretion over the application of our cash or cash equivalents and investments and could spend the proceeds in ways that do not improve our operating results or increase our market share. In addition,
these proceeds may not be invested to yield a favorable rate of return.





Future sales of shares by existing stockholders could cause
our stock price to decline.





If our existing stockholders sell, or are perceived to sell, substantial amounts
of our common stock in the public market, the market price of our common stock could decline. As of September 30, 2002, there were 77,893,007 shares of common stock outstanding. Large portions of these freely tradeable shares are still held by the
same entities that purchased our preferred stock prior to our initial public offering. In October 2002, 5,762,502 shares resulting from the conversion of Series F preferred stock became saleable pursuant to Rule 144 of the Securities Act.
Additionally, 32,841,838 shares were held by directors, executive officers and other affiliates, that are subject to volume limitations under Rule 144, various vesting agreements and our quarterly and other blackout periods.
Furthermore, shares subject to outstanding options and warrants and shares reserved for future issuance under our stock option and purchase plans will become eligible for sale in the public market to the extent permitted by the provisions of various
vesting agreements, the lock-up agreements and Rules 144 and 701 under the Securities Act.





Provisions in our charter documents might
deter a company from acquiring us, which could inhibit a stockholder from receiving an acquisition premium for their shares.





We have adopted a classified board of directors. Our board is divided into three classes that serve staggered three-year terms. Only one class of directors will be elected each year, while the directors in the other classes will
continue on our board for the remainder of their terms. This classification of our board could make it more difficult for a third party to acquire, or could discourage a third party from acquiring, control of NetScreen since it would make it more
difficult and time-consuming to replace our then current directors. In addition, our stockholders are unable to call special meetings of stockholders, to act by written consent, to remove any director or the entire board of directors without a
supermajority vote or to fill any vacancy on our board of directors. Our stockholders must also meet advance notice requirements for stockholder proposals. Our board may also issue preferred stock without any vote or further action by the
stockholders. These provisions and other provisions under Delaware law could make it more difficult for a third party to acquire us, even if doing so would benefit our stockholders.




39




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Item 7A.Quantitative and Qualitative Disclosures About Market Risk.





We develop products in the United States and sell them worldwide. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign
markets. Since our sales are currently priced in U.S. dollars and are translated to local currency amounts, a strengthening of the dollar could make our products less competitive in foreign markets.





As of September 30, 2002, our investment portfolio consisted of money market funds, corporate-backed debt obligations, municipal bonds and
U.S. government discount notes, and earned interest at an average rate of 2.2%. We place investments with high quality issuers and limit the amount of credit exposure to any one issuer. These securities are subject to interest rate risks. Based on
our portfolio content and our ability to hold investments to maturity, we believe that, a hypothetical 10% increase or decrease in interest rates would not materially affect our interest income, although there can be no assurance of this.





Item 8.Financial Statements and Supplementary Data.





Financial
Statements





Our financial statements required by this item are set forth as a separate section of this report.
See Item 15(a)(1) for a listing of financial statements provided in the section titled Financial Statements.





Supplementary Data





The following tables set forth unaudited quarterly supplementary data
for each of the years in the two-year period ended September 30, 2002 (in thousands, except per share amounts):





Quarter EndedDecember 31


March 31


June 30


September 30Fiscal 2002Total revenues

$
28,973


$
32,037


$
36,411


$
41,061Gross margin


20,481



23,508



26,990



30,902Income (loss) from operations


(5,740
)


(3,910
)


(2,140
)


116Net loss


(5,710
)


(3,294
)


(2,442
)


(925
)Deemed dividend on Series E and F redeemable convertible preferred stock


(28,743
)










Net loss applicable to common stockholders


(34,453
)


(3,294
)


(2,442
)


(925
)Basic and diluted net loss per share applicable to common stockholders

$
(1.25
)

$
(0.05
)

$
(0.03
)

$
(0.01
)





Quarter EndedDecember 31


March 31


June 30


September 30Fiscal 2001Total revenues

$
17,156


$
19,068


$
23,003


$
26,336Gross margin


11,949



13,219



16,030



18,569Loss from operations


(8,299
)


(8,598
)


(8,999
)


(6,327
)Net loss


(7,800
)


(8,247
)


(8,820
)


(6,438
)Deemed dividend on Series E redeemable convertible preferred stock


(731
)


(731
)


(730
)


(731
)Net loss applicable to common stockholders


(8,531
)


(8,978
)


(9,550
)


(7,169
)Basic and diluted net loss per share applicable to common stockholders

$
(0.58
)

$
(0.56
)

$
(0.55
)

$
(0.38
)




40




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##### Table of Contents




Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.





Not applicable.





PART III





Item 10.Directors and Executive Officers of the Registrant.





Information relating to our executive officers and directors will be presented under the caption Executive Officers and Directors in our definitive proxy statement in connection with our 2003 Annual Meeting of
Stockholders to be held in February 2003. That information is incorporated into this report by reference.





Item 11.Executive Compensation.





Information relating to executive compensation will be presented under the caption Executive Compensation in our definitive proxy statement. That information is incorporated into this report by reference.





Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.





Information relating to the security ownership of our common stock by our management and other beneficial owners will be presented under the caption Security
Ownership of Certain Beneficial Owners and Management in our definitive proxy statement. That information is incorporated into this report by reference.





Item 13.Certain Relationships and Related Transactions.





During the years ended September 30, 2002 and 2001, we sold products and services to companies affiliated with the brother of Feng Deng, an executive officer and director of the Company. The total amount sold to these companies
during the years ended September 30, 2002 and 2001 was approximately $767,000 and $1,574,000, respectively.





During the year ended September 30, 2002, we sold products and services to companies affiliated with members of our Board of Directors. The total sold to these companies was approximately $124,000. As of September 30, 2002, accounts
receivable included approximately $10,000 due from these companies.





Other information relating to certain
relationships of our directors and executive officers and related transactions will be presented under the caption Certain Relationships and Related Transactions in our definitive proxy statement. That information is incorporated into
this report by reference.





Item 14.Controls and Procedures.





Within
the 90-day period prior to the filing of this Annual Report of Form 10-K, an evaluation was carried out under the supervision and with the participation of our management, including the Chief Executive Officer (the CEO) and Chief
Financial Officers (the CFO), of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, the CEO and CFO have concluded that our disclosure controls and procedures are effective
to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms. There
were no significant changes in our internal controls or in other factors that could significantly affect the disclosure controls subsequent to the date of that evaluation.




41




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##### Table of Contents




PART IV





Item 15.Exhibits, Financial Statement Schedules, and Reports on Form 8-K.





|(a)    Documents filed as part of this report: |  | 
|---------------------------------------------- |  | 




1.

Financial StatementsSelected Consolidated Financial Data

15Index to Consolidated Financial Statements

48Report of Ernst & Young LLP, Independent Auditors

49Consolidated Balance Sheets as of September 30, 2002 and 2001

50Consolidated Statements of Operations for the years ended September 30, 2002, 2001 and 2000

51Consolidated Statements of Redeemable Convertible Preferred Stock and Stockholders Equity (Net Capital
Deficiency) for the years ended September 30, 2002, 2001 and 2000

52Consolidated Statements of Cash Flows for the years ended September 30, 2002, 2001 and 2000

53Notes to Consolidated Financial Statements

542.

ScheduleSchedule IIValuation and Qualifying Accounts for the years ended September 30, 2002, 2001 and 2000

74Schedules other than that listed above have been omitted since they are either not required, not applicable, or because the information required is included
in the consolidated financial statements or the notes thereto.3.

Exhibits





The following exhibits are filed as a part of this
report:





Incorporated by ReferenceExhibit Number

Exhibit Description

Form

File No.

Date of First Filing

Exhibit Number

Filed Herewith2.01

Agreement and Plan of Merger, dated August 22, 2002, among the Registrant, Tango Acquisition Corp. and OneSecure, Inc.

8-K

000-33387

10/03/02

2.013.01

Registrants Form of Restated Certificate of Incorporation.

S-1

333-71048

10/05/01

3.023.02

Registrants Restated Bylaws, effective December 17, 2001.

10-Q

000-33387

05/15/02

3.014.01

Fifth Amended and Restated Investors Rights Agreement dated October 3, 2001.

S-1

333-71048

10/05/01

4.014.02

Specimen Stock Certificate representing shares of Registrants Common Stock.

S-1/A

333-71048

11/23/01

4.0210.01

Registrants 1997 Equity Incentive Plan, as amended August 10, 2001, and form of stock option agreement. (1)

S-1

333-71048

10/05/01

10.0210.02

Registrants 2001 Equity Incentive Plan, and form of stock option agreement. (1)

S-1/A

333-71048

12/10/01

10.0310.03

Registrants 2001 Employee Stock Purchase Plan. (1)

S-1/A

333-71048

12/10/01

10.04




42




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##### Table of Contents

Incorporated by ReferenceExhibit Number

Exhibit Description

Form

File No.

Date of First Filing

Exhibit Number

Filed Herewith10.04

Registrants 1997 Equity Incentive Plan form of stock option agreement for executive officers. (1)

S-1

333-71048

10/05/01

10.0510.05

OneSecure, Inc. 2000 Stock Option/Stock Issuance Plan, and forms of stock option agreements. (1)

S-8

333-100088

09/25/02

4.0110.06

Stock Option Agreement by and between OneSecure, Inc. and Nir Zuk dated as of January 24, 2001. (1)

8-K

000-33387

10/03/02

99.0610.07

Stock Option Agreement by and between OneSecure, Inc. and Nir Zuk dated as of July 5, 2001. (1)

8-K

000-33387

10/03/02

99.0710.08

Stock Option and Vesting Waiver Agreement by and between Nir Zuk and the Registrant dated August 22, 2002. (1)

8-K

000-33387

10/03/02

99.0810.09

Stock Vesting Waiver Agreement by and between Rakesh K. Loonkar and the Registrant dated August 22, 2002. (1)

8-K

000-33387

10/03/02

99.0910.10

Registrants Form of Restated Founders Restricted Stock Purchase Agreement. (1)

S-1

333-71048

10/05/01

10.0110.11

Restricted Common Stock Purchase Agreement by and between OneSecure, Inc. and Nir Zuk dated as of February 18, 2000.

8-K

000-33387

10/03/02

99.0410.12

Restricted Common Stock Purchase Agreement by and between OneSecure, Inc. and Rakesh K. Loonkar dated as of February 18, 2000.

8-K

000-33387

10/03/02

99.0510.13

Registrants Form of Offer Letter for executive officers. (1)

S-1

333-71048

10/05/01

10.0610.14

Offer Letter to Nir Zuk dated August 22, 2002. (1)(2)

8-K

000-33387

10/03/02

99.0210.15

Offer Letter to Rakesh K. Loonkar dated August 22, 2002. (1)(2)

8-K

000-33387

10/03/02

99.0310.16

Form of Noncompetition Agreement by and between the Registrant and each of Nir Zuk and Rakesh K. Loonkar dated August 22, 2002.

8-K

000-33387

10/03/02

99.1010.17

Form of Indemnity Agreement to be entered into by and between the Registrant and each executive officer and director.

S-1

333-71048

10/05/01

10.0710.18

Form of Promissory Notes from executive officers to the Registrant made in connection with exercise of options.

S-1

333-71048

10/05/01

10.0810.19

Manufacturing Agreement by and between Flash Electronics, Inc. and the Registrant dated January 3, 2002. (2)

10-Q

000-33387

02/14/02

10.01




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##### Table of Contents

Incorporated by ReferenceExhibit Number

Exhibit Description

Form

File No.

Date of First Filing

Exhibit Number

Filed Herewith10.20

Master Lease Agreement by and between Comdisco, Inc. and the Registrant dated October 27, 1998.

S-1

333-71048

10/05/01

10.1010.21

Software and License Agreement by and between Information Resource Engineering, Inc. (now SafeNet, Inc.) and the Registrant dated June 30, 2000.

S-1

333-71048

10/05/01

10.1210.22

Lease Agreement by and between Ariba, Inc. and the Registrant dated October 18, 2002.









X10.23

Sublease Agreement by and between Philips Electronics North America Corporation and the Registrant dated September 29, 2000.

S-1

333-71048

10/05/01

10.1310.24

Purchase/Service Agreement by and between Avaya, Inc. and the Registrant dated November 21, 2000.

S-1

333-71048

10/05/01

10.1410.25

Manufacturing Agreement by and between A-Plus Manufacturing Corporation (now Solectron Corporation) and the Registrant dated December 15, 2000.
(1)

S-1

333-71048

10/05/01

10.1510.26

Loan and Security Agreement by and between GATX Ventures, Inc. and the Registrant dated April 13, 2001.

S-1

333-71048

10/05/01

10.1610.27

Amendment #1 to Software License Agreement by and between Information Resource Engineering, Inc. (now SafeNet, Inc.) and the Registrant dated June 22,
2001.

S-1

333-71048

10/05/01

10.1710.28

Amendment #2 to Software License Agreement by and between SafeNet, Inc. and the Registrant dated December 26, 2001. (3)









X10.29

International Customer Agreement by and between IBM Global Services and the Registrant dated July 25, 2001.

S-1

333-71048

10/05/01

10.1810.30

Master Loan and Security Agreement by and between Wells Fargo Equipment Finance, Inc. and the Registrant dated August 17, 2001.

S-1

333-71048

10/05/01

10.1921.01

List of Registrants subsidiaries.









X23.01

Consent of Ernst & Young LLP, Independent Auditors.









X


---

|(1) |  | Represents a management contract or compensatory plan or arrangement.
|--- |  | ---------------------------------------------------------------------

|(2) |  | Confidential treatment has been granted with respect to certain portions of this agreement. Such portions were omitted from the respective filing and were filed
separately with the Securities and Exchange Commission.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) |  | Confidential treatment has been requested for portions of this exhibit. These portions have been omitted from this filing and have been filed separately with
the Securities and Exchange Commission.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



44




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##### Table of Contents




(b)    Reports on Form 8-K





On October 3, 2002, Registrant filed a Current Report on Form 8-K under Item 2 (Acquisition or Disposition of Assets) reporting its September 18, 2002 acquisition of
OneSecure, Inc.





On November 27, 2002, Registrant filed an amendment to its October 3, 2002 Current Report on Form
8-K to file required financial statements under Item 7 (Financial Statements and Exhibits).




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##### Table of Contents




SIGNATURES





Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Sunnyvale, State of California, on this 30th day of December, 2002.





NETSCREEN TECHNOLOGIES, INC.By:

/s/    ROBERT D.
THOMASRobert D. Thomas President,
Chief Executive Officer and Director





Pursuant to the requirements of the Securities Exchange Act of
1934, this Annual Report on Form 10-K has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.





Name

Title

DatePrincipal Executive Officer:/s/    ROBERT D.
THOMAS

President, Chief Executive Officer

December 30, 2002Robert D. Thomas

and DirectorPrincipal Financial Officer andPrincipal Accounting Officer:/s/    REMO E.
CANESSA

Chief Financial Officer

December 30, 2002Remo E. Canessa

and Corporate SecretaryAdditional Directors:/s/    FENG DENG

Vice President of Engineering

December 30, 2002Feng Deng

and Director/s/    ALAN L.
EARHART

Director

December 30, 2002Alan L. Earhart/s/    MICHAEL L.
GOGUEN

Director

December 30, 2002Michael L. Goguen


/s/    KATHERINE M.
JEN

Director

December 30, 2002Katherine M. Jen/s/    FRANK J.
MARSHALL

Director

December 30, 2002Frank J. Marshall/s/    THOMAS F.
MENDOZA

Director

December 30, 2002Thomas F. Mendoza/s/    VICTOR E. PARKER,
JR.

Director

December 30, 2002Victor E. Parker, Jr.




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##### Table of Contents




CERTIFICATION PURSUANT TO


SECTION 302 OF THE


SARBANES-OXLEY ACT OF 2002





I, ROBERT D. THOMAS, certify that:





1.    I have reviewed this annual report on Form 10-K of NetScreen Technologies, Inc.;





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





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





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





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




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




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




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





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




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




6.    The registrants other certifying officers and I have indicated
in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.





Date: December 30, 2002


By:

/s/    ROBERT D.
THOMASRobert D. Thomas President,
Chief Executive Officer




47




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##### Table of Contents




CERTIFICATION PURSUANT TO


SECTION 302 OF THE


SARBANES-OXLEY ACT OF 2002





I, REMO E. CANESSA, certify that:





1.    I have reviewed this annual report on Form 10-K of NetScreen Technologies, Inc.;





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





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





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





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




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




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




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





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




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




6.    The registrants other certifying officers and I have indicated
in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.





Date: December 30, 2002

By:

/s/    REMO E.
CANESSARemo E. Canessa Chief
Financial Officer




48




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##### Table of Contents




NETSCREEN TECHNOLOGIES, INC.


INDEX TO CONSOLIDATED FINANCIAL STATEMENTS








PageReport of Ernst & Young LLP, Independent Auditors

50Consolidated Balance Sheets as of September 30, 2002 and 2001

51Consolidated Statements of Operations for the years ended September 30, 2002, 2001 and 2000

52Consolidated Statements of Redeemable Convertible Preferred Stock and Stockholders Equity (Net Capital
Deficiency) for the years ended September 30, 2002, 2001 and 2000

53Consolidated Statements of Cash Flows for the years ended September 30, 2002, 2001 and 2000

55Notes to Consolidated Financial Statements

57




49




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##### Table of Contents




REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS





The Board of Directors and Stockholders


NetScreen Technologies, Inc.





We have audited the accompanying consolidated balance sheets of NetScreen Technologies, Inc. as of September 30, 2002 and 2001,
and the related consolidated statements of operations, redeemable convertible preferred stock and stockholders equity (net capital deficiency), and cash flows for each of the three years in the period ended September 30, 2002. Our audits also
included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial
statements and schedule based on our audits.





We conducted our audits in accordance with auditing standards
generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.





In our opinion, the
financial statements referred to above present fairly, in all material respects, the consolidated financial position of NetScreen Technologies, Inc. at September 30, 2002 and 2001, and the consolidated results of their operations and their cash
flows for each of the three years in the period ended September 30, 2002, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation
to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.





/S/     ERNST & YOUNG LLP





|San |  | Jose, California
|--- |  | ----------------

|October |  | 23, 2002
|------- |  | --------



50




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##### Table of Contents




NETSCREEN TECHNOLOGIES, INC.





CONSOLIDATED BALANCE SHEETS


(in thousands, except share and per share
amounts)





September 30,2002


2001AssetsCurrent assets:Cash and cash equivalents

$
11,153


$
11,505Short-term investments


238,711



6,150Restricted cash


1,611



3,236Accounts receivable, net of allowances for doubtful accounts and sales returns of $7,784 and $5,184 at September 30,
2002 and 2001


18,046



16,355Inventories


2,249



1,877Other current assets


5,231



2,814Total current assets


277,001



41,937Property and equipment


6,264



6,186Restricted cash






1,377Intangible assets


5,759



Goodwill


56,807



Other assets


853



701Total assets

$
346,684


$
50,201Liabilities, Redeemable Convertible Preferred Stock and Stockholders Equity(Net Capital Deficiency)Current liabilities:Accounts payable

$
5,027


$
4,586Accrued expenses


11,452



6,977Accrued compensation


6,909



4,632Accrued income taxes


1,865



164Deferred revenue


26,150



15,737Current portion of restructuring liabilities


541



Current portion of debt and capital lease obligations


1,761



1,511Total current liabilities


53,705



33,607Restructuring liabilities, less current portion


2,577



Long-term portion of debt and capital lease obligations


1,513



2,663Commitments and contingenciesRedeemable convertible preferred stock, $0.001 per value, issuable in series:Authorized sharesnone at September 30, 2002; 33,600,000 at September 30, 2001Issued and outstanding sharesnone at September 30, 2002; 32,473,082 at September 30,2001






56,542Stockholders equity (net capital deficiency):Preferred stock, $0.001 par value:Authorized shares10,000,000 at September 30, 2002; none at September 30, 2001Issued and outstanding shares: none at September 30, 2002 and 2001






Common stock, $0.001 par value:Authorized shares500,000,000 and 100,000,000 at September 30, 2002 and 2001Issued and outstanding shares77,893,007 and 23,780,742 at September 30, 2002 and 2001


78



24Additional paid-in capital


464,524



105,267Accumulated deficit


(132,550
)


(91,436
)Accumulated other comprehensive gain


501



Deferred stock compensation


(42,162
)


(54,895
)Stockholders notes receivable


(1,502
)


(1,571
)Total stockholders equity (net capital deficiency)


288,889



(42,611
)Total liabilities, redeemable convertible preferred stock and stockholders equity (net capital
deficiency)

$
346,684


$
50,201





See accompanying notes.




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NETSCREEN TECHNOLOGIES, INC.


CONSOLIDATED STATEMENTS OF OPERATIONS





(in thousands, except
share and per share amounts)





Year Ended September 30,2002


2001


2000Revenues:Product

$
113,943


$
71,197


$
23,438Maintenance and service


24,539



14,366



3,146Total revenues


138,482



85,563



26,584Cost of revenues:Product (1) (2)


28,729



22,128



6,578Maintenance and service (1)


7,872



3,668



1,797Total cost of revenues


36,601



25,796



8,375Gross margin


101,881



59,767



18,209Operating expenses:Research and development (1) (2)


32,845



25,595



14,365Sales and marketing (1) (2)


63,914



54,784



27,536General and administrative (1)


16,796



11,611



9,786Total operating expenses


113,555



91,990



51,687Loss from operations


(11,674
)


(32,223
)


(33,478
)Interest expense


(470
)


(258
)


(202
)Interest and other income


3,831



1,344



659Loss before income taxes


(8,313
)


(31,137
)


(33,021
)Provision for income taxes


(4,058
)


(168
)


Net loss


(12,371
)


(31,305
)


(33,021
)Deemed dividend on Series E and F redeemable convertible preferred stock


(28,743
)


(2,923
)


(699
)Net loss applicable to common stockholders

$
(41,114
)

$
(34,228
)

$
(33,720
)Basic and diluted net loss per share applicable to common stockholders

$
(0.68
)

$
(2.05
)

$
(2.82
)Shares used in computing basic and diluted net loss per share applicable to common stockholders


60,564



16,696



11,954(1) Includes stock-based compensation of the following:Cost of product revenues

$
1,644


$
1,405


$
991Cost of maintenance and service revenues


1,017



1,210



671Research and development


7,665



6,376



4,082Sales and marketing


11,116



9,348



5,993General and administrative


2,817



704



3,003Total stock-based compensation

$
24,259


$
19,043


$
14,740(2) Includes amortization of intangible assets of the following:Cost of product revenues

$
31Research and development


4Sales and marketing


6Total amortization of intangible assets

$
41





See accompanying notes.




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NETSCREEN TECHNOLOGIES, INC.





CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS EQUITY


(NET CAPITAL DEFICIENCY)


(in thousands, except share and per share amounts)





Redeemable Convertible Preferred Stock


Common Stock


Additional Paid-in Capital


Accumulated Deficit


Accumulated Other
Comprehensive Gain

Deferred Stock Compensation


Stockholders Notes Receivable


Total Stockholders Equity(Net Capital Deficiency)Shares

Amount


Shares


AmountBalance at September 30, 1999

22,896,786

$
16,497


18,043,906


$
18


$
20,598


$
(23,488
)

$


$
(8,457
)

$
(364
)

$
(11,693
)Repurchase of founders stock







(733,334
)


(1
)


(1
)

















(2
)Issuance of Series E convertible preferred stock at $3.82 per share, net of issuance costs of $101

9,576,296


36,433





























Deemed dividend on Series E convertible preferred stock




699














(699
)













(699
)Issuance of common stock under stock option plan at $0.0005 to $2.50







6,990,774



7



2,930














(1,476
)


1,461Issuance of common stock upon exercise of nonplan stock options at $0.0005 to $0.75







490,000



1



255














(210
)


46Repurchase of common stock







(122,500
)






(30
)

















(30
)Compensation expense for options to consultants















1,515


















1,515Deferred stock compensation















101,073










(101,073
)






Amortization of deferred stock compensation


























14,740







14,740Reversal of deferred compensation for terminated employees















(13,613
)









13,613







Net loss and other comprehensive loss



















(33,021
)













(33,021
)Balance at September 30, 2000

32,473,082


53,629


24,668,846



25



112,727



(57,208
)





(81,177
)


(2,050
)


(27,683
)Issuance costs of Series E convertible preferred stock




(10
)




























Deemed dividend on Series E convertible preferred stock




2,923














(2,923
)













(2,923
)Issuance of common stock under stock option plan at $0.075 to $5.00







69,582







129


















129Issuance of common stock upon exercise of nonplan stock options at $0.50







30,000







15


















15Repurchase of common stock







(987,686
)


(1
)


(476
)













399



(78
)Repayment of stockholders note






























80



80Issuance of warrants in connection with debt arrangements















111


















111Deferred stock compensation















6,804










(6,804
)






Amortization of deferred stock compensation


























19,043







19,043Reversal of deferred stock compensation for terminated employees















(14,043
)









14,043







Net loss and other comprehensive loss



















(31,305
)













(31,305
)Balance at September 30, 2001

32,473,082


56,542


23,780,742



24



105,267



(91,436
)





(54,895
)


(1,571
)


(42,611
)




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NETSCREEN TECHNOLOGIES, INC.





CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS EQUITY


(NET CAPITAL DEFICIENCY)(Continued)


(in thousands, except share and per share amounts)





Redeemable Convertible Preferred Stock


Common Stock

Additional Paid-in Capital


Accumulated Deficit


Accumulated Other
Comprehensive Gain

Deferred Stock Compensation


Stockholders Notes Receivable


Total Stockholders Equity(Net Capital Deficiency)Shares


Amount


Shares


AmountBalance at September 30, 2001

32,473,082


$
56,542


23,780,742


$
24

$
105,267


$
(91,436
)

$


$
(54,895
)

$
(1,571
)

$
(42,611
)Issuance of Series F convertible preferred stock at $5.21 per share, net of issuance cost of $278

5,762,502



29,722




























Deemed dividend on Series E and F convertible preferred stock





28,743













(28,743
)













(28,743
)Issuance of common stock in initial public offering at $16.00 per share, net of issuance costs of $15,361








11,500,000



12


168,627


















168,639Conversion of redeemable convertible preferred stock into common stock

(38,235,584
)


(115,007
)

38,235,584



38


114,969


















115,007Issuance of common stock and stock options in connection with the acquisition OneSecure, Inc.








3,185,978



3


59,600










(587
)


(7
)


59,009Issuance of common stock under stock option plans at $0.13 to $6.00








1,038,600



1


2,678


















2,679Issuance of common stock upon exercise of nonplan stock options at prices ranging from $0.50 to $5.00









62,000






59


















59Issuance of common stock under employee stock purchase plan at $8.36








86,360






722


















722Tax benefits from employee stock option plans















1,295


















1,295Issuance of common stock upon net exercise of warrants








111,884

























Repurchase of common stock








(108,141
)





(56
)

















(56
)Repayment of stockholders notes






























76



76Compensation expense related to accelerated vesting of stock options















360


















360Compensation expense related to stock options granted to consultant















64


















64Deferred stock compensation















13,461










(13,461
)






Amortization of deferred stock compensation


























24,259







24,259Reversal of deferred stock compensation for terminated employees















(2,522
)









2,522







Comprehensive loss:Net loss



















(12,371
)













(12,371
)Unrealized gain on available-for-sale investments























501










501Comprehensive loss


































(11,870
)Balance at September 30, 2002




$



77,893,007


$
78

$
464,524


$
(132,550
)

$
501

$
(42,162
)

$
(1,502
)

$
288,889





See accompanying notes.




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NETSCREEN TECHNOLOGIES, INC.


CONSOLIDATED STATEMENTS OF CASH FLOWS


(in thousands)





Year Ended September 30,2002


2001


2000Operating activitiesNet loss

$
(12,371
)

$
(31,305
)

$
(33,021
)Adjustments to reconcile net loss to net cash provided by (used in) operating activities:Depreciation and amortization


3,402



2,172



686Net loss on disposal of property and equipment


654







199Amortization of deferred stock compensation


24,259



19,043



14,740Tax benefits from employee stock option plans


1,295







In-process research and development charge


200







Compensation expense for options granted to consultants


64







1,515Compensation expense related to accelerated vesting of stock options


360







Compensation expense related to warrants issued in connection with debt arrangements


33



23



Changes in operating assets and liabilities:Accounts receivable (net of allowances)


(1,414
)


(5,819
)


(8,311
)Inventories


(299
)


(78
)


(1,043
)Other current assets


(1,743
)


(1,558
)


(1,001
)Other assets


43



(257
)


(154
)Accounts payable


(1,141
)


(1,354
)


4,856Accrued expenses


4,218



3,287



2,809Accrued compensation


2,083



2,730



1,063Accrued income taxes


1,701



164



Deferred revenue


10,340



6,101



7,624Net cash provided by (used in) operating activities


31,684



(6,851
)


(10,038
)Investing activitiesPurchase of property and equipment


(3,366
)


(5,605
)


(1,653
)Cash used in business combination, net of cash acquired


(600
)






Purchases of short-term investments


(372,427
)


(19,850
)


(6,200
)Maturities of short-term investments


140,367



19,500



400Net cash used in investing activities


(236,026
)


(5,955
)


(7,453
)Financing activitiesProceeds from borrowing arrangements


944



3,325



5Principal payments on debt and capital lease obligations


(1,858
)


(642
)


(300
)Restricted cash


3,063



(4,577
)


Proceeds from initial public offering of common stock, net


168,639







Proceeds from issuance of common stock under stock option and stock purchase plans, net of repurchases


3,404



66



1,477Proceeds from issuance of redeemable convertible preferred stock, net


29,722



(10
)


36,433Repayment of stockholders notes


76



80



Repurchase of founders stock










(2
)Net cash provided by (used in) financing activities


203,990



(1,758
)


37,613Net increase (decrease) in cash and cash equivalents


(352
)


(14,564
)


20,122Cash and cash equivalents at beginning of period


11,505



26,069



5,947Cash and cash equivalents at end of period

$
11,153


$
11,505


$
26,069




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##### Table of Contents

NETSCREEN TECHNOLOGIES, INC.


CONSOLIDATED STATEMENTS OF CASH FLOWS(Continued)


(in thousands)





Year Ended September 30,2002

2001

2000Supplemental disclosures of cash flow informationCash paid for interest

$
509

$
213

$
176Cash paid for taxes

$
1,089

$


$
Supplemental schedule of noncash investing and financing activitiesProperty and equipment acquired under capital lease

$


$
490

$
526Issuance of warrants in connection with debt arrangements

$


$
111

$
Issuance of common stock for business combination

$
59,009

$


$
Deferred stock compensation related to options issued below fair market value

$
13,461

$
6,804

$
101,073Reversal of deferred stock compensation for terminated employees

$
2,522

$
14,043

$
13,613Deemed dividends on Series E and F preferred stock

$
28,743

$
2,923

$
699Conversion of preferred stock to common stock

$
115,007

$


$












See accompanying notes.




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NETSCREEN TECHNOLOGIES, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





1.    The Company and Summary of Significant Accounting Policies





The Company





NetScreen Technologies, Inc. (the Company or
NetScreen) was incorporated in Delaware on October 30, 1997. NetScreen develops, markets and sells a broad family of integrated network security solutions. NetScreens solutions provide key security technologies, such as
virtual private network, denial of service protection, firewall and intrusion detection and prevention, in a line of easy-to-manage security systems and appliances.





NetScreens firewall and VPN systems and appliances deliver integrated firewall, virtual private network and denial of service protection capabilities in a single
device using our proprietary application specific integrated circuits, referred to as the GigaScreen and GigaScreen II ASICs, and proprietary security operating systems and applications, referred to as ScreenOS. In addition, the Companys
family of intrusion detection and prevention appliances run a secure version of the Linux operating system and use proprietary software and multiple detection methods to identify network and application attacks and prevent them from reaching
mission-critical resources.





The Companys security systems and appliances can be centrally managed with
flexible management software. For the Companys firewall and VPN systems and appliances, the Companys NetScreen Global-PRO and Global-PRO Express enable secure, scalable monitoring of devices, network traffic and security events and
policy administration. For the Companys IDP appliances, the Companys NetScreen-IDP Manager gives administrators control over which traffic the IDP appliance should examine and how it should respond when intrusions are detected.





Recent Events





The Company completed the sale of a total of 11,500,000 shares of common stock in December 2001 in an initial public offering (IPO) at a price of $16.00 per
share. The Company received net proceeds of approximately $168.6 million upon the consummation of the IPO. See Note 10 Stockholders Equity for additional details.





On September 18, 2002, the Company acquired OneSecure, Inc. (OneSecure), a developer of intrusion detection and prevention technology for a total purchase price
of $60.3 million. The transaction was accounted for under the purchase method of accounting. The consolidated results of operations include OneSecures results of operations from September 18, 2002. See Note 4 Business Combination
for additional details.





Accounting Policies





Revenue recognition





The
Company derives revenues primarily from sales of its hardware-based security systems and appliances and maintenance arrangements, and, to a lesser extent, from sales of software products and services. The Company generally recognizes revenues when
persuasive evidence of an arrangement exists, delivery or customer acceptance, where applicable, has occurred, the fee is fixed or determinable, and collection is probable. For newly introduced technically complex products, the Company defers
revenues from the sale of these products until they have successfully performed in the marketplace and sales returns are not unusually high. The determination of which products are complex, and the timing of the end of deferral for particular
products, can be expected to vary.





The Company defers revenues on sales to its distributors until the distributor
has sold the products to its customers. The Companys agreements with distributors provide for limited stock rotation and price protection




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##### Table of Contents

rights. Stock rotation rights provide distributors with the right to exchange unsold inventory for alternate products of equal or greater value. Price protection rights grant distributors the
right to credit on future purchases in the event of decreases in the prices of the Companys products. The Companys agreements with value-added resellers typically do not include stock rotation or price protection rights. At the time of
shipment to value-added resellers, the Company reserves for estimated returns and exchanges. These revenue reserves are estimated and adjusted periodically based on historical rates of returns and allowances, inventory levels for value-added
resellers that submit inventory or sell-through reports, the volume of sales to value-added resellers that the Company ships directly to end customers, and for sales to value-added resellers that do not submit inventory or sell-through reports,
accounts receivable balances, payment history and other related factors.





The Company defers
a portion of its product revenues based on the value of certain maintenance arrangements included with each product sale and recognizes these revenues over the applicable maintenance period. The Company also derives a portion of its revenues from
sales of separate extended maintenance arrangements. The Company sells extended hardware maintenance, faster hardware replacements for defective units, software maintenance as well as world-wide technical support with access 24 hours a day, seven
days a week. These arrangements are sold as a bundle or as separate support offerings providing only hardware maintenance, technical support or software maintenance. For bundled arrangements, revenue is allocated among the elements at the time of
sale based on their fair values as determined by the prices charged by the Company when each element is sold separately (renewal rate). Revenue from extended maintenance arrangements is recognized over the period of coverage purchased by the
customer.





Accounts receivable





The Company has a large, diversified customer base, which includes customers located in foreign countries. The Company monitors the creditworthiness of its customers but
has experienced losses related to its accounts receivable in the past. The Company records an allowance for doubtful accounts based on past history, current economic conditions and the composition of its accounts receivable aging and, in some cases,
makes allowances for specific customers based on several factors, such as the creditworthiness of those customers and payment history.





Sales return reserve





The Company regularly records a sales return reserve that
approximates the aggregate dollar amount of expected future returns and allowances. The sales return reserve is calculated based on past return history, product mix, channel mix and, in some cases, allowances for specific customers based on several
factors such as return rights included in the Companys agreements with customers.





Inventory





Given the volatility of the networking market, the rapid obsolescence of technology and short product life
cycles, the Company writes down inventories to net realizable value based on backlog and forecasted demand.





Warranty obligations





The Companys hardware products carry a one-year warranty that
includes factory repair services or replacement parts as needed. The Company accrues estimated expenses for warranty obligations at the time that products are shipped based on historical product repair and replacement information.





Valuation of Long-Lived Assets Including Goodwill and Other Intangible Assets





The Company reviews property, plant and equipment, goodwill and other intangible assets for impairment whenever events or circumstances
indicate the carrying amount of the assets may not be recoverable. The




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Companys review of goodwill and other intangible assets is based on the estimated future cash flows the assets are expected to generate. The Companys review is based on its best
estimate of a variety of factors, including future market growth, forecasted revenues and costs and a strategic review of its business and operations. In the event the Company determines that an asset is impaired in the future, an adjustment to the
value of the asset would be charged to earnings in the period such determination is made.





Principles of
consolidation





The consolidated financial statements include the Companys accounts and those of its
wholly owned subsidiaries. Upon consolidation, all significant intercompany accounts and transactions have been eliminated.





Foreign currency transactions





Foreign currency transactions of foreign operations are
measured using U.S. dollars as the functional currency. Accordingly, monetary accounts (principally cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities) are remeasured using the foreign exchange rate at the
balance sheet date. Accounts related to operations and non-monetary balance sheet items are remeasured at the rate in effect at the date of the transaction. The effects of foreign currency remeasurement are reported in current operations and were
immaterial for all periods presented.





Use of estimates





The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States
requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.





Reclassifications





Certain
amounts have been reclassified to conform to the current presentation.





Cash and cash equivalents





The Company considers all highly liquid investments with a maturity of three months or less at the date of
purchase to be cash equivalents. The carrying value of cash and cash equivalents approximated fair value at September 30, 2002 and 2001.





Concentrations of credit risk





Financial instruments that potentially subject the
Company to concentrations of credit risk consist primarily of cash equivalents, short-term investments and accounts receivable. The Company places all of its cash equivalents with high credit-rated issuers. Carrying amounts of financial instruments
held by the Company, which include cash equivalents, short-term investments, restricted cash, accounts receivable, accounts payable and accrued expenses, approximate fair value due to their short duration. The Company performs ongoing credit
evaluations of its customers, generally requires customers to prepay for maintenance and maintains reserves for potential losses. The Companys customer base is primarily composed of businesses throughout the United States, Europe and Asia.





Capitalized software





The Company capitalizes eligible software costs as products achieve technological feasibility, subject to net realizable value considerations. SFAS No.
86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed requires the capitalization of certain software development costs once




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technological feasibility is established, which the Company defines as the completion of a working model. Development costs incurred after the establishment of technological feasibility have not
been material and, therefore, have been expensed.





Advertising costs





The Companys policy is to expense advertising costs as incurred. The Companys advertising costs were approximately $630,000,
$4.3 million and $3.4 million for the years ended September 30, 2002, 2001 and 2000, respectively.





Stock-based
compensation





The Company accounts for stock-based awards to employees using the intrinsic value method in
accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25). Expenses associated with stock-based compensation are being amortized ratably over the vesting periods of the
individual awards consistent with the method described in FASB Interpretation No. 28. The Company provides additional pro forma disclosures as required under Statement of Financial Accounting Standards (SFAS) No. 123,
Accounting for Stock-Based Compensation (SFAS 123). Options granted to consultants and other non-employees are accounted for in accordance with Emerging Issues Task Force Consensus No. 96-18, Accounting for Equity
Investments That Are Issued to Other Than Employees for Acquiring, or In Conjunction with Selling, Goods or Services, and valued using the Black-Scholes method prescribed by SFAS 123. The options are subject to periodic revaluation over their
vesting periods.





Recent accounting pronouncements





In July 2001, the FASB issued Statement of Financial Accounting Standards No. 141, Business Combination (SFAS 141). SFAS 141 established new
standards for accounting and reporting for business combinations initiated after June 30, 2001. Use of the pooling-of-interests method is prohibited. The Company adopted this statement during the first quarter of fiscal 2002. The adoption of this
pronouncement did not have a material impact on the Companys operating results or financial position.





In
July 2001, the FASB issued Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142), which supersedes APB Opinion No. 17, Intangible Assets. SFAS 142 established new standards
for goodwill, including the elimination of goodwill amortization, which has been replaced with methods of periodically evaluating goodwill for impairment. The Company adopted this statement during the first quarter of fiscal 2002. The adoption of
this pronouncement did not have a material impact on the Companys operating results or financial position.





In August 2001, the FASB issued Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144). SFAS 144 superseded Statement of Accounting
Standards No. 121, Accounting for the Impairment of Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions relating to the disposal of a segment of a business in Accounting Principles Board No. 30. The Company
adopted SFAS 144 during the second quarter of fiscal 2002. The adoption of this pronouncement did not have a material impact on the Companys operating results or financial position.





In November 2001, the Emerging Issues Task Force (EITF) released Issue No. 01-09, Accounting for Consideration Given by a Vendor to a Customer or a
Reseller of the Vendors Product, which applies to annual or interim financial statement periods beginning December 15, 2001. This release requires that cash consideration (including sales incentives) that we give our customers or
resellers should be accounted for as a reduction of revenue unless we receive a benefit that is identifiable and that can be reasonably estimated. The Company adopted this release as of January 1, 2002. The adoption of this release did not have a
material impact on the Companys total revenues.




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In July 2002, the FASB issued Statement of Financial Accounting Standards No.
146, Accounting for Costs Associated with Exit or Disposal Activities (SFAS 146). SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue no. 94-3,
Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS 146 requires that a liability for a cost associated with an exit or disposal
activity be recognized when the liability is incurred rather than when the exit or disposal is approved. The Company will adopt this pronouncement on January 1, 2003. The adoption of this pronouncement is not expected to have a material impact on
the Companys operating results or financial position.





2.     Balance Sheet Details





Inventories





Inventories are stated at the lower of standard cost, which approximates actual (first-in, first-out method) or market value. The valuation of inventories at the lower of standard cost or market value
requires the use of estimates regarding the amount of inventory that will be sold and the prices at which current inventory will be sold. These estimates are dependent on the Companys assessment of current and expected orders from its
customers.





Inventories consisted of the following (in thousands):





September 30,2002

2001Raw materials

$
539

$
709Finished goods


1,710


1,168$
2,249

$
1,877





Property and Equipment





Property and equipment are carried at cost, net of accumulated depreciation and amortization. Depreciation is computed using the
straight-line method over the estimated useful lives of the property and equipment of one to three years. Leasehold improvements are amortized over the shorter of the lease term or the useful lives of the assets.





Property and equipment consisted of the following (in thousands):





September 30,2002


2001Computers and equipment

$
9,631


$
7,184Software


1,324



1,026Furniture and fixtures


545



564Leasehold improvements


530



60112,030



9,375Accumulated depreciation and amortization


(5,766
)


(3,189
)$
6,264


$
6,186





Property and equipment included assets under equipment financing
arrangements totaling approximately $4,833,000 and $4,973,000 at September 30, 2002 and 2001, respectively. The accumulated depreciation related to assets under equipment financing arrangements was approximately $2,881,000 and $1,832,000 at
September 30, 2002 and 2001, respectively.




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Intangible Assets





Intangible assets at September 30, 2002 are carried at cost less accumulated amortization. Amortization of intangible assets is computed
using the straight-line method over their expected useful lives ranging from three to ten years. Intangible assets, at September 30, 2002, consisted of the following (in thousands):





Intangible assets

$
5,800Accumulated amortization


(41
)$
5,759





Comprehensive Gain





Comprehensive gain and loss includes certain unrealized gains and losses that are recorded as a component of stockholders equity and
excluded from the determination of net loss. The Companys only component of accumulated other comprehensive gain was an unrealized gain on investments in the year ended September 30, 2002. The unrealized gain was approximately $501,000 as of
September 30, 2002. Comprehensive gains and losses were not material for the years ended September 30, 2001 and 2000.





3.     Net Loss Per Share





In accordance with SFAS 128, Earnings
Per Share, basic net loss per share is calculated using the weighted-average number of shares of common stock outstanding during the period, less shares subject to repurchase. Diluted net loss per share would give effect to any dilutive effect
of common stock equivalents consisting of convertible preferred stock, stock options and warrants (using the treasury method). Potentially dilutive securities have been excluded from the Companys diluted net loss per share computations as
their inclusion would be antidilutive. The total number of shares excluded from the computations of diluted net loss per share were approximately 12,614,000, 41,554,000 and 37,097,000 and for the years ended September 30, 2002, 2001 and 2000,
respectively.





The following table presents the calculation of historical basic and diluted net loss per share
applicable to common stockholders (in thousands, except per share amounts):





Year Ended September 30,2002


2001


2000Net loss applicable to common stockholders

$
(41,114
)

$
(34,228
)

$
(33,720
)Basic and diluted:Weighted-average shares of common stock outstanding


63,427



24,247



20,811Less weighted-average shares subject to repurchase(1)


(2,863
)


(7,551
)


(8,857
)Shares used in computing basic and diluted net loss per share applicable to common stockholders


60,564



16,696



11,954Basic and diluted net loss per share applicable to common stockholders

$
(0.68
)

$
(2.05
)

$
(2.82
)


---

|(1) |  | The weighted-average shares subject to repurchase represent unvested shares. Employees purchased shares by exercising options before the options had vested. In
addition, shares of common stock purchased by the founders are subject to vesting. The unvested shares are subject to a right of repurchase by the Company at the initial purchase price if the employee forfeits the shares before the employee
satisfies the service requirement, generally four years.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




4.    Business Combination





On September 18, 2002, the Company completed its acquisition of OneSecure, a developer of intrusion
protection and detection technology. The acquisition of OneSecure expanded NetScreens product portfolio to




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include an intrusion detection and prevention device, and allows NetScreen to enter the intrusion detection system market. The preliminary purchase price was $60.3 million and the transaction has
been accounted for as a purchase. NetScreen exchanged 3.2 million shares of its common stock with a fair value of $43.7 million for all of the outstanding stock of OneSecure. The common stock issued in the acquisition was valued using the average
closing price of the Companys common stock from two days before to two days after the date the transaction was announced, which was $13.71 per share. NetScreen also assumed all of the outstanding stock options of OneSecure, which were
converted into options to purchase approximately 349,000 shares of the Companys common stock, and issued options to purchase 1.4 million shares of NetScreen common stock with an exercise price of $11.65 per share in connection with the
transaction. The fair value of the stock options assumed and issued in connection with the transaction, net of deferred stock compensation, was approximately $15.9 million. The options were valued using the Black-Scholes option pricing model using a
volatility factor of 80%, expected lives of two to five years, a risk-free interest rate of 4.3% and a per share market value of $13.71 as described above. The total purchase price also includes an estimate of the direct costs associated with the
transaction totaling approximately $716,000.





The acquisition has been accounted for under the purchase method of
accounting in accordance with SFAS 141, Business Combinations. Under the purchase method of accounting, the total purchase price is allocated to the tangible and intangible assets acquired and the liabilities assumed based on their
estimated fair values. The excess of the purchase price over those fair values is recorded as goodwill. The fair values assigned to the tangible and intangible assets acquired and liabilities assumed are based on estimates and assumptions provided
by management, and other information compiled by management, including independent valuations, prepared by independent valuation specialists, that utilize established valuation techniques appropriate for the high technology industry. In accordance
with SFAS 142, Goodwill and Other Intangible Assets, goodwill will not be amortized but instead will be reviewed periodically for impairment.





A summary of the total preliminary purchase price is as follows (in thousands):





Common stock

$
43,687Outstanding OneSecure stock options, net of deferred stock compensation


2,588NetScreen stock options issued in connection with the transaction


13,328Estimated direct costs of the acquisition


716Total purchase price

$
60,319





The total preliminary purchase price has been allocated as follows
(in thousands):





Equipment

$
728Other assets and liabilities, net


897Restructuring liabilities


(3,118
)Accounts payable


(1,582
)Fair value of net liabilities assumed


(3,075
)In-process research and development


200Purchased technology


2,450Technology patent application


2,550Non-compete agreements


550Value-added reseller relationships


250Goodwill


56,807Deferred stock compensation


587Total purchase price

$
60,319





OneSecure was a loss company through the acquisition date. The potential value of the
combined companies, products and technologies contributed to a purchase price that resulted in the recognition of goodwill. The total




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purchase price is preliminary and is subject to change as the Company obtains additional information concerning direct costs of the acquisition and fair values of the liabilities of OneSecure.





Intangible assets





Of the total purchase price, $5.8 million was allocated to intangible assets, including purchased technology, technology patent application, non-compete agreements and value-added reseller
relationships. All of the intangible assets were valued using the income approach, which measures present worth and anticipated future benefits of the intangible asset. This approach calculates the value of the intangible asset as being the present
value of the after tax cash flows potentially attributable to it, net of adjustments made to account for the replacement and obsolescence of technology and a fair rate of return on other assets that contribute to the income stream attributable to
the intangible asset.





Purchased technology consists of products that have reached technological feasibility and
includes OneSecures intrusion protection and detection product line. Technology patent application consists of OneSecures patent applications for products whose concept and design are under development. NetScreen is amortizing the fair
value of the purchased technology and technology patent application on a straight-line basis over useful lives of five and ten years, respectively. Value-added reseller relationships represent the value of OneSecures existing contracts with
value-added resellers. NetScreen is amortizing the fair value of value-added reseller relationships on a straight-line basis over a useful life of five years. Non-compete agreements represent the value of non-compete agreements signed by key
executives of OneSecure. NetScreen is amortizing the fair value of non-compete agreements on a straight-line basis over a useful life of three years.





In-process research and development





Of the total purchase
price, approximately $200,000 was allocated to in-process research and development and was included in research and development in the consolidated statement of operations in the quarter ended September 30, 2002. This amount represents the fair
value of projects that have not reached technological feasibility and which had no alternative future use.





Deferred stock compensation





Unvested stock options with an intrinsic value of
approximately $587,000 have been allocated to deferred stock compensation and are being amortized to expense on a straight-line basis over the vesting period. Options assumed in connection with the acquisition had exercise prices of $5.34 and $10.98
per share, with a weighted exercise price of $10.92 per share and a weighted average remaining contractual life of approximately 5.6 years. Options to purchase a total of approximately 349,000 shares of NetScreen common stock were assumed. All stock
options assumed were exercisable and options to purchase approximately 67,000 shares of NetScreen common stock assumed were vested.





Pro forma results





The following unaudited pro forma financial information
presents the combined results of operations of NetScreen and OneSecure as if the acquisition had occurred on October 1, 2000. The unaudited pro forma financial information for 2002 was derived from NetScreens audited statement of operations
for the year ended September 30, 2002 and OneSecures unaudited statement of operations for the period October 1, 2001 to September 18, 2002 (the date the acquisition was completed). Due to different fiscal years, the unaudited pro forma
financial information for 2001 was derived from NetScreens audited consolidated statement of operations for the year ended September 30, 2001 and OneSecures audited statement of operations for the year ended December 31, 2001. Due to
different fiscal years, OneSecures results of operations for the three months ended December 31, 2001 have been included in the unaudited pro forma information for both 2001 and the year ended




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September 30, 2002. OneSecures unaudited net loss was $2.9 million in the three months ended December 31, 2001. During the three months ended December 31, 2001, OneSecures unaudited
results of operations were a net loss of $2.9 million. During this period, OneSecure incurred $2.8 million of operating expenses and had no revenues.





Adjustments of $1.0 million have been made to the combined results of operations for both 2002 and 2001, reflecting the amortization of the intangible assets acquired and deferred stock compensation
associated with the OneSecure stock options assumed by NetScreen. The unaudited pro forma basic and diluted net loss per share computations are based upon the weighted average of outstanding common stock of NetScreen during the periods presented,
plus the number of shares of NetScreen common stock issued to complete the acquisition as of the acquisition had occurred on October 1, 2000. The unaudited pro forma financial information is not intended to represent or be indicative of the
consolidated results of operations or financial condition that NetScreen would have reported had the acquisition been completed as of the dates presented, and should not be taken as representative of the future consolidated results of operations.





Unaudited pro forma financial information is as follows (in thousands, except per share amounts):





Year Ended2002


2001Revenues

$
139,482


$
86,337Net loss applicable to common stockholders

$
(55,188
)

$
(68,184
)Basic and diluted net loss per share applicable to common stockholders

$
(0.87
)

$
(3.43
)





The pro forma financial information for the year ended 2001
includes non-recurring restructuring and asset impairment costs incurred by OneSecure of $6.1 million and $3.0 million, respectively.





5.    Financial Instruments





Investments, including cash equivalents,
restricted cash and short-term investments were as follows (in thousands):





September 30,2002


2001Money market and mutual funds

$
8,485


$
2,030Commercial paper


75,635



U.S. government securities


40,626



7,223Municipal bonds and notes


122,450



6,150Total investments


247,196



15,403Amounts classified as cash equivalents and restricted cash


(8,485
)


(9,253
)Total short-term investments

$
238,711


$
6,150





Maturities of short-term investments as of September 30, 2002 were
as follows:





Due within one year

$
211,919Due between one year and two years


26,792Total short-term investments

$
238,711





Unrealized gains on available-for-sale securities at September 30,
2002 were $501,000. Unrealized gains at September 30, 2001 were immaterial.




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Restricted cash





As of September 30, 2002 and 2001, the Company had $1.6 million and $4.6 million, respectively, as collateral for an irrevocable standby letter of credit in connection with
a facility lease.





6.    Long-Term Debt and Capital Lease Obligations





In October 1998, the Company entered into a $318,000 (later adjusted to $404,000) equipment leasing arrangement. During the year ended
September 30, 2000, the Company expanded the equipment leasing arrangement by an additional $500,000. As of September 30, 2002, there was no availability for future purchases of equipment under this leasing arrangement and $176,000 was outstanding.





In February 2001, the Company entered into an equipment leasing arrangement of $514,000. The lease is payable in
monthly installments of principal and interest of approximately $15,000 through February 2004. As of September 30, 2002, $239,000 was outstanding under this arrangement.





In April 2001, the Company entered into a loan and security agreement for $3.5 million. Under the agreement, the Company may borrow amounts to finance eligible equipment
purchases. The lender has a security interest in the purchased equipment. Borrowings under the agreement bear interest at the U.S. Treasury note rate for notes with a three-year maturity plus 3.75% and are payable in equal monthly installments over
a three-year term. A final payment equal to 9% of the amount borrowed is due at the end of the three-year term, has been treated as an additional finance charge and is being amortized over the term of the loan. The Company is not required to meet
any financial covenants under this agreement. The commitment terminated on November 30, 2001. As of September 30, 2002, the Company had borrowed $2.0 million at an annual interest rate of 8.2% under this agreement, of which approximately $1.2
million was outstanding.





In August 2001, the Company entered into a loan and security agreement for $3.0 million.
Under the agreement, the Company could borrow amounts to finance eligible equipment purchases. The lender has a security interest in the purchased equipment. Borrowings under the agreement bear interest at the U.S. Treasury note rate for notes with
a three-year maturity plus 9.5% and are payable in equal monthly installments over terms ranging from 33 to 36 months. The Company is required to maintain an unrestricted cash balance of $11.0 million while borrowings are outstanding under the
agreement. The commitment terminated on November 30, 2001. As of September 30, 2002, the Company had borrowed $1.3 million at an annual interest rate of 13.8% and approximately $944,000 at an annual interest rate of 13.3% under this
arrangement. The total amount outstanding under this arrangement was approximately $1.6 million as of September 30, 2002.





Equipment acquired under these arrangements has been included in Property and Equipment on the accompanying balance sheet.





Future principal payments under debt and capital lease obligations are as follows (in thousands):





Year ending September 30:2003

$
1,7612004


1,513Total future principal payments

$
3,274




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7.    Commitments and Contingencies





Commitments





The Company leases its office facilities under noncancelable operating leases expiring at various dates through October 2004.





In August 2000, the Company entered into a lease for approximately 51,000 square feet of office space in Sunnyvale, California, which commenced on January 21, 2001 and will terminate on February 14,
2003. The related cost of the lease is approximately $270,000 per month. The lease is secured by a $1.6 million irrevocable standby letter of credit as of September 30, 2002.





Rent expense was approximately $4.3 million, $3.4 million and $1.2 million for the years ended September 30, 2002, 2001 and 2000, respectively.





The Company has entered into several leases for domestic and foreign sales office facilities. The leases expire at various
dates through October 2004. The related cost of the leases is approximately $173,000 per month.





Future minimum
lease payments under noncancelable operating leases at September 30, 2002 were as follows (in thousands):





Year ending September 30:2003

$
2,3252004


3392005


18Total minimum payments

$
2,682





Flash Electronics, Inc. manufactures, assembles and tests the
NetScreen-100, NetScreen-50, NetScreen-25, NetScreen-204, NetScreen-208 and NetScreen-IDP 100 products. Solectron Corporation manufactures, assembles and tests the NetScreen-5200, NetScreen-5400, NetScreen-1000, NetScreen-500, NetScreen-5XP and
NetScreen-5XT products. The Company purchases from these manufacturers on a purchase order basis and does not have a long-term supply contract. At September 30, 2002, the Company had noncancelable purchase orders of $5.0 million to Flash
Electronics, Inc. and Solectron Corporation.





Contingencies





The Company is subject to legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these
matters is currently not determinable, the Company does not expect that the ultimate costs to resolve these matters will have a material adverse affect on its consolidated financial position, results of operations, or cash flows.




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8.    Restructuring Liabilities





The Company acquired OneSecure, Inc. in September 2002. In connection with the acquisition, the Company assumed noncancelable operating
leases for domestic sales offices which were not occupied by OneSecure and which will not be occupied by NetScreen. In addition, the Company assumed the noncancelable operating lease for OneSecures headquarters in Sunnyvale, California, which
is a duplicate facility. The Company has recorded a restructuring liability for the net present value of these leases, net of expected sublease income, for the periods these facilities will be unoccupied. The liability for the net present value of
future net lease payments for the excess facilities, discounted at a 6.5% borrowing rate, will decrease as required lease payments are made as follows:





Year ending September 30:2003

$
5412004


6342005


5762006


5032007


420Thereafter


444Total net present value

$
3,118





9.     Redeemable Convertible Preferred Stock





In October 2001, the Company completed the sale of 5,762,502 shares of the Companys Series F redeemable convertible
preferred stock, $0.001 par value per share, at a price of $5.2061 per share, for proceeds of $29.7 million, net of issuance costs of $278,000. The deemed fair value of the shares at the time of issuance was approximately $10.00 per share. The
difference between the deemed fair value of $10.00 per share and the issue price of $5.2061 per share was accounted for as a deemed dividend totaling $27.6 million in the quarter ended December 31, 2001.





The Companys Series E and Series F redeemable convertible preferred stock were entitled to cumulative dividends at the rate of
approximately $0.31 and $.042 per share, respectively. The Company recorded deemed dividends of approximately $625,000 and $493,000 to account for the cumulative dividends on its Series E and Series F convertible preferred stock in the quarter ended
December 31, 2001. The Company recorded deemed dividends of $2.9 million and $699,000 in the years ended September 30, 2001 and 2000, respectively, to account for the cumulative dividend on its Series E convertible preferred stock.





All outstanding redeemable convertible preferred stock automatically converted into an aggregate of 38,235,584 shares of common
stock upon the closing of the Companys initial public offering in December 2001. In addition, all dividend rights, as well as voting and liquidation rights, attributable to the preferred stock terminated upon the closing of the IPO.





10.    Stockholders Equity





Convertible Preferred Stock





As of September 30, 2002, the Company was authorized to issue up to 10,000,000 shares of convertible preferred stock with a par value of $0.001 per share. No shares were issued and outstanding at September 30, 2002.





Common Stock





On December 17, 2001, the Company closed the sale of 11,500,000 shares of common stock, including the underwriters exercise of an over-allotment option, in an initial public offering at a price
of $16.00 per share. A




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total of $184.0 million in gross proceeds was raised from these transactions. After deducting the underwriting discount of approximately $12.9 million and approximately $2.5 million of offering
expenses, net proceeds were $168.6 million.





The Company is authorized to issue up to 500,000,000 shares of common
stock. As of September 30, 2002, 77,893,007 shares of common stock were issued and outstanding and common stock was reserved for future issuance as follows:





Outstanding stock options

12,614,494Shares of common stock available for grant under stock option plans

18,014,351Shares of common stock available for issuance under the employee stockpurchase plan

913,64031,542,485





Founders Shares





In October 1997, the Company issued 12,000,000 shares of common stock to its three founders for cash proceeds of $30,000. Of these shares,
2,400,000 were vested immediately, 1,200,000 shares became vested six months after the effective date of the agreement and an additional 1,200,000 shares became vested one year after the effective date of the agreement. The remaining shares vested
2.77% per month for thirty-six months. In the event a founders employment with the Company terminated, the Company had the right to repurchase all unvested shares from that founder at the original issuance price. During the year ended
September 30, 2000, 733,334 shares were repurchased from a founder. At September 30, 2002, all shares were vested.





Warrants





In October 1998, in connection with the negotiation of a loan and equipment lease
agreement, the Company granted warrants to purchase 60,952 shares of Series C convertible preferred stock at $0.53 per share and 20,960 shares of Series D convertible preferred stock at $1.14 per share to the lender. The fair value of the
warrants was approximately $18,000 using the Black-Scholes option pricing model based on a risk-free interest rate of 6%, a volatility of .5, and expected lives ranging from 0 to 6 years. In January 2002, the warrants were exercised on a net basis
for a total of 79,536 shares.





In April 2001, in connection with a loan and security agreement, the Company
granted warrants to purchase 41,284 shares of Series E convertible preferred stock at $3.82 per share to the lender. The fair value of the warrants was approximately $191,000 using the Black-Scholes option pricing model based on a risk-free interest
rate of 6%, a volatility of .9, and expected life of 10 years. The fair value of the warrants is being amortized over three years, which is the term of the related loan. In March 2002, the warrants were exercised on a net basis for a total of 32,348
shares.





As of September 30, 2002, no warrants were outstanding.





2001 Employees Stock Purchase Plan





In September 2001, the Companys Board of Directors adopted the 2001 Employee Stock Purchase Plan (the 2001 ESPP). The 2001 ESPP was approved by the Companys stockholders in
November 2001. The 2001 ESPP is designed to enable eligible employees to purchase shares of the Companys common stock at a discount and was effective on December 12, 2001, the first day on which price quotations were available for the
Companys common stock on the Nasdaq National Market. Except for the first offering period, each offering period will be for two years and will consist of four six-month purchase periods. The first offering period began December 12, 2001 and
ended on April 30, 2002. All subsequent offering periods begin on November 1 and May 1. The purchase price for shares of common stock under the 2001 ESPP is 85% of the lesser of the fair




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market value of the Companys common stock on the first day of the applicable offering period or the last day of each purchase period.





The Company initially reserved 1,000,000 shares of common stock for issuance under the 2001 ESPP. The number of shares reserved for issuance under the 2001 ESPP will
increase automatically on October 1 of each year by an amount equal to the number of shares sold under the plan in the preceding fiscal year.





During the year ended September 30, 2002, 86,360 shares of common stock at a price of $8.36 per share were issued under the 2001 ESPP. As of September 30, 2002, 913,640 shares were reserved for
future issuance.





Employee Stock Option Plans





1997 Equity Incentive Plan





In November 1997, the Company adopted the 1997 Equity Incentive Plan (the 1997 Plan), which provides for the granting of incentive stock options and nonqualified stock options and the making of restricted stock
awards to employees, officers, directors and consultants. The 1997 Plan authorized the grant of options to purchase up to 23,200,014 shares of the Companys common stock. Under the 1997 Plan, the Companys Board of Directors determines the
term of each award and the award price. In the case of incentive stock options, the exercise price may be established at an amount not less than the fair market value of the Companys common stock on the date of grant, while nonqualified stock
options may have an exercise price not less than 85% of the fair market value on the date of grant. Options granted may be immediately exercisable. The Company has the right to purchase any exercised and unvested shares at the original exercise
price. Options generally vest ratably over a four-year period commencing with the grant date and expire no later than ten years from the date of grant.





2001 Equity Incentive Plan





In September 2001, the Companys
Board of Directors adopted the 2001 Equity Incentive Plan (the 2001 Plan). The 2001 Plan was approved by the Companys stockholders in November 2001 and was effective on December 12, 2001, the date of the Companys IPO. The
2001 Plan provides for the granting of incentive stock options, nonqualified stock options, restricted stock and stock bonuses to employees, officers, directors, consultants, independent contractors and advisors.





The 2001 Plan is the successor to the Companys 1997 Plan and no additional shares will be granted under the 1997 Plan after December
12, 2001. The Company has reserved 20,000,000 shares of common stock for issuance under the 2001 Plan. The number of shares reserved for issuance under the 2001 Plan increased by the number of shares available for grant under the 1997 Plan on
December 12, 2001 and any shares that are canceled or repurchased under the 1997 Plan after December 12, 2001. Shares subject to awards which cease to be subject to such award for any reason other than exercise of such award, which are forfeited or
repurchased by the Company or which are subject to an award that otherwise terminates without shares being issued will again be available for grant and issuance under the 2001 Plan. In addition, the number of shares reserved for issuance under the
2001 Plan will increase automatically on October 1 of each year by an amount equal to 5% of the Companys total outstanding shares of common stock as of the immediately preceding September 30.





The terms of options and restricted stock awards granted under the 2001 Plan are similar to the terms that apply to options and restricted
stock awards under the 1997 Plan. The Companys Board of Directors determines the terms of stock bonuses under the 2001 Plan, which may be awarded for past services already rendered to the Company or which may be awarded upon satisfaction of
certain performance goals set out in advance. The 2001 Plan additionally provides for automatic option grants to outside directors of the Company that vest monthly over three years. The vesting of automatic option grants to outside directors
accelerates in the even of a dissolution or liquidation of the Company, a merger or the sale of all or substantially all of the Companys assets.




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The following is a summary of activity for the 1997 and 2001 Plans:





Outstanding OptionsShares Available for Grant


Number of Shares


Weighted Average Exercise PriceOptions outstanding as of September 30, 1999

909,606


2,646,488


$
0.06Options authorized

8,600,014


Options granted

(10,154,130
)

10,154,130


$
1.22Options exercised




(6,990,774
)

$
0.42Options canceled

1,355,470


(1,355,470
)

$
3.10Shares repurchased

122,500





$
0.25Options outstanding as of September 30, 2000

833,460


4,454,374


$
1.22Options authorized

5,000,000


Options granted

(5,167,700
)

5,167,700


$
5.01Options exercised




(69,582
)

$
1.90Options canceled

660,343


(660,343
)

$
3.56Shares repurchased

987,686





$
0.48Options outstanding as of September 30, 2001

2,313,789


8,892,149


$
3.23Options authorized

20,000,000


Options granted

(5,381,696
)

5,381,696


$
9.89Options exercised




(1,038,600
)

$
2.58Options canceled

974,117


(974,117
)

$
5.47Shares repurchased

108,141





$
0.52Options outstanding as of September 30, 2002

18,014,351


12,261,128


$
6.03





As of September 30, 2002, 8,928,325 shares were exercisable at a
weighted average exercise price of $3.75, of which 2,956,149 shares were vested but not exercised at a weighted average exercise price of $2.98 per share. As of September 30, 2002, 1,719,626 unvested options had been exercised and were subject to
repurchase.





As of September 30, 2002, the weighted average remaining contractual life of outstanding options
under the 1997 and 2001 Plans was 8.13 years. The range of exercise prices of options outstanding at September 30, 2002 was $0.08 to $22.70.





In addition, the following table summarizes information about options under the 1997 and 2001 Plans that were outstanding and exercisable at September 30, 2002:





Options Outstanding

Options ExercisableRange of Exercise
Prices

Number Outstanding

Weighted Average Remaining Contractual Life
(Years)

Weighted Average Exercise Price

Number Exercisable

WeightedAverage Exercise Price$0.08$  0.75

2,812,961

7.55

$  0.67

2,812,961

$  0.67$2.50$  4.50

352,984

7.95

$  2.58

352,984

$  2.58$5.00$  5.00

3,628,674

8.47

$  5.00

3,628,674

$  5.00$5.10$  8.75

2,338,146

9.10

$  6.14

2,128,146

$  5.88$9.02$22.70

3,128,363

7.57

$12.36

5,560

$11.20$0.08$22.70

12,261,128

8.13

$  6.03

8,928,325

$  3.75




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##### Table of Contents




Nonplan Option Grants





During the year ended September 30, 2000, the Company issued options to purchase 578,000 shares of common stock to entities at prices
ranging from $0.0005 to $0.75 per share. The Company granted an additional 8,000 options at a price of $5.00 during the year ended September 30, 2001. The Company issued nonplan options due to the limited number of options available under the 1997
Plan. Of the 586,000 nonplan options granted, 420,000 were to an employee and 166,000 were to consultants. The employee options vest over four years. The Company recorded $1.2 million of deferred stock compensation expense related to the employee
during fiscal 2000 and 2001. The vast majority of the consultant options vesting was accelerated in August 2000. The Company recorded $1.3 million and $30,000 of stock-based compensation expenses related to these consultant options during fiscal
2000 and 2001, respectively. (See Consultant Options.)





During the year ended September 30, 2000,
490,000 shares were exercised at prices ranging from $0.0005 to $0.75 per share. During the year ended September 30, 2001, 30,000 shares were exercised at a price of $0.50 per share. During the year ended September 30, 2002, 62,000 shares were
exercised at prices ranging from $0.50 per share to $5.00 per share. As of September 30, 2002, 4,000 options at a price of $5.00 per share were outstanding and exercisable.





In connection with its acquisition of OneSecure in September 2002, the Company assumed all of the outstanding OneSecure stock options, which were converted into options to
purchase approximately 349,000 shares of the Companys common stock. The stock options generally have terms of between five and ten years and generally vest over a four-year period. These options were assumed at prices of $5.34 and $10.98
per share, with a weighted average exercise price of $10.92 per share. All stock options assumed were exercisable and approximately 67,000 of the stock options assumed were vested with a weighted average exercise price of $10.73 per share. No
further stock options can be granted under the OneSecure plan.





Restricted Stock Program to Certain Employees





In July 2000, the Company cancelled 474,000 options granted in March 2000 and replaced them with restricted
stock with an exercise price of $0.0005. The Company is recording deferred stock compensation over the vesting period of the restricted stock for the difference between the fair market value in July 2000 of $1.50 and the exercise price of $0.0005.





Consultant Options





As of September 30, 2002, the Company had granted options to purchase approximately 232,000 shares of common stock to individual consultants at exercise prices ranging from $0.0005 to $7.50 per share.
The options were granted in exchange for consulting services rendered and vest over terms ranging from immediately to four years. The options issued to consultants have been and will be marked to market using the estimate of fair value at the end of
each accounting period pursuant to FASBs Emerging Issues Task Force Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction with Selling, Goods, or Services. The
Company recorded stock-based compensation expense of approximately $64,000, $166,000 and $1.5 million in the years ended September 30, 2002, 2001 and 2000, respectively, related to options issued to consultants. As of September 30, 2002, all
consultant options were fully vested.




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##### Table of Contents




Pro Forma Stock-Based Compensation





Pro forma information regarding net loss is required by SFAS 123. The information is required to be determined as if the Company had
accounted for its employee stock options granted under the fair value method. The fair value of these options was estimated at the date of grant using the Black-Scholes method and the following weighted average assumptions:





Year Ended September 30,2002

2001

2000Expected life

3 years

5 years

5 yearsExpected stock price volatility

70%

90%

90%Risk-free interest rate

3.03%

4.99%

6.29%Dividend yield

None

None

None





The fair value of shares issued under the employee stock purchase
plan during the year ended September 30, 2002 was estimated using an expected life of 0.47 years, expected price volatility of 84%, a risk free interest rate of 1.89% and no dividend yield.





For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options respective vesting periods. If the Company had
elected to recognize compensation cost based on the fair value of the options granted at the grant date as prescribed by SFAS 123, net loss applicable to common stockholders and net loss per share applicable to common stockholders would have
increased to the pro forma amounts indicated in the table below (in thousands, except per share amounts):





Year Ended September 30,2002


2001


2000Net loss applicable to common stockholders:As reported

$
(41,114
)

$
(34,228
)

$
(33,720
)Pro forma

$
(51,611
)

$
(39,008
)

$
(36,369
)Basic and diluted net loss per share applicable to common stockholders:As reported

$
(0.68
)

$
(2.05
)

$
(2.82
)Pro forma

$
(0.85
)

$
(2.34
)

$
(3.04
)





The weighted average fair value of options granted during the years
ended September 30, 2002, 2001 and 2000 was $6.76, $4.25 and $10.32, respectively. The fair value of shares issued under the employee stock purchase plan was $4.22 during the year ended September 30, 2002.





The option valuation models were developed for use in estimating the fair value of traded options, which have no vesting restrictions and
are fully transferable. In addition, option valuation models require the input of highly subjective assumptions. Because the Companys employee stock options have characteristics significantly different from those of traded options and because
changes in the subjective input assumptions can materially affect the fair value estimate, in managements opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.





Deferred Stock Compensation





During the years ended September 30, 2002, 2001 and 2000, in connection with the grant of stock options to employees, the Company recorded deferred stock compensation of
$13.5 million, $6.8 million and $101.1 million, respectively, representing the difference between the exercise price and the deemed fair value for financial reporting purposes of the Companys common stock on the date these stock options
were granted. The Company also recorded deferred stock compensation of approximately $587,000 representing the intrinsic value




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of unvested stock options assumed in connection with the acquisition of OneSecure. Restricted stock acquired through the exercise of unvested stock options is subject to the Companys right
to repurchase the unvested stock at the price paid, which right lapses over time. Deferred stock compensation is included as a reduction of stockholders equity and is being amortized ratably over the vesting period of the individual award,
generally four years, consistent with the method described in FASB Interpretation No. 28. During the years ended September 30, 2002, 2001 and 2000, the Company recorded amortization of deferred stock compensation of $24.3 million, $19.0 million and
$14.7 million, respectively, related to employee stock options. This stock-based compensation expense relates to stock options granted to individuals in all cost of revenues and operating expense categories and has been included in those categories.
At September 30, 2002, $42.2 million of deferred stock compensation related to employee stock options remained unamortized.





Stockholders Notes Receivable





The stockholders notes
receivable were issued in conjunction with the issuance of common stock under the Companys stock option plan. The notes were secured by the related shares of common stock and are full recourse notes, with interest compounded annually on the
unpaid balance at a rate of 6% per year. During the year ended September 30, 2002, the Company received payments on the notes of $76,000. During the year ended September 30, 2001, the Company received payments on the notes of $80,000 and canceled
notes totaling $399,000 in connection with the repurchase of unvested shares.





11.    Income Taxes





The components of the provision (benefit) for income taxes is as follows:





Year Ended September 30,2002


2001

2000(in thousands)Current:Federal

$
8,147


$


$
State


851






Foreign


743



168


9,741



168


Deferred:Federal


(5,033
)





State


(650
)





Foreign









(5,683
)





$
4,058


$
168

$






The U.S. income tax benefit related to the exercise of certain
employee stock options decreased accrued income taxes and was credited to additional paid-in capital. Such amount was $1.3 million for the year ended September 30, 2002.





Income (loss) before income taxes consisted of the following:





Year Ended September 30,2002


2001


2000(in thousands)Domestic

$
(9,513
)

$
(31,386
)

$
(33,021
)Foreign


1,200



249



$
(8,313
)

$
(31,137
)

$
(33,021
)




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##### Table of Contents




A reconciliation of the provision (benefit) computed at the statutory federal
income tax rate to the income tax provision is as follows:





Year Ended September 30,2002


2001


2000(in thousands)Income tax benefit at U.S. statutory rate

$
(2,909
)

$
(10,898
)

$
(11,557
)State income tax, net of federal benefit


201







Stock based compensation


4,492







Research tax credits


(686
)






Valuation allowance


1,515



10,898



11,557Foreign income taxes for which no U.S. benefit is currently recognizable


323



168



Other individually immaterial items, net of effective income tax provision


1,122







$
4,058


$
168


$






Deferred income taxes reflect the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The principal components of deferred tax assets and liabilities are as follows:





September 30,2002


2001Deferred tax assets:Deferred compensation

$
11,922


$
7,967Net operating loss carryforwards


17,855



6,473Tax credit carryforwards


4,303



1,872Deferred revenue


5,360



5,661Fixed assets


800



Other reserves and accruals


5,641



3,361Total gross deferred tax assets


45,881



25,334Valuation allowance


(43,577
)


(25,334
)Total deferred tax assets


2,304



Deferred tax liabilities:Acquisition related intangibles


(2,304
)


Net deferred tax assets

$



$






Realization of the $43.6 million of net deferred tax assets is
dependent upon the Companys ability to generate sufficient future taxable income, the timing and amount of which are uncertain. Accordingly, a valuation allowance in an amount equal to the net deferred tax assets as of September 30, 2002 and
September 30, 2001 has been established to reflect these uncertainties. The valuation allowance increased by $18.2 million, $11.4 million and $9.4 million during the years ended September 30, 2002, 2001 and 2000, respectively. Approximately
$14.6 million of the valuation allowance at September 30, 2002 is attributable to deferred tax assets that if realized, will first reduce unamortized goodwill, then other non-current intangible assets of acquired subsidiaries, and then income tax
expense.





As of September 30, 2002, the Companys tax credit carryforwards were approximately $4.3 million.
If not utilized, the tax credit carryforwards will begin to expire in fiscal 2013. As of September 30, 2002, the Company had federal and state net operating loss carryforwards of approximately $45.7 million and $37.6 million, respectively. If not
utilized, the net operating loss carryforwards will begin to expire in fiscal 2020. Utilization of the net operating loss and tax credit carryforwards may be subject to a substantial annual limitation due to the




75




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##### Table of Contents

ownership change limitations provided by the Internal Revenue Code Section 382 and Section 383 and similar state provisions. The annual limitation may result in the expiration of net operating
loss and tax credit carryforwards before utilization.





12.    Business Segment Information





The Company operates in one business segment, the sale of security and traffic management solutions for network environments.





The Chief Executive Officer has been identified as the Chief Operating Decision Maker (CODM) because
he has the final authority over resource allocation decisions and performance assessment. The CODM does not receive discrete financial information about individual components of the Companys business.





The Company sells its products and technology primarily to customers in the Americas, Asia and the Pacific Rim (APAC) and Europe, the
Middle East and Africa (EMEA). Revenues by geographic region were as follows:





Year Ended September 30,2002

2001

2000Revenues:Americas

$
61,886

$
45,537

$
20,343APAC


46,705


25,228


3,540EMEA


29,891


14,798


2,701Total

$
138,482

$
85,563

$
26,584





No single customer accounted for 10% or more of revenues in the
years ended September 30, 2002, 2001 or 2000. One customer accounted for more than 10% of accounts receivable as of September 30, 2002. As of September 30, 2001, no single customer accounted for more that 10% of accounts receivable. The Company
generally does not require any collateral from its customers.





13.    401(k) Plan





The Company has a defined contribution plan intended to qualify under Section 401 of the Internal Revenue Code, or a 401(k) plan. All
employees may elect to contribute up to 15%, but no greater than $11,000 per year in 2002 and $10,500 per year in prior years, of their annual compensation to the plan through salary deferrals, subject to IRS limits. From October 30, 1997
(inception) to September 30, 2002, the Company made no matching contributions to the plan.





14.    Related Party
Transactions





During the years ended September 30, 2002 and 2001, we sold products and services to companies
affiliated with the brother of Feng Deng, an executive officer and director of the Company. The total amount sold to these companies during the years ended September 30, 2002 and 2001 was approximately $767,000 and $1,574,000, respectively.





During the year ended September 30, 2002, we sold products and services to companies affiliated with members of
our Board of Directors. The total sold to these companies was approximately $124,000. As of September 30, 2002, accounts receivable included approximately $10,000 due from these companies.




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##### Table of Contents




15.    Subsequent Event





Facilities Lease





In
October 2002, the Company entered into a lease arrangement for a new approximately 156,000 square foot corporate headquarters in Sunnyvale, California. Rent payments under the lease are approximately $231,000 per month and commence February 14,
2003. The lease terminates on May 13, 2008. Under the terms of the lease, the Company may lease an additional 22,000 square feet in the facility at an additional monthly rent of approximately $32,000. The Company has the option to lease the
additional space through February 14, 2004.





Future minimum lease payments under noncancelable operating leases,
including the new lease, are as follows (in thousands):





Year ending September 30:2003

$
4,0542004


3,1052005


2,7842006


2,7662007


2,766Thereafter


1,729Total minimum payments

$
17,204




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##### Table of Contents

NETSCREEN TECHNOLOGIES, INC.


SCHEDULE IIVALUATION AND QUALIFYING ACCOUNTS


(in thousands)





Description

Balance at Beginning of Period

Additions Charged to Costs and Expenses

Deductions (1)

Balance at End of PeriodAllowance for doubtful accounts receivable:Year ended September 30, 2000

$
349

$
2,356

$
989

$
1,716Year ended September 30, 2001

$
1,716

$
3,251

$
2,093

$
2,874Year ended September 30, 2002

$
2,874

$
1,544

$
1,575

$
2,843


---

|(1) |  | Represents amounts written off as uncollectable.
|--- |  | ------------------------------------------------




Description

Balance at Beginning of Period

Additions Charged to Costs and Expenses

Deductions (1)

Balance at End of PeriodAllowance for sales returns:Year ended September 30, 2000

$
158

$
2,389

$
605

$
1,942Year ended September 30, 2001

$
1,942

$
4,706

$
4,338

$
2,310Year ended September 30, 2002

$
2,310

$
10,157

$
7,526

$
4,941


---

|(1) |  | Represents actual returns taken against the allowance.
|--- |  | ------------------------------------------------------



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##### Table of Contents




EXHIBIT INDEX





Set forth below is a list of exhibits that are being filed or incorporated by reference into this Report:





Incorporated by ReferenceExhibit Number

Exhibit Description

Form

File No.

Date of First Filing

Exhibit Number

Filed Herewith2.01

Agreement and Plan of Merger, dated August 22, 2002, among the Registrant, Tango Acquisition Corp. and OneSecure, Inc.

8-K

000-33387

10/03/02

2.013.01

Registrants Form of Restated Certificate of Incorporation.

S-1

333-71048

10/05/01

3.023.02

Registrants Restated Bylaws, effective December 17, 2001.

10-Q

000-33387

05/15/02

3.014.01

Fifth Amended and Restated Investors Rights Agreement dated October 3, 2001.

S-1

333-71048

10/05/01

4.014.02

Specimen Stock Certificate representing shares of Registrants Common Stock.

S-1/A

333-71048

11/23/01

4.0210.01

Registrants 1997 Equity Incentive Plan, as amended August 10, 2001, and form of stock option agreement. (1)

S-1

333-71048

10/05/01

10.0210.02

Registrants 2001 Equity Incentive Plan, and form of stock option agreement. (1)

S-1/A

333-71048

12/10/01

10.0310.03

Registrants 2001 Employee Stock Purchase Plan. (1)

S-1/A

333-71048

12/10/01

10.0410.04

Registrants 1997 Equity Incentive Plan form of stock option agreement for executive officers. (1)

S-1

333-71048

10/05/01

10.0510.05

OneSecure, Inc. 2000 Stock Option/Stock Issuance Plan, and forms of stock option agreements. (1)

S-8

333-100088

09/25/02

4.0110.06

Stock Option Agreement by and between OneSecure, Inc. and Nir Zuk dated as of January 24, 2001. (1)

8-K

000-33387

10/03/02

99.0610.07

Stock Option Agreement by and between OneSecure, Inc. and Nir Zuk dated as of July 5, 2001. (1)

8-K

000-33387

10/03/02

99.0710.08

Stock Option and Vesting Waiver Agreement by and between Nir Zuk and the Registrant dated August 22, 2002. (1)

8-K

000-33387

10/03/02

99.0810.09

Stock Vesting Waiver Agreement by and between Rakesh K. Loonkar and the Registrant dated August 22, 2002. (1)

8-K

000-33387

10/03/02

99.0910.10

Registrants Form of Restated Founders Restricted Stock Purchase Agreement. (1)

S-1

333-71048

10/05/01

10.0110.11

Restricted Common Stock Purchase Agreement by and between OneSecure, Inc. and Nir Zuk dated as of February 18, 2000.

8-K

000-33387

10/03/02

99.04




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##### Table of Contents

Incorporated by ReferenceExhibit Number

Exhibit Description

Form

File No.

Date of First Filing

Exhibit Number

Filed Herewith10.12

Restricted Common Stock Purchase Agreement by and between OneSecure, Inc. and Rakesh K. Loonkar dated as of February 18, 2000.

8-K

000-33387

10/03/02

99.0510.13

Registrants Form of Offer Letter for executive officers. (1)

S-1

333-71048

10/05/01

10.0610.14

Offer Letter to Nir Zuk dated August 22, 2002. (1)(2)

8-K

000-33387

10/03/02

99.0210.15

Offer Letter to Rakesh K. Loonkar dated August 22, 2002. (1)(2)

8-K

000-33387

10/03/02

99.0310.16

Form of Noncompetition Agreement by and between the Registrant and each of Nir Zuk and Rakesh K. Loonkar dated August 22, 2002.

8-K

000-33387

10/03/02

99.1010.17

Form of Indemnity Agreement to be entered into by and between the Registrant and each executive officer and director.

S-1

333-71048

10/05/01

10.0710.18

Form of Promissory Notes from executive officers to the Registrant made in connection with exercise of options.

S-1

333-71048

10/05/01

10.0810.19

Manufacturing Agreement by and between Flash Electronics, Inc. and the Registrant dated January 3, 2002. (2)

10-Q

000-33387

02/14/02

10.0110.20

Master Lease Agreement by and between Comdisco, Inc. and the Registrant dated October 27, 1998.

S-1

333-71048

10/05/01

10.1010.21

Software and License Agreement by and between Information Resource Engineering, Inc. (now SafeNet, Inc.) and the Registrant dated June 30, 2000.

S-1

333-71048

10/05/01

10.1210.22

Lease Agreement by and between Ariba, Inc. and the Registrant dated October 18, 2002.









X10.23

Sublease Agreement by and between Philips Electronics North America Corporation and the Registrant dated September 29, 2000.

S-1

333-71048

10/05/01

10.1310.24

Purchase/Service Agreement by and between Avaya, Inc. and the Registrant dated November 21, 2000.

S-1

333-71048

10/05/01

10.1410.25

Manufacturing Agreement by and between A-Plus Manufacturing Corporation (now Solectron Corporation) and the Registrant dated December 15, 2000.
(1)

S-1

333-71048

10/05/01

10.1510.26

Loan and Security Agreement by and between GATX Ventures, Inc. and the Registrant dated April 13, 2001.

S-1

333-71048

10/05/01

10.16




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##### Table of Contents

Incorporated by ReferenceExhibit Number

Exhibit Description

Form

File No.

Date of First Filing

Exhibit Number

Filed Herewith10.27

Amendment #1 to Software License Agreement by and between Information Resource Engineering, Inc. (now SafeNet, Inc.) and the Registrant dated June 22,
2001.

S-1

333-71048

10/05/01

10.1710.28

Amendment #2 to Software License Agreement by and between SafeNet, Inc. and the Registrant dated December 26, 2001. (3)









X10.29

International Customer Agreement by and between IBM Global Services and the Registrant dated July 25, 2001.

S-1

333-71048

10/05/01

10.1810.30

Master Loan and Security Agreement by and between Wells Fargo Equipment Finance, Inc. and the Registrant dated August 17, 2001.

S-1

333-71048

10/05/01

10.1921.01

List of Registrants subsidiaries.









X23.01

Consent of Ernst & Young LLP, Independent Auditors.









X


---

|(1) |  | Represents a management contract or compensatory plan or arrangement.
|--- |  | ---------------------------------------------------------------------

|(2) |  | Confidential treatment has been granted with respect to certain portions of this agreement. Such portions were omitted from the respective filing and were filed
separately with the Securities and Exchange Commission.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) |  | Confidential treatment has been requested for portions of this exhibit. These portions have been omitted from this filing and have been filed separately with
the Securities and Exchange Commission.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



81