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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K



(Mark One)

|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------



FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004



or



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



For The Transition Period From
                     To                     .



Commission file number 0-27074



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SECURE COMPUTING CORPORATION

(Exact name of registrant as specified in its
charter)



|                                                              |  |                                    
|------------------------------------------------------------- |  | -----------------------------------
|Delaware                                                      |  | 52-1637226                         
|(State or other jurisdiction ofincorporation or organization) |  | (I.R.S. EmployerIdentification No.)
|                                                              | 
|4810 Harwood Road, San Jose, California                       |  | 95124                              
|(Address of principal executive offices)                      |  | (Zip code)                         



Registrants
telephone number, including area code: (408) 979-6100



---



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

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

Common Stock, par value $.01 per share



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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 Rule 12b-2 of the Act). Yes  x    No ̈



The aggregate market value of the Common Stock held by non-affiliates of the Registrant as of June 30, 2004 was $415,163,769 based on the closing sale price for the Companys Common Stock on that date. For
purposes of determining this number, all officers and directors of the Registrant are considered to be affiliates of the Registrant, as well as individual stockholders holding more than 10% of the Registrants outstanding Common Stock. This
number is provided only for the purpose of this report on Form 10-K and does not represent an admission by either the Registrant or any such person as to the status of such person.



As of March 1, 2005, the Registrant had 35,841,493 shares of Common Stock issued and outstanding.



DOCUMENTS INCORPORATED BY REFERENCE



Portions of the Registrants Proxy Statement for its Annual Meeting of
Stockholders to be held May 9, 2005 for the year ended December 31, 2004 are incorporated by reference in Part III hereof.



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##### Table of Contents

TABLE OF CONTENTS



|         |  |                                                                                                   |  |     
|-------- |  | ------------------------------------------------------------------------------------------------- |  | ----
|         |  |                                                                                                   |  | Page
|PART I  
|         |  |                                                                                                  
|ITEM 1.  |  | BUSINESS                                                                                          |  | 2   
|         |  |                                                                                                  
|ITEM 2.  |  | PROPERTIES                                                                                        |  | 17  
|         |  |                                                                                                  
|ITEM 3.  |  | LEGAL PROCEEDINGS                                                                                 |  | 17  
|         |  |                                                                                                  
|ITEM 4.  |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                               |  | 17  
|        
|PART II 
|         |  |                                                                                                  
|ITEM 5.  |  | MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY |  | 18  
|         |  |                                                                                                  
|ITEM 6.  |  | SELECTED FINANCIAL DATA                                                                           |  | 19  
|         |  |                                                                                                  
|ITEM 7.  |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS             |  | 20  
|         |  |                                                                                                  
|ITEM 7A. |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                        |  | 28  
|         |  |                                                                                                  
|ITEM 8.  |  | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                       |  | 28  
|         |  |                                                                                                  
|ITEM 9.  |  | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE              |  | 28  
|         |  |                                                                                                  
|ITEM 9A. |  | CONTROLS AND PROCEDURES                                                                           |  | 28  
|        
|PART III
|         |  |                                                                                                  
|ITEM 10. |  | DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT                                                |  | 30  
|         |  |                                                                                                  
|ITEM 11. |  | EXECUTIVE COMPENSATION                                                                            |  | 30  
|         |  |                                                                                                  
|ITEM 12. |  | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT                                    |  | 30  
|         |  |                                                                                                  
|ITEM 13. |  | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                    |  | 30  
|         |  |                                                                                                  
|ITEM 14. |  | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                            |  | 30  
|        
|PART IV 
|         |  |                                                                                                  
|ITEM 15. |  | EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K                                  |  | 31  



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PART I



Forward-looking statements made in this Annual Report on Form 10-K or in the documents incorporated by reference herein that are not statements of
historical fact are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The words expect, plan,
anticipate, believe, predict, and other similar expressions identify forward-looking statements. In addition, statements which refer to projections of our future financial performance, anticipated growth and
trends in our business, and other discussions of future events or circumstances are forward-looking statements. A number of risks and uncertainties, including those discussed under the caption Certain Factors That May Affect Future
Results in this Form 10-K and the documents incorporated by reference herein, could affect such forward-looking statements and could cause actual results to differ materially from the statements made. We do not undertake any obligation to
update or correct any forward-looking statements.



In this
Annual Report on Form 10-K, Secure Computing, we, us, our, and Registrant refer to Secure Computing Corporation.



ITEM 1.    BUSINESS



We are a Delaware corporation and were incorporated in July 1989. We use our broad expertise in security technology to develop network security solutions that allow organizations to exchange critical information
safely with their customers, partners and employees. To achieve this, they must create trusted connections. Securing these connections, and providing the highest level of industry-recognized security, is at the heart of our mission. Our customers
operate some of the worlds largest and most sophisticated electronic business operations, and include prominent organizations in banking, financial services, healthcare, telecommunications, manufacturing, public utilities, and federal and
local governments. The premise of our security philosophy, which we build into each product, is that the rightpeople need to be connected with necessary network and application resources, and the wrong people need to be denied
connections. We work closely with customers to provide them with reliable access control and innovative new features that are comprehensive, easy to manage and highly effective in securing the connections between people, applications and networks.



Across virtually all industries, organizations use the
Internet to expand their business. Our commitment is to support this opportunity for exchanging information by mitigating risks and protecting information assets from the multitude of threats present on the Internet. Along with the opportunity
networking provides comes the need to secure the sharing of information resources at every connection point. Our technologies enable customers to achieve this security, and implement a balance between security and accessibility according to their
security policy.



We have formed partnerships with a number of
companies in several different capacities. These partnerships include members of our Secure Alliance program, resellers, systems integrators, and companies that include our solutions in their product offerings. These companies include, for example:
Alternative Technologies, Blue Coat Systems, Cisco, Computer Associates, Crossbeam, CSC, Dell, EDS, F5 Networks, Finjan, Hewlett-Packard, Network Appliance, NetOne Systems, Northrop Grumman, Radware, SafeNet, Sun PS, Tech Data, Vertex Link, Volera,
Wavecrest Computing, Westcon, and 3Com.



Industry Background



The rapid adoption of the Internet as a worldwide networking standard has
accelerated the distribution and sharing of data and applications, enabling enterprises to adopt new ways of doing business. The developing reliance on worldwide connectedness has allowed companies to greatly expand their business opportunities.
Activities such as electronic trading of goods and services, online delivery of digital content, electronic funds transfers, and share trading, are now commonplace. But with this growing opportunity comes new challenges for securing IT systems. The
very features that give electronic business its power have elevated information security to a critical business issue.



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Todays enterprise is no longer confined to a set of physical buildings, rather, the enterprise has
become virtual. The Internets power of connectivity has erased physical barriers, allowing an organization to establish ties around the globe. Many businesses are no longer a single, isolated entity; they are part of a greater whole of
interdependent entities whose lifeblood depends on the secure, electronic sharing of information. Organizations must now expand their security measures outward to protect their digital resources beyond their physical buildings. They must also
migrate their security measures inward to each individuals computer or laptop.



The key reason many organizations have rapidly moved to an Internet-based business model is the direct interaction between the e-business system and its suppliers, customers and partners. This direct interaction can
lower costs of doing business and expedite commerce. A well-designed e-business infrastructure can give an organization a competitive advantage. The move to Internet-based business processes brings speed and efficiency, but it also exposes
organizations and their partners to increased security risks of theft, downtime, espionage, embarrassment, and infiltration.



Conducting Business Over Public Networks



As this expanding Internet-based infrastructure broadens, so do the risks associated with this exposure. These risks increase daily and threaten
confidentiality, integrity, and secure availability of intellectual property, proprietary data, and computing resources. Such threats present themselves in many forms, including the following:



| |  |  | Intruders gaining unauthorized access to private computing resources and software applications;
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | Legal liability exposure resulting from employee Internet access, or from hijacked use of desktop personal computers (PCs) and servers for unauthorized file storage and file-sharing
schemes;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Theft of private citizen records in violation of numerous Government regulations;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | Identity theft and spoofing;
| | - |  | ----------------------------



| |  |  | Network and application server downtime due to denial of service (DoS) and distributed denial of service attacks (DDoS);
| | - |  | ------------------------------------------------------------------------------------------------------------------------



| |  |  | Risks from exposure to malicious software, worms, and viruses that can enter networks from many sources and cause damage, install spyware, or open secret backdoors into private
computing resources;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Confidentiality leaks via e-mail, instant messaging (IM) chat sessions, person to person (P2P) file sharing, and unauthorized attachments that leave private networks unfiltered ;
and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Productivity losses from spam clogging e-mail inboxes.
| | - |  | ------------------------------------------------------



According to the 2004 CSI/FBI Computer Crime and Security Survey, the risk of cyber attacks continues to be high. Denial of service and theft of
intellectual property crimes have caused the greatest financial losses.



More Than Networks Are At RiskApplications Are Also Vulnerable



In todays highly complex Internet environment, network attacks have evolved into application-level attacks, and recently, an entirely new class of application-specific threats has arisen that require far more
stringent protection. Protecting the network is highly important, but by itself, is not sufficient. The network is the foundation for communication, and the conduit over which people connect to the application resources they need and it is precisely
these applications that can expose an organizations information resources to extreme vulnerability. Our products address every network security issue, whether its employees utilizing the Internet, or remote partners and customers
accessing the intranet, Web services, and applications from outside the internal network. Our security measures extend beyond the network level, protecting applications and their resources so organizations can conduct their business and expand their
reach.



From email applications to Web services, File Transfer
Protocol (FTP), customer relationship management (CRM) and sales force automation systems, people connect across networks to applications in order to conduct



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business every day. Misuse of applications and Web portals can result in the loss of valuable resources and millions of dollars. As the applications we use
have become more sophisticated, so have the attack capabilities that threaten them. Applications contain inherent vulnerabilities, and sophisticated attackers can exploit these vulnerabilities and undermine an organizations ability to conduct
its business. Defensive measures must be even moresophisticated in their ability to protect against application-level threatsand our technology is designed with this in mind.



Along with protecting against known threats, todays security solutions
are being challenged to anticipate unknown threats before they enter the network. Our Sidewinder G2® Security Appliance includes advanced application proxies and other patented technology that defend against both known and unknown threats offering protection against the entire threat
matrix. A central part of an organizations business model must include provisions for safeguarding their business connections from being compromised to the highest degree possible.



Market Need and Strategy



More than ever before, organizations realize that they must take responsibility to protect their own confidential information and that of their customers
and partners. Government regulations in recent years, such as the Federal Information Security Management Act, the Health Insurance Portability and Accountability Act, the Gramm-Leach Bliley Act, and the Childrens Internet Protection Act, have
heightened awareness and mandated that organizations secure their information across multiple segmentsfinancial, medical, educational, and more. Enterprises must know that the data residing on a given network is secure and that parameters are
in place for managing access to their proprietary information.



Our strategy is to provide organizations with broad assistance, beginning with knowledge about security risks and regulations, accompanied by industry-leading security products to assist with mitigating these risks, and lastly, providing
comprehensive security management capabilities as well. Our goal is to help organizations have confidence in the overall functionality and security of their network and application operations. We accomplish this by providing scalable, manageable,
highly available solutions that meet their needs today and in the future. This objective includes meeting our customers requirements for security products that provide broad solutions by integrating with each other and interoperate within
current infrastructures. All of our products are designed to provide the strongest network protection available, along with central manageability, scalability, and interoperability.



Providing solutions that are manageable, easy to use and that lead the industry in total cost of ownership are our top
objectives. We make the process of securing connections between people, applications, and networks easy and efficient for all concerned. For the administrators configuring the Sidewinder G2 Security Appliance, user authentication, and Web filtering,
they experience a fast and easy installation process with customizable options, and simple-to-use system graphical user interfaces (GUIs). In addition, they experience tight integration with existing systems, including user management systems such
as Active Directory. For businesses that need access to critical information, SafeWord® provides strong authentication through reliable, non-expiring tokens, and an authentication process that is simple to use, deploy, and maintain. When accessing the Internet, seamless Web filtering with
SmartFilter® products make Web use simple for
administrator and user alike. As a result, business practices and the workplace are kept secure, productive, and easily manageable.



Our strategy also encompasses our award-winning service and support organization. Our worldwide support division has again been acknowledged by Frost and
Sullivan as the best in the industry. We provide all of our customers with unwavering, world-class service and support.



Secure Computing Solutions



We have been applying our expertise to solving the most difficult network and application security challenges for over 20 years. Our specialized solutions
are designed to meet customers needs to balance security and accessibility, and to help them create trusted environments both inside and outside their organizations. Each of our products provides a complete solution in and of itself, and they
also integrate with each other for a more



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comprehensive, unified, and centrally managed solution. Our products ability to scale as the infrastructure or number of users grows has always been,
and continues to be, one of our hallmarks. Our solutions run on a variety of platforms and integrate with other enterprise solutions, making our products a safe and economical choice for organizations worldwide.



Organizations need to allow external access for their customers and partners
to confidential information, resources, and applications through Web browsers, virtual private networks (VPNs), and dial-up lines. Organizations also need to allow people on the inside of their networks to access the Internet in productive and
secure ways. Accomplishing mission-critical tasks depends on securing the connections between all parties involvedmaking sure that the right people are connected with the necessary network and application resources they require, and also
making sure that the wrong people are denied connections. Our primary objectives are to ensure that the right people have access to the right information on the applications and networks they use while securing the information itself that is relayed
through those network connections.



We take a three-pronged
approach to securing the enterprise by providing technologies in three critical areas: security appliances, strong authentication, and Web filtering.



Sidewinder G2 Firewall



In February 2004, we released our next-generation Sidewinder G2 Security Appliance product line. These appliances provide all-in-one, consolidated
protection through standard and optional features, including the worlds strongest firewall, anti-virus, and anti-spam gateways, Web content universal resource locator (URL) filtering, secure domain name system (DNS), VPN, Secure Sockets Layer
(SSL) gateways, and more. We are well positioned to satisfy increased market demands for application security, in which we have been a leader for nearly a decade. Of particular importance is our application security performance, which, based on an
advanced security proxy architecture, achieves gigabit throughput speeds.



The release of our new Sidewinder G2 Security Appliance, including the complementary Sidewinder® G2 Enterprise ManagerTMfor managing distributed appliances, also represents the completion of our promised two-phase integration of the Sidewinder and GauntletTMfirewalls, following the 2002 acquisition of the Gauntlet firewall business from Network Associates.



Sidewinder G2 continues its unique and remarkable track record of never having had a CERT vulnerability posting against it in over 10 years, in great part
due to our SecureOS® operating system protected
with our patented Type Enforcement® technology. It
has also achieved the highest level of EAL4+ Common Criteria certification possible. The Common Criteria EAL4+ accomplishment puts us in a very strong position when competing for Sidewinder G2 business in the United States and other Government
opportunities all over the world.



Finally, the Sidewinder G2
Security Appliance further extends its value by integrating our award-winning SmartFilter On-Box filtering software and SafeWord® strong authentication starter system with every purchase, solidifying our position in the new market of security appliances, called Unified Threat Management.



SafeWord Products



Remote access to network resources is a requirement for many businesses and
verifying the identity of remote users is vital for security. Organizations are increasingly realizing the many vulnerabilities of passwords, and they need strong authentication systems that are easy to install and deploy, simple to manage, and able
to grow with their needs. SafeWord products meet these needs. Positively identifying users through strong authentication, SafeWord products assure that only the right people can make connections to applications and networks. SafeWord software and
SafeWord tokens offer unparalleled flexibility, scalability, and ease of use, and are used by thousands of organizations and millions of end users worldwide every day.



| |  |  | SafeWord PremierAccess® is a complete, powerful, and robust strong authentication system that protects Web, VPN, wireless, Citrix®, Oracle, Windows, remote dial-up, and many other network
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | applications. PremierAccess comes with integrated reporting, role-based authorization, public key infrastructure (PKI) user authentication, and powerful
software kits to customize any aspect of network authentication. PremierAccess includes advanced and powerful capabilities, such as the Universal Web Agent, user self-enrollment, and brokered authentication to external systems, which make it the
most complete and flexible strong authentication solution on the market.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | SafeWord RemoteAccess is a simple, complete strong authentication solution designed to protect VPN, RADIUS, Citrix, and Outlook Web Access connections. The product is managed through Microsoft
Active Directory, and is available in the following branded versions: SafeWord RemoteAccessCisco compatible, SafeWord for Citrix® MetaFrame®, SafeWord for Check Point, and SafeWord for Nortel Networks.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Web Filtering Products



In 2004, with the release of SmartFilter 4.0, we introduced a combined control list based on our prior URL control list and the URL control list acquired
from N2H2 in 2003. The result is a comprehensive list, which solidifies our position as one of the worlds leading suppliers of Web filtering. Containing millions of sites, the new URL control list offers 62 categories and covers over 60
languages. Brought together, the new combined lists accuracy and breadth of coverage is highly competitive in the industry. Under the brand of SmartFilter products, we sell and support three best-of-breed Web filtering products: SmartFilter,
Bess®, and Sentian.



| |  |  | SmartFilter,our flagship filtering application, is an enterprise Web filtering solution currently used by thousands of organizations. With the launch of SmartFilter 4.0 in
June 2004, the new control list was introduced, along with its new reporting feature, SmartReporter. SmartReporter adds powerful reporting capabilities to SmartFilter that make reporting on Web usage patterns easy for customers. SmartFilter
continues to be the market-leading de-facto standard for Web filtering on edge or caching devices through original equipment manufacturer (OEM) relationships. We are the only company with OEM relationships for On-Box filtering with all three of the
top caching appliance vendorsBlue Coat, Cisco, and Network Appliance, as well as other industry-leading vendors such as Computer Associates.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Bess is the leading filtering application in the education market and is currently installed in approximately 40% of the K-12 schools across the United States. Bess
offers customers the ability to deploy an off-box filtering solution (installed on a separate server) in conjunction with leading firewall and caching devices including Cisco Pix and Microsoft ISA.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Sentian is targeted at the corporate market, and is primarily an off-box filtering solution, featuring delegated administration and multiple deployment options for flexible
enterprise content management. We continue to offer Sentian to customers whose platform of choice will not allow filtering to be hosted On-Box (on the same server).
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We now offer customers enhanceddeployment and platform flexibility with over 30 different Web filtering options. Our
customers can choose to run filtering on the same server as the firewall, proxy server or caching system (co-host); they can elect to run filtering on a separate server (off-box), or they can purchase a platform from one of our OEM partners with
SmartFilter natively integrated (On-Box).



Embedded Firewall



Our Embedded Firewall technology is commercially
available through 3Com. By embedding access control technology inside the network interface cards, independent of the host operating system, the embedded firewall offers a scalable, tamper-resistant, and non-by-passable security solution to manage
access control inside the corporate perimeter firewall. The 3Com Embedded Firewall provides the next-generation of secure e-business connectivity, allowing employees, partners, and suppliers to access only the information they require.



The embedded firewall uses a centrally managed architecture.
The user-friendly GUI is designed to allow administrators to quickly and easily define access control policies on the Embedded FirewallPolicy Server. This



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flexible, scalable solution allows administrators to securely allow access to resources required by employees, partners, and suppliers, without sacrificing
the integrity and confidentiality of the network. The product is available for desktop, laptop, and server environments.



Security and Support Services



Our services are designed to ensure customers make optimal use of our products. We provide a life cycle of support and services: Solution Planning,
Solution Implementation, and Solution Support.



| |  |  | Solution Planning.    Our Security Services offerings include a variety of options for rapid assessment of a companys current network architecture
and evaluation of the current status of network security. We then compare this information to the companys business needs, both current and future, to help plan a scalable, secure e-commerce solution. In addition, we offer security policy
services that help customers prepare a policy and plan that transfers their security policy from paper to practice. We provide the following services: network architecture security assessment; security policy assessment and development; and
authentication, authorization and administration (AAA) system security assessment.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Solution Implementation.    Our Network Services team offers a full range of rapid-deployment integration services and training to assist our customers
through implementation and integration of our products. Both the configuration process of a security system and the security products themselves, by their nature, may have an impact on several areas within a customers network. Accordingly, we
offer a complete package of product integration assistance to help ensure our customers maximize network uptime and maintain productivity during the process. We provide the following services: product implementation; product audit and configuration;
and product training.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As part of our Network
Services training program, we provide extensive product and network training on-line with our Web-based training, through our tutor assisted training at our training facilities, and on-site worldwide for customers and partners. These services help
our customers understand basic and advanced administration rules and tools that enable partners to configure, integrate, and maintain our products as part of a comprehensive e-business solution.



| |  |  | Solution SupportSecureSupport®.    We offer industry leading live answer support services. SecureSupport has a team of technical support engineers that provide customer support around the
clock via e-mail, the Web, or telephone. Service options are tailored for each of our network security products. Customers can select the SecureSupport option that best meets their needs.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We designed SecureSupport Online, a tool to assist our customers and channel
partners with any problem they may experience with any of our products. Through this process, technical expertise is offered on-line through a searchable knowledge base, viewable support history, and email access. Product patches and release notes
can also be downloaded.



We offer our customers the option to
purchase software support and upgrade service for an annual fee. We provide software updates and technical support through this program.



Customers



Our customers operate some of the largest and most sensitive networks and applications in the world. Our partners and customers include the majority of
the Dow Jones Global 50 Titans and numerous organizations in the Fortune 1000, as well as banking, financial services, healthcare, telecommunications, manufacturing, public utilities, schools, and federal, state and local governments. We have
relationships with the largest agencies of the United States government. Our customer list also includes numerous international organizations and foreign governments. Overseas, our customers are concentrated primarily in Europe, Japan, China, the
Pacific Rim, and Latin America.



No customer accounted for more
than 10% of our total revenue in 2004, 2003 or 2002.



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Sales



We sell our products and services through both indirect and direct channels, using a worldwide sales organization. For 2004, sales to major end users
comprised 30% of total product sales, while indirect channel sales comprised 70%. Indirect channels include sales made to domestic and international distributors, value-added resellers, major integrators, and OEMs.



Our sales strategy is a hybrid, high-touch model designed to reduce possible
channel conflict and allow the customer to decide how best to acquire our products. In this model, our territory sales teams work closely with our channel and OEM partners to ensure that the customer is satisfied. Our direct demand creation
representatives in the field are compensated such that whether the customer buys our product and services directly from us or from one of our channel or OEM partners, both salespeople are compensated for the transaction. As an enterprise software
vendor, our goal is to ensure that our applications are successfully implemented and supported. This model allows the customer to choose their preferred partner for purchase, implementation and support, all of which are endorsed by us.



Our market strategy revolves around our PartnersFirst reseller program, a
channel program through which nearly all of our global indirect business is conducted. The program reflects our commitment to a partner-focused sales model, and enhances access to our products by making them available through a large number of
resellers via leading distribution partners and streamlined processes. Our channel program makes the process of doing business with us simple, while giving partners enhanced abilities to increase revenue.



We have a United States federal government sales team and maintain a General
Services Administration (GSA) schedule for our products to facilitate government orders. The United States government is the worlds largest buyer of security products, and continues to be a strong market for us.



International sales accounted for 31% of total revenue during 2004. In each
country, we have independent channel partners that are responsible for marketing, selling, and supporting our products to resellers and end users within their defined territories. Independent market analyst reports indicate that international
markets will continue to provide increased opportunities for e-business security products. The following table summarizes our domestic and international sales (in thousands):



|                    |  |                         |        |      |   |        |  |   |       
|------------------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------
|                    |  | Year ended December 31,
|                    |  | 2004                    |        | 2003 |   | 2002  
|Revenues:           |  |                         |        |      |   |        |  |   |       
|Domestic sales      |  | $                       | 64,431 |      | $ | 53,673 |  | $ | 44,842
|International sales |  |                         | 28,947 |      |   | 22,540 |  |   | 17,118
|                    |  |                         |        |      |   |        |  |   |       
|                    |  | $                       | 93,378 |      | $ | 76,213 |  | $ | 61,960
|                    |  |                         |        |      |   |        |  |   |       



Marketing



We market our products to existing customers and prospects worldwide using a
variety of integrated marketing programs. Our marketing team creates and implements marketing campaigns in each of our major functional market areascorporate marketing for company and brand awareness, product marketing, and partner marketing.



By leveraging relationships with our channel partners, we
generate sales leads and brand awareness through customer focused initiatives. Additionally, we work closely with industry analysts and current customers to understand the trends and needs associated with the security marketplace. Our research and
experience help drive key marketing initiatives including: direct marketing, Web marketing, print advertising, customer seminars, Web seminars, and trade shows.



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An active international public relations program ensures that we receive appropriate press coverage for
our various programs and announcements as well as obtain product reviews and speaking engagements. In addition to our marketing programs, we stimulate interest and demand for our solutions through our corporate Web site, channel partner Web sites
and other industry-specific Web sites, providing white papers, newsletters, and technical notes. Several of our senior technical staff contribute articles to industry periodicals as well as abstracts for presentations they provide to industry
specific summits and events, further extending our ability to educate the industry about e-business security.



Through our partnering programs, we enter strategic marketing and selling relationships with various vendors of communications, security, and network
management products or managed services. With tightly integrated solutions, these partners promote our products along with theirs in helping customers build a security solution.



Competition



The market for network security is highly competitive, and we expect competition to intensify in the future. Our products compete on the basis of quality
of security, ease of installation and management, scalability, performance and flexibility. Each of our individual products competes with a different group of competitors and products. Current competitors for our existing products include:



| |  |  | Check Point Software Technologies Ltd.;
| | - |  | ---------------------------------------



| |  |  | Cisco Systems, Inc.;
| | - |  | --------------------



| |  |  | CyberGuard Corp.;
| | - |  | -----------------



| |  |  | Fortinet, Inc.;
| | - |  | ---------------



| |  |  | Juniper Networks;
| | - |  | -----------------



| |  |  | RSA Security, Inc.;
| | - |  | -------------------



| |  |  | SurfControl, plc;
| | - |  | -----------------



| |  |  | Symantec Corporation; and
| | - |  | -------------------------



| |  |  | Websense, Inc.
| | - |  | --------------



Backlog



Our backlog
for products at any point in time is not significant since products are shipped upon receipt of order. We do not believe that our backlog at any particular point in time is indicative of future sales levels. The timing and volume of customer orders
are difficult to forecast because our customers typically require prompt delivery of products and a majority of our sales are booked and shipped in the same quarter. In addition, sales are generally made pursuant to standard purchase orders that can
be rescheduled, reduced, or canceled prior to shipment with little or no penalty.



Manufacturing



Our manufacturing operations
consist primarily of light manufacturing of our software and appliance products. For software products, we use subcontractors to duplicate software media and print user documentation and product packaging. For appliance products, we procure computer
servers from major computer manufacturers. We then assemble the final software and hardware products at our facilities in St. Paul, Minnesota.



Our SafeWord product line includes a small token, available in various designs, which is used for user authentication. We source these tokens through an
electronics assembly manufacturer located in China. In addition, we utilize specialized robotic equipment for certain automated deployment services for some of our SafeWord token customers.



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The majority of the materials used in our manufacturing operations are industry-standard parts. Typical
materials required are media and media duplication services, user documentation and other printed materials, product packaging, and computer systems (computer servers, computer peripherals, memory disk drives, and storage devices).



Research and Development



Our internal engineering staff performs internal development of new products
and features. Of our 86 engineering employees at March 1, 2005, 12 held postgraduate degrees. For the years ended December 31, 2004, 2003, and 2002, our research and development expenses were $16.1 million, $15.2 million, and $14.9 million,
respectively.



We intend to keep our products broadly
compatible with a variety of host computer configurations, other information security products and other applications. In addition, we will introduce new products as market demand develops for such products. We design our products so that they
support emerging security and content standards, such as the Public Key Cryptography Standard (PKCS), the IPSec, the Lightweight Directory Access Protocol (LDAP), Internet Protocol Version 6 (IPv6), Secure Sockets Layer (SSL), Hypertext Transfer
Protocol (HTTP), Extensible Markup Language (XML), Simple Mail Transfer Protocol (SMTP), and others.



Patents and Proprietary Technology



We rely on patent, trademark, copyright, and trade secret laws, employee and third-party nondisclosure agreements, and other methods to protect our proprietary rights. We currently hold a number of United States and
foreign patents relating to computer security software and hardware products. We believe that our patents are broad and fundamental to information security computer products.



Our success depends, in part, upon our proprietary software and security technology. We also rely on trade secrets and
proprietary expertise that we seek to protect, in part, through confidentiality agreements with employees, consultants, and other parties.



We have used, registered, and/or applied to register certain trademarks and service marks to distinguish genuine Secure Computing products, technologies
and services from those of our competitors in the United States and in foreign countries and jurisdictions. We enforce our trademark, service mark and trade name rights in the United States and abroad.



Employees



As of March 1, 2005, we had approximately 378 employees. Of these employees, 137 were involved in sales and marketing, 54 in
customer support and services, 107 in research and development, 29 in production, 23 in information technology and 28 in administrative, human resources and finance. None of our employees are represented by a labor union or is subject to a
collective bargaining agreement. We believe that we maintain good relations with our employees.



Executive Officers



Our
executive officers and their ages as of March 1, 2005 are as follows:



|                     |  |     |  |                                                             
|-------------------- |  | --- |  | ------------------------------------------------------------
|EXECUTIVE OFFICERS   |  | AGE |  | POSITION WITH SECURE COMPUTING CORPORATION                  
|John E. McNulty      |  | 58  |  | Chief Executive Officer, President and Chairman of the Board
|Timothy J. Steinkopf |  | 43  |  | Senior Vice President and Chief Financial Officer           
|Vincent M. Schiavo   |  | 47  |  | Senior Vice President of Worldwide Sales                    
|Michael J. Gallagher |  | 41  |  | Senior Vice President of Product Development                
|Mary K. Budge        |  | 49  |  | Senior Vice President, Secretary and General Counsel        



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JOHN E. MCNULTY is our Chairman, President and Chief Executive Officer. Mr. McNulty first joined us as
President and Chief Operating Officer in May 1999 and assumed the positions of Chairman of the Board and Chief Executive Officer in July 1999. From 1997 until joining us, he served as Senior Vice President of Sales, Services, and Business
Development at Genesys Telecommunications Laboratories. Mr. McNulty was also previously with Intel Corporation, where he held a number of positions, including Director of Marketing and Business Development for the Enterprise Server Group, which he
launched.



TIMOTHY J. STEINKOPF is our Senior Vice President
and Chief Financial Officer. Mr. Steinkopf first joined us as Treasurer and Director of Investor Relations in September 2000 and assumed the positions of Vice President and Chief Financial Officer in March 2001. Mr. Steinkopf was appointed to Senior
Vice President in January 2002. From 1999 until joining us, he was at Silicon Entertainment, Inc. where his last position was Chief Financial Officer and Vice President of Finance. He was the Vice President of Finance, Secretary and Treasurer at
Watt/Peterson Inc. from 1991 to 1999. Prior to that, he was at Ernst & Young LLP.



VINCENT M. SCHIAVO is our Senior Vice President of Worldwide Sales. Mr. Schiavo joined us in April 2001. From 1998 until joining us, he served as President of PolyServe, Inc. Prior to that he served as Vice President
of Worldwide Sales at Sonic Solutions and in various other sales management roles at Radius, Apple Computer and Data General Corporation.



MICHAEL J. GALLAGHER is our Senior Vice President of Product Development. Mr. Gallagher rejoined us as Vice President and General Manager of our Network
Security Division in 1999 and assumed the position of Senior Vice President of Product Development in August 2003. From 1997 until rejoining us, he was the Vice President of Software and Systems Engineering at Datakey. In 1996 and into 1997, he was
employed by us and was responsible for management of several firewall and security initiatives. Prior to that he held various software engineering and technical management positions with increasing responsibility at Unisys Corporation.



MARY K. BUDGE is our Senior Vice President, Secretary and General Counsel.
Ms. Budge joined us in November 1996 as corporate counsel and was appointed Senior Vice President in February 2005. Prior to joining us, she was an attorney for Schwegman, Lundberg, Woessner & Kluth where she specialized in trademark and
copyright law. Ms. Budge is a member of the Minnesota Bar Association and the American Corporate Counsel Association.



None of the executive officers are related to each other or to any other director of Secure Computing.



Certain Factors That May Affect Future Results



The following important factors, among others, could cause actual results to
differ materially from those indicated by forward-looking statements made in this Annual Report on Form 10-K and presented elsewhere by us from time to time.



We have experienced operating losses in the past and may experience operating losses in the future.    In 2004 we had operating
profit. However, we have incurred losses in the past. If we are unable to attain operating profits in each quarter and for the year, our stock price may decline, which could cause you to lose part or all of your investment.



In 2004 we were cash flow positive, however, we have experienced negative
cash flow in the past and may experience negative cash flow in the future. If, at that time, sources of financing are not available, we may not have sufficient cash to satisfy working capital requirements.    We believe that
our current cash balances are sufficient to satisfy our working capital requirements for at least the next twelve months. We may need to obtain additional financing at that time or sooner if our plans change or if we expend cash sooner than
anticipated. We currently do not have any commitments from third parties to provide additional capital. The risk to us is that if at any time we will need cash, financing from other sources may not be available on satisfactory terms or at all. Our
failure to obtain financing at that time could result in our insolvency and the loss to investors of their entire investment in our common stock.



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The potential increase in revenue from our relationships with various vendors of communications,
security, and network management products or managed services may be reduced by requirements to provide volume price discounts and other allowances and significant costs incurred in customizing our products.    Although we do
not intend that such relationships be exclusive, we may be required to enter into an exclusive relationship or forego a significant sales opportunity. To the extent we become dependent on actions by such parties, we could be adversely affected if
the parties fail to perform as expected. To minimize our risk, we often set minimum quotas with our customers as a condition of exclusivity.



Competition from companies producing enterprise network and data security products could reduce our sales and market
share.    The market for network security products is intensely competitive and characterized by rapid technological change. We believe that competition in this market is likely to persist and to intensify as a result of
increasing demand for security products. Each of our individual products competes with a different group of competitors and products. Because the market for our products is highly competitive, it may be difficult to significantly increase our market
share or our share may actually decline.



Our customers
purchase decisions are based heavily upon the quality of the security our products provide, the ease of installation and management, the ability to increase the numbers of individuals using our software simultaneously, and the flexibility of our
software. If a competitor can offer our customers a better solution in these areas or others and we are unable to rapidly offer a competitive product, we may lose customers. Competitors with greater resources could offer new solutions rapidly and at
relatively low costs which could lead to increased price pressure, reduced margins, and a loss of market share.



Many of our competitors and potential competitors have significantly greater financial, marketing, technical, and other competitive resources than we
have. Our larger actual and potential competitors may be able to leverage an installed customer base and/or other existing or future enterprise-wide products, adapt more quickly to new or emerging technologies and changes in customer requirements,
or devote greater resources to the promotion and sale of their products than we can. Additionally, we may lose product sales to these competitors because of their greater name recognition and reputation among potential customers.



Our future potential competitors could include developers of operating
systems or hardware suppliers not currently offering competitive enterprise-wide security products, including Microsoft Corporation, Sun Microsystems, Inc., IBM, Computer Associates, and Hewlett Packard. If any of those potential competitors begins
to offer enterprise-wide security systems as a component of its hardware, demand for our software could decrease. Ultimately, approaches other than ours may dominate the market for enterprise network and data security products.



In the future, we may also face competition from our competitors and other
parties that develop or acquire network security products based upon approaches similar to or different from those we employ. There are no guarantees that our approach will compete successfully against network security products of our competitors.
While we believe that we do not compete against manufacturers of other classes of security products, such as encryption, due to the complementary functions performed by such other classes, our customers may perceive such other companies as our
competitors.



Consolidation among competitors may erode our
market share.    Current and potential competitors have established, or may in the future establish, cooperative relationships among themselves or with third parties to increase the ability of their products to address the
needs of our prospective customers. Accordingly, it is possible that new competitors or alliances may emerge and rapidly acquire significant market share. If this were to occur, it could materially and adversely affect the financial condition or
results of our operations.



The trend toward multi-function
security solutions may result in a consolidation of the market around a smaller number of vendors that are able to provide the necessary breadth of products and services. In the event that we are unable to internally develop all of the products
needed for a complete, secure e-business solution, we



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may need to acquire such technology or be acquired by a larger entity. However, there can be no assurance that, in the event that we are not able to
internally develop all of the products needed for an enterprise-wide security solution, we will be able to acquire or merge with other entities on terms favorable to us and our stockholders.



The pricing policies of our competitors may impact the overall demand for
our product and our profitability.    Some of our competitors are capable of operating at significant losses for extended periods of time, enabling them to sell their products at a lower price. If we do not maintain
competitive pricing, the demand for our products, as well as our market share, may decline, having an adverse effect on our business. From time to time, in responding to competitive pressures we lower the price of our products. When this happens, if
we are unable to reduce our component costs or improve operating efficiencies, our margins will be adversely affected.



Other vendors may include products similar to ours in their hardware or software and render our products obsolete.    In the
future, vendors of hardware and of operating system or other software may continue to enhance their products or bundle separate products to include functions that are currently provided primarily by network security software. If network security
functions become standard features of computer hardware or of operating system software or other software, our products may become obsolete and unmarketable, particularly if the quality of these network security features is comparable to that of our
products. Furthermore, even if the network security and/or management functions provided as standard features by hardware providers or operating systems or other software is more limited than that of our products, our customers might accept this
limited functionality in lieu of purchasing additional software. Sales of our products would suffer materially if we were then unable to develop new network security and management products to further enhance operating systems or other software and
to replace any obsolete products.



If an OEM customer
reduces or delays purchases, our revenue may decline and/or our business could be adversely affected.    We currently have formed relationships with several OEMs including Cisco, Blue Coat, and Network Appliance. If we fail
to sell to such OEMs in the quantities expected, or if any OEM terminates our relationship, this could adversely affect our reputation, the perception of our products and technology in the marketplace and the growth of our business, and your
investment in our common stock may decline in value.



Technology in the network security market is changing rapidly, and if we fail to develop new products that are well accepted, our market share will erode.    To compete successfully, we must enhance our existing
products and develop and introduce new products in a timely manner. Our net sales and operating results could be materially affected if we fail to introduce new products on a timely basis. The rate of new network security product introductions is
substantial and security products have relatively short product life cycles. Our customer requirements and preferences change rapidly. Our net sales and operating results will be materially affected if the market adopts, as industry standards,
solutions other than those we employ.



Denial of our patent
applications or invalidation or circumvention of our patents may weaken our ability to compete in the network security market.    While we believe that our pending applications relate to patentable devices or concepts, there
can be no assurances that any pending or future patent applications will be granted. There is also the risk that a current or future patent, regardless of whether we are an owner or a licensee of such patent, may be challenged, invalidated or
circumvented. In addition, there are no assurances that the rights granted under a patent or under licensing agreements will provide competitive advantages to us.



If another party alleges that we infringe its patents or proprietary rights, we may incur substantial litigation
costs.    We are not aware of any third-party claims that we or our products have infringed a patent or other proprietary rights. However, the computer technology market is characterized by frequent and substantial
intellectual property litigation. Intellectual property litigation is complex and expensive, and the outcome of such litigation is difficult to predict. In the event that a third party were to make a claim of infringement against us, we could be
required to devote substantial resources and management time to the defense of such claim, which could have a material adverse effect on our business and results of operations.



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Disclosure of our trade secrets or proprietary information may undermine our competitive
advantages.    There can be no assurances that the confidentiality agreements protecting our trade secrets and proprietary expertise will not be breached, that we will have adequate remedies for any breach, or that our trade
secrets will not otherwise become known to or independently developed by competitors.



If the use of public switched networks such as the Internet does not continue to grow, our market and ability to sell our products and services may be limited.    Our sales also depend upon
a robust industry and infrastructure for providing access to public switched networks, such as the Internet. If the infrastructure or complementary products necessary to take these networks into viable commercial marketplaces are not developed or,
if developed, these networks do not become and continue to be viable commercial marketplaces, our net sales and operating results could suffer.



Our reliance on third party manufacturers of hardware components that are used in our Sidewinder appliance and SafeWord token product lines could cause
a delay in our ability to fill orders.    We currently purchase the hardware components for our Sidewinder appliance product line from one major supplier. For fulfillment of our SafeWord token sales, we source through a
supplier in China. Delays in receiving components would harm our ability to deliver our products on a timely basis and net sales and operating results could suffer.



Our product lines are not diversified beyond providing network security solutions to our customers, and any drop in the
demand for network security products would materially harm our business.    Substantially all of our revenue comes from sales of enterprise network security products and related services. We expect this will continue for the
foreseeable future. As a result, if for any reason our sales of these products and services are impeded, our net sales and operating results will be significantly reduced.



Our stock price is highly volatile, which may cause our investors to lose money and may impair our ability to raise
money, if necessary.    The price of our common stock, like that of many technology companies, has fluctuated widely. During 2004, our stock price ranged from a per share high of $19.95 to a low of $5.80. Fluctuation in our
stock price may cause our investors to lose money and impair our ability to raise additional capital, if necessary. Factors that may affect stock price volatility include:



| |  |  | Unexpected fluctuations in operating results;
| | - |  | ---------------------------------------------



| |  |  | Secure Computing or its competitors announcing technological innovations or new products;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | General economic conditions and weaknesses in geographic regions of the world;
| | - |  | ------------------------------------------------------------------------------



| |  |  | Threat of terrorist attacks or acts of war in the United States or abroad;
| | - |  | --------------------------------------------------------------------------



| |  |  | Developments with respect to our patents or other proprietary rights or those of our competitors;
| | - |  | -------------------------------------------------------------------------------------------------



| |  |  | Our ability to successfully execute our business plan and compete in the network security industry;
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | Relatively low trading volume;
| | - |  | ------------------------------



| |  |  | Product failures; and
| | - |  | ---------------------



| |  |  | Analyst reports and media stories.
| | - |  | ----------------------------------



If our products fail to function properly or are not properly designed, our reputation may be harmed, and customers may make product liability and
warranty claims against us.    Our customers rely on our information security products to prevent unauthorized access to their networks and data transmissions. These customers include major financial institutions,
defense-related government agencies protecting national security information, and other large organizations. These customers use our products to protect confidential business information with commercial value far in excess of our net worth.
Therefore, if our products malfunction or are not properly designed, we could face warranty and other legal claims, which may exceed our ability to pay. We seek to reduce the risk of these losses by attempting to negotiate warranty disclaimers and
liability limitation clauses in our sales agreements and by maintaining product liability insurance. However, these measures may ultimately prove ineffective in limiting our liability for damages.



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In addition to any monetary liability for the failure of our products, an actual or perceived breach of
network or data security at one of our customers could harm the markets perception of our products and our business. The harm could occur regardless of whether that breach is attributable to our products.



We also face the more general risk of bugs and other errors in our software.
Software products often contain undetected errors or bugs when first introduced or as new versions are released, and software products or media may contain undetected viruses. Errors or bugs may also be present in software that we license from third
parties and incorporate into our products. Errors, bugs, or viruses in our products may result in loss of or delay in market acceptance, recalls of hardware products incorporating the software, or loss of data. Our net sales and operating results
could be materially reduced if we experience delays or difficulties with new product introductions or product enhancements.



If we lose a significant customer, we will realize smaller profits.    We derive a significant portion of our revenues from a
limited number of customers. For example, our top five customers in products and services made up 24% of our revenue in 2004. If we lose any of these customers or if our revenues from any of these customers are reduced, and we fail to replace the
customer or fail to increase revenues from other customers, we will incur smaller profits.



If we fail to collect amounts due from our customers on a timely basis, our cash flow and operating results may
suffer.    Because the timing of our revenues is difficult to predict and our expenses are often difficult to reduce in the short run, management of our cash flow is very important to us. Like most companies, we anticipate
that a portion of the amounts owed to us will never be paid. However, if our actual collection of amounts owed to us is less than we have estimated, we will have less cash to fund our operations than we anticipated, and our financial condition and
operating results could be adversely affected.



In addition,
collection of amounts due us from sales to international customers generally takes longer than for other sales. Therefore, if our sales to international customers increase as a percentage of our total revenue, the average number of days it takes for
us to collect amounts due from our customers may increase. If there is an increase in the time required for us to collect amounts due us, we will have less cash to fund our operations than we anticipated. This in turn could adversely affect our
financial condition and operating results.



We have taken and
may from time to time take various forms of action to manage the amounts due us from customers and grant customer discounts in exchange for earlier payment.



Quarterly revenues and operating results depend on the volume and timing of orders received, which may be affected by large individual transactions and
which sometimes are difficult to predict. Our quarterly operating results may vary significantly depending on a number of other factors, including:



| |  |  | The timing of the introduction or enhancement of products by us or our competitors;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | The size, timing, and shipment of individual orders;
| | - |  | ----------------------------------------------------



| |  |  | Market acceptance of new products;
| | - |  | ----------------------------------



| |  |  | Changes in our operating expenses;
| | - |  | ----------------------------------



| |  |  | Personnel departures and new hires and the rate at which new personnel become productive;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | Mix of products sold;
| | - |  | ---------------------



| |  |  | Changes in product pricing;
| | - |  | ---------------------------



| |  |  | Development of our direct and indirect distribution channels;
| | - |  | -------------------------------------------------------------



| |  |  | Costs incurred when anticipated sales do not occur; and
| | - |  | -------------------------------------------------------



| |  |  | General economic conditions.
| | - |  | ----------------------------



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Sales of our products generally involve a significant commitment of capital by customers, with the
attendant delays frequently associated with large capital expenditures. For these and other reasons, the sales cycle for our products is typically lengthy and subject to a number of significant risks over which we have little or no control. We are
often required to ship products shortly after we receive orders, and consequently, order backlog, if any, at the beginning of any period has in the past represented only a small portion of that periods expected revenue. As a result, our
product revenue in any period substantially depends on orders booked and shipped in that period. We typically plan our production and inventory levels based on internal forecasts of customer demand, which are highly unpredictable and can fluctuate
substantially.



If customer demand falls below anticipated
levels, it could seriously harm our operating results. In addition, our operating expenses are based on anticipated revenue levels, and a high percentage of our expenses are generally fixed in the short term. Based on these factors, a small
fluctuation in the timing of sales can cause operating results to vary significantly from period to period.



The Internet may become subject to increased regulation by government agencies.    Due to the increasing popularity and use of
the Internet, it is possible that a number of laws and regulations may be adopted with respect to the Internet, covering issues such as user privacy, pricing and characteristics, and quality of products and services. In addition, the adoption of
laws or regulations may slow the growth of the Internet, which could in turn decrease the demand for our products and increase our cost of doing business or otherwise have an adverse effect on our business, operating results or financial
condition.



Anti-takeover provisions in our charter
documents, share right agreement, and Delaware law could discourage a takeover or future financing.    The terms of our certificate of incorporation and share right agreement permit our Board of Directors to issue up to
2,000,000 shares of preferred stock and determine the price, rights, preferences, privileges, and restrictions, including voting rights, of those shares without any further vote or action by our stockholders.



The Board may authorize the issuance of preferred stock with voting or
conversion rights that could materially weaken the voting power or other rights of the holders of our common stock. The issuance of preferred stock, while providing desirable flexibility in connection with possible acquisitions and other corporate
purposes, could make it more difficult for a third party to acquire a majority of our outstanding voting stock. Further, provisions of Delaware law, our certificate of incorporation and our bylaws, such as a classified board and limitations on the
ability of stockholders to call special meetings, and provisions of our share rights agreement could delay or make more difficult a merger, tender offer, proxy contest, or other takeover attempts.



The ability to attract and retain highly qualified personnel to develop
our products and manage our business is extremely important, and our failure to do so could harm our business.    We believe our success depends to a large extent upon a number of key technical and management employees. We
may be unable to achieve our revenue and operating performance objectives unless we can attract and retain technically qualified and highly skilled engineers and sales, consulting, technical, financial, operations, marketing, and management
personnel. These personnel are particularly important to our research and development efforts and to our growing professional service business, where we employ a large number of technical personnel holding advanced degrees and special professional
certification. Competition for qualified personnel is intense, and we expect it to remain so for the foreseeable future. We may not be successful in retaining our existing key personnel and in attracting and retaining the personnel we require. Our
operating results and our ability to successfully execute our business plan will be adversely affected if we fail to retain and increase our key employee population.



Our international operations subject us to risks related to doing business in foreign
countries.    International sales are a substantial portion of our business. Although all of our sales are payable in U.S. dollars, several factors could make it difficult for customers from foreign countries to purchase our
products and services or pay us for obligations already incurred. Such factors include:



| |  |  | Severe economic decline in one of our major foreign markets; and
| | - |  | ----------------------------------------------------------------



| |  |  | Substantial decline in the exchange rate for foreign currencies with respect to the U.S. dollar.
| | - |  | ------------------------------------------------------------------------------------------------



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A decline in our international sales or collections of amounts due us from customers could materially
affect our operations and financial conditions. For fiscal year 2004, 31% of our total sales came from international sales compared to 30% in 2003. A very large drop in our sales or collections of amounts due us in these specific countries as a
result of recession or other economic or political disturbances would likely harm our net sales and operating results.



In addition, we face a number of general risks inherent in doing business in international markets including, among others:



| |  |  | Unexpected changes in regulatory requirements;
| | - |  | ----------------------------------------------



| |  |  | Tariffs and other trade barriers;
| | - |  | ---------------------------------



| |  |  | Legal uncertainty regarding liability;
| | - |  | --------------------------------------



| |  |  | Threat of terrorist attacks or acts of war;
| | - |  | -------------------------------------------



| |  |  | Political instability;
| | - |  | ----------------------



| |  |  | Potentially greater difficulty in collecting amounts due us;
| | - |  | ------------------------------------------------------------



| |  |  | Longer periods of time to collect amounts due us; and
| | - |  | -----------------------------------------------------



| |  |  | A higher rate of piracy of our products in countries with a high incidence of software piracy.
| | - |  | ----------------------------------------------------------------------------------------------



Other



Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports are available, free of
charge, on our website at www.securecomputing.com as soon as reasonably practicable after they are filed with the SEC.



ITEM 2.    PROPERTIES



We are currently headquartered in approximately 11,000 square feet of office space in San Jose, California. We have two separate facilities with a combined square footage of approximately 73,000 square feet in St.
Paul, Minnesota, that are occupied by production, research and development, and administration. We have research facilities located in Concord, California; Gaithersburg, Maryland; and Seattle, Washington that occupy approximately 17,000 square feet,
6,800 square feet and 39,000 square feet, respectively. In support of our United States field sales organization, we also lease 5,200 square feet of office space in Reston, Virginia. We occupy these premises under leases expiring at various times
through the year 2010. We also have foreign offices in London, England; Sydney, Australia; Munich, Germany; Paris, France; Singapore; Japan; China and Hong Kong. We believe that our facilities are adequate for our current needs.



ITEM 3.    LEGAL PROCEEDINGS



In December 2002, we were named as the defendant in a rental property lawsuit brought by Salvio Pacheco Square LLP in the United States Superior Court of Contra Costa County. The complaint alleges that we had violated
our one-time cancellation provision in a lease for our Concord, CA office and asked for relief in the form of compensatory and other damages. The Court entered a judgment in favor of the plaintiff in June 2004 in the amount of $1.1 million. We
believe that the allegations included in the complaint are wholly without merit, have filed an appeal to the judgment, and intend to defend this litigation vigorously. It is not possible to predict the timing or outcome of this litigation, however,
if we do not prevail in the appeal process, we could incur costs for approximately $1.1-2 million.



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



No matters were submitted to a vote of the stockholders during the three months ended December 31, 2004.



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PART II



ITEM 5.    MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER                    MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES



Market Information



Our common stock is listed on the NASDAQ national market
under ticker symbol: SCUR. As of March 1, 2005, there were approximately 1,100 registered holders. The number of registered holders represents the number of shareholders of record plus the number of individual participants in security position
listings. We believe, however, that many beneficial holders of our common stock have registered their shares in nominee or street name and that there are approximately 15,600 beneficial owners. The low and high sale price of our common stock during
the last eight quarters are as follows:



|        |  |       |  |       |  |       |  |      
|------- |  | ----- |  | ----- |  | ----- |  | -----
|        |  | 2004  |  | 2003 
|Quarter |  | High  |  | Low   |  | High  |  | Low  
|First   |  | 19.95 |  | 12.25 |  | 7.79  |  | 3.60 
|        |  |       |  |      
|Second  |  | 17.89 |  | 8.48  |  | 9.25  |  | 3.50 
|        |  |       |  |      
|Third   |  | 11.77 |  | 5.80  |  | 13.80 |  | 7.66 
|        |  |       |  |      
|Fourth  |  | 10.65 |  | 7.50  |  | 18.25 |  | 11.40



We have not paid any
dividends on our common stock during the periods set forth above. It is presently the policy of the Board of Directors to retain earnings for use in expanding and developing our business. Accordingly, we do not anticipate paying dividends on the
common stock in the foreseeable future.



Equity Compensation Plan
Information



The following table sets forth information
regarding securities authorized for issuance under equity compensation plans:



|                                                           |  |                                                                                          |  |                                                                          |       |                                                                                          |          
|---------------------------------------------------------- |  | ---------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------ | ----- | ---------------------------------------------------------------------------------------- | ---------
|Plan category                                              |  | Number of securities tobe issued upon exerciseof outstanding options,warrants and rights |  | Weighted-averageexercise price ofoutstanding options,warrants and rights |       | Number of securitiesremaining available forfuture issuance underequity compensationplans
|Equity compensation plans approved by stockholders (1)(2)  |  | 6,207,779                                                                                |  | $                                                                        | 10.73 |                                                                                          | 303,265  
|Equity compensation plans not approved by stockholders (3) |  | 1,981,430                                                                                |  | $                                                                        | 7.68  |                                                                                          | 1,317,595
|                                                           |  |                                                                                          |  |                                                                          |       |                                                                                          |          
|Total                                                      |  | 8,189,209                                                                                |  | $                                                                        | 9.99  |                                                                                          | 1,620,860
|                                                           |  |                                                                                          |  |                                                                          |       |                                                                                          |          

---

|(1) | In September 1995, our Board of Directors and stockholders approved our 1995 Omnibus Stock Plan. Under the terms of this Plan, key employees and non-employees may be granted options
to purchase up to 11,494,131 shares of our Common Stock. The majority of options granted under this plan have ten year terms and vest either annually over three years, or fully vest at the end of three years. Beginning in 2003, all new stock options
granted under this plan vest 25% after the first year and then monthly over the following three years.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | In connection with our acquisition of N2H2, Inc. in October 2003, we assumed all of the outstanding N2H2 stock options under the 1997 Stock Option Plan, 1999 Stock
Option Plan, 1999 Non-Employee Director Plan, 1999/2000 Transition Plan, the 2000 Stock Option Plan, and the Howard Philip Welt Plan (the N2H2 Plans), which were converted into options to purchase approximately 420,000 shares of our
common stock. All stock options assumed were exercisable and vested. These options were assumed at prices between
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

| | $1.55 and $258.63 per share, with a weighted average exercise price of $9.45 per share. The options granted under these plans have ten year terms and vest
25% after the first year and then monthly over the following three years.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | In July 2002, our Board of Directors and compensation committee approved our 2002 Stock Option Plan. Under the terms of this Plan, key employees and non-employees may be granted
options to purchase up to 3,500,000 shares of our Common Stock. The options granted in 2002 have ten year terms and vest either annually over three years, or fully vest at the end of three years. Directors and executive officers are not included in
this plan. Beginning in 2003, all new stock option grants under this plan vest 25% after the first year and then monthly over the following three years.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



ITEM 6.    SELECTED FINANCIAL DATA



The consolidated statement of operations data set forth below for the fiscal years ended December 31, 2004, 2003 and 2002, and the consolidated balance sheet data at December 31, 2004 and 2003, are derived from the
audited consolidated financial statements included elsewhere in this Form 10-K. The consolidated statement of operations data set forth below for the fiscal years ended December 31, 2001 and 2000, and the consolidated balance sheet data at December
31, 2002, 2001 and 2000, are derived from audited consolidated financial statements which are not included in this Form 10-K. You should read the data set forth below in conjunction with the financial statements and notes thereto and
Managements Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Form 10-K.



|                                                              |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|------------------------------------------------------------- |  | ---------------------------------------------- | ------- | ------- | - | ------- | ------- |  | - | ------ | - |  | ---- | ------ | - |  | - | ------- | -
|                                                              |  | Year ended December 31,                        |        
|                                                              |  | (Table in thousands, except per share amounts) |        
|                                                              |  | 2004(1)                                        |         | 2003(1) |   |         | 2002(2) |  |   | 2001   |   |  | 2000 |       
|STATEMENT OF OPERATIONS DATA:                                 |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|Revenue                                                       |  | $                                              | 93,378  |         | $ | 76,213  |         |  | $ | 61,960 |   |  | $    | 48,353 |   |  | $ | 34,649  |  
|Gross profit                                                  |  |                                                | 81,043  |         |   | 68,592  |         |  |   | 57,253 |   |  |      | 42,573 |   |  |   | 25,793  |  
|Net income (loss) from continuing operations                  |  |                                                | 12,835  |         |   | 9,290   |         |  |   | (5,166 | ) |  |      | (7,237 | ) |  |   | (16,967 | )
|Net loss from discontinued operations/disposal of AT division |  |                                                |        |         |   | (1,034  | )       |  |   | (1,310 | ) |  |      | (1,733 | ) |  |   | (2,203  | )
|Net income (loss)                                             |  |                                                | 12,835  |         |   | 8,256   |         |  |   | (6,476 | ) |  |      | (8,970 | ) |  |   | (19,170 | )
|                                                              |  |                                                |         |         |  
|Basic income (loss) per share:                                |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|Continuing operations                                         |  |                                                | 0.36    |         |   | 0.29    |         |  |   | (0.18  | ) |  |      | (0.26  | ) |  |   | (0.67   | )
|Discontinued operations                                       |  |                                                |        |         |   | (0.03   | )       |  |   | (0.04  | ) |  |      | (0.06  | ) |  |   | (0.09   | )
|                                                              |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|Basic income (loss) per share                                 |  | $                                              | 0.36    |         | $ | 0.26    |         |  | $ | (0.22  | ) |  | $    | (0.32  | ) |  | $ | (0.76   | )
|                                                              |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|Diluted income (loss) per share:                              |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|Continuing operations                                         |  |                                                | 0.34    |         |   | 0.28    |         |  |   | (0.18  | ) |  |      | (0.26  | ) |  |   | (0.67   | )
|Discontinued operations                                       |  |                                                |        |         |   | (0.03   | )       |  |   | (0.04  | ) |  |      | (0.06  | ) |  |   | (0.09   | )
|                                                              |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|Diluted income (loss) per share                               |  | $                                              | 0.34    |         | $ | 0.25    |         |  | $ | (0.22  | ) |  | $    | (0.32  | ) |  | $ | (0.76   | )
|                                                              |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|BALANCE SHEET DATA:                                           |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|Working capital                                               |  | $                                              | 51,391  |         | $ | 28,989  |         |  | $ | 8,817  |   |  | $    | 20,790 |   |  | $ | 22,010  |  
|Total assets                                                  |  |                                                | 130,914 |         |   | 108,475 |         |  |   | 60,943 |   |  |      | 44,833 |   |  |   | 44,971  |  
|Stockholders equity                                          |  |                                                | 91,826  |         |   | 72,014  |         |  |   | 29,663 |   |  |      | 28,696 |   |  |   | 30,626  |  

---

|(1) | 2004 and 2003 balance sheet data includes $25.5 million and $26.5 million, respectively, of goodwill related to the acquisition of N2H2, Inc. completed in late 2003 and $13.8
million and $14.0 million, respectively, of goodwill related to the acquisition of the GauntletTMfirewall and VPN
business completed in early 2002.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | 2002 balance sheet data includes $15.2 million of goodwill related to the acquisition of the Gauntlet firewall and VPN business completed in early 2002 and a litigation settlement
accrual of $7.3 million.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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ITEM 7.    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
                   RESULTS OF OPERATIONS



Information Regarding Forward-Looking Statements



The following discussion contains forward-looking statements, including statements regarding our expectations, beliefs, intentions, or strategies
regarding the future. These statements are not guarantees of future performance and are subject to risks, uncertainties, and other factors, some of which are beyond our control and difficult to predict and could cause actual results to differ
materially from those expressed or forecasted in the forward-looking statements. The risks and uncertainties are summarized in Item 1 above and in the other documents we file with the SEC. These forward-looking statements reflect our view only as of
the date of this report. We cannot guarantee future results, levels of activity, performance, or achievement. We do not undertake any obligation to update or correct any forward-looking statements.



Executive Overview



Our specialized solutions are designed to meet our customers needs to balance security and accessibility and to help
them create trusted environments both inside and outside their organizations. Each of our products provides a complete solution in and of itself, and they also integrate well with each other for a more comprehensive, unified, and centrally managed
solution. Our products ability to scale as the infrastructure or number of users grows has always been, and continues to be, one of our hallmarks. Our solutions run on a variety of platforms and integrate well with other enterprise solutions,
making our products a safe and economical choice for organizations worldwide. The three product lines that represent the majority of our revenue are the Sidewinder G2 Security Appliance, our SafeWord products and our Web filtering products.



In February 2004, we released our next-generation Sidewinder
G2 Security Appliance product line. These appliances provide all-in-one, consolidated protection through standard and optional features, including the worlds strongest firewall, anti-virus, and anti-spam gateways, Web content URL filtering,
secure DNS, VPN, and SSL gateways, and more. These appliances are well positioned to satisfy increased market demands for application security.



The release of our new Sidewinder G2 Security Appliance, including the complementary Sidewinder G2 Enterprise Manager for managing distributed appliances,
also represents the completion of our promised two-phase integration of the Sidewinder and Gauntlet firewalls, following the 2002 acquisition of the Gauntlet firewall business from Network Associates.



We continue to find innovative distribution and partnership models to expand
our presence in the strong authentication market with our SafeWord product line. In 2004, we made tremendous strides in extending the reach of our SafeWord product line into both mid-market organizations and large enterprises. We have also gained
traction with our SafeWord For partner program introduced in 2003, and in particular with Citrix and Cisco.



In 2004, with the release of SmartFilter 4.0, we introduced a combined control list based on our prior URL control list and the URL control list acquired
from N2H2 in 2003. The result is a comprehensive list, which solidifies our position as one of the worlds leading suppliers of Web filtering. Containing millions of sites, the new URL control list offers 62 categories and covers over 60
languages.



With the launch of SmartFilter 4.0 in June, the new
control list was introduced, along with its new reporting feature, SmartReporter. SmartReporter adds powerful reporting capabilities to SmartFilter that make reporting on Web usage patterns easy for customers. SmartFilter continues to be the
market-leading de-facto standard for Web filtering on edge or caching devices through OEM relationships.



In addition to increasing functionality, platforms and technology integrations of our products, we continued to expand our market presence through an
extensive worldwide network of value-added resellers, distributors, and OEM partners. These partners generated 70% of our revenues in 2004.



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##### Table of Contents

Our customers operate some of the largest and most sensitive networks and applications in the world. Our
partners and customers include the majority of the Dow Jones Global 50 Titans and numerous organizations in the Fortune 1000, as well as banking, financial services, healthcare, telecommunications, manufacturing, public utilities, schools and
federal and local governments. We also have close relationships with the largest agencies in the United States government, both federal and local.



International sales accounted for 31% of total revenue during 2004. Major foreign markets for our products include Europe, Japan, China, the Pacific Rim
and Latin America. In each country, we have independent channel partners responsible for marketing, selling and supporting our products to resellers and end users.



Each of our individual products competes with a different group of competitors and products. In this highly competitive
market, characterized by rapid technological change, our customers purchase decisions are based heavily upon the quality of the security our products provide, the ease of installation and management, and the scalability and flexibility of our
software.



Specific challenges and risks that our product lines
face include, but are not limited to: responding to competitor pricing policies and competitive features; rapid technological change in the network security market; and risk of bugs and other errors in our software.



In 2004, we focused our efforts on strengthening our core product offerings
and developing a stronger worldwide channel. Our year over year improvement in net income from continuing operations was driven by strong revenue growth, strong gross margins and our ability to control operating expenses.



Results of Operations



The following table sets forth, for the periods indicated, certain items from the statements of operations of our company
expressed as a percentage of revenue:



|                                                 |  |                         |   |  |       |   |  |       |   
|------------------------------------------------ |  | ----------------------- | - |  | ----- | - |  | ----- | --
|                                                 |  | Year ended December 31, |  
|                                                 |  | 2004                    |   |  | 2003  |   |  | 2002  |   
|Net revenue                                      |  | 100.0                   | % |  | 100.0 | % |  | 100.0 | % 
|Cost of revenue                                  |  | 13.2                    |   |  | 10.0  |   |  | 7.6   |   
|                                                 |  |                         |   |  |       |   |  |       |   
|Gross profit                                     |  | 86.8                    |   |  | 90.0  |   |  | 92.4  |   
|Operating expenses:                              |  |                         |   |  |       |   |  |       |   
|Selling and marketing                            |  | 49.5                    |   |  | 50.8  |   |  | 56.5  |   
|Research and development                         |  | 17.3                    |   |  | 19.9  |   |  | 24.1  |   
|General and administrative                       |  | 6.9                     |   |  | 7.3   |   |  | 8.2   |   
|Separation costs                                 |  |                        |   |  |      |   |  | 0.9   |   
|                                                 |  |                         |   |  |       |   |  |       |   
|Total operating expenses                         |  | 73.7                    |   |  | 78.0  |   |  | 89.7  |   
|                                                 |  |                         |   |  |       |   |  |       |   
|Operating income                                 |  | 13.1                    |   |  | 12.0  |   |  | 2.7   |   
|Other non-recurring expense                      |  |                        |   |  |      |   |  | (11.7 | ) 
|Interest and other income                        |  | 0.6                     |   |  | 0.2   |   |  | 0.7   |   
|                                                 |  |                         |   |  |       |   |  |       |   
|Income (loss) from continuing operations         |  | 13.7                    |   |  | 12.2  |   |  | (8.3  | ) 
|Loss from operations of discontinued AT division |  |                        |   |  | (1.0  | ) |  | (2.2  | ) 
|Loss on disposal of discontinued AT division     |  |                        |   |  | (0.4  | ) |  | 0.0   |   
|                                                 |  |                         |   |  |       |   |  |       |   
|Net income (loss)                                |  | 13.7                    | % |  | 10.8  | % |  | (10.5 | )%
|                                                 |  |                         |   |  |       |   |  |       |   



Comparison of Years Ended December
31, 2004 and 2003.



The comparison of years ended December
31, 2004 and 2003 reflects the classification of the AT division as discontinued operations.



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Revenue.    Our revenue increased 22.5% to $93.4 million in 2004, up from
$76.2 million in 2003. The increase in revenue in 2004 was driven by growth across all product lines. Our Sidewinder G2 Firewall product line revenue increase was due to demand for our next-generation security appliance line. Our Web filtering
product line revenue increase was due to continued traction through OEM relationships and the incremental Bess and Sentian revenue contributed as a result of the N2H2, Inc. acquisition late in 2003. The SafeWord product line revenue increase was
driven by sustained demand for high assurance solutions. For 2005, revenues are expected to be in the range of $104 million to $106 million.



Gross Profit.    Gross profit as a percentage of revenue decreased from 90.0% in 2003 to 86.8% in 2004. This decline was driven
by increased sales volume on products containing a hardware component, primarily the Sidewinder G2 appliance sales, which have a lower gross profit margin than our software products. Gross margins were also reduced as a result of a larger portion of
business being transacted with channel partners versus direct to end users in 2004 as compared to 2003.



Operating Expenses.    Operating expenses consist of selling and marketing, research and development, general and
administrative expenses, and separation costs. Total operating expenses increased 15.8% to $68.8 million for 2004, up from $59.4 million in 2003. This increase was driven primarily by an inflationary increase in payroll and related costs and
inflationary increases in allocated corporate costs. As a percentage of revenue, total operating expenses were 73.7% for 2004 compared to 78.0% in 2003. This improvement was primarily driven by revenue growth outpacing the growth of operating
expenses during 2004 compared to 2003.



Selling and
Marketing.    Selling and marketing expenses consist primarily of salaries, commissions, and benefits related to personnel engaged in selling, marketing and customer support functions, along with costs related to advertising,
promotions, public relations, travel and allocations of corporate costs, which include information technology, facilities and human resources expenses. Selling and marketing expenses increased 19.4% to $46.3 million in 2004, up from $38.7 million in
2003. This increase was driven primarily by inflationary increases in payroll and related costs, an increase in commission expense due to expanding revenues, and inflationary increases in allocated corporate costs. As a percentage of revenue,
selling and marketing expenses were 49.5% in 2004 compared to 50.8% in 2003. This improvement was primarily driven by revenue growth outpacing the growth of selling and marketing expenses during 2004 compared to 2003.



Research and Development.    Research and
development expenses consist primarily of salaries and benefits for our product development personnel and allocations of corporate costs, which include information technology, facilities and human resources expenses. Research and development
expenses increased 6.1% to $16.1 million in 2004, up from $15.2 million in 2003. This increase was driven by inflationary increases in payroll, benefits and allocated corporate costs as well as increased facility costs as a direct result of our N2H2
acquisition in late 2003. As a percentage of revenue, research and development expenses were 17.3% for the year compared to 19.9% in 2003. This improvement was primarily driven by revenue growth outpacing the growth of research and development
expenses during 2004 compared to 2003.



General and
Administrative.    General and administrative expenses consist primarily of salaries, benefits and related expenses for our executive, finance and legal personnel, directors and officers insurance and allocations of corporate
costs, which include information technology, facilities and human resources expenses. General and administrative expenses increased 16.6% to $6.5 million in 2004, up from $5.5 million in 2003. This increase was driven primarily by an increase in
audit and legal fees, inflationary increases in allocated corporate costs, and to a lesser extent, inflationary increases in payroll and benefits. As a percentage of revenue, general and administrative expenses were 6.9% for the year compared to
7.3% in 2003. This improvement was primarily driven by revenue growth outpacing the growth of general and administrative expenses during 2004 compared to 2003.



Interest and Other Income.    Net interest and other income was $607,000 in 2004, an increase from $141,000 in 2003. The
increase reflects higher interest rates on higher cash balances in 2004 as compared to 2003 and a foreign currency translation adjustment related to the liquidation of a foreign entity.



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Net Loss From Disposal of AT Division.    In 2003, we determined that we would
no longer invest in our AT division and exited the business. Net loss from discontinued operations was $0 and $757,000 for the years ended December 31, 2004 and 2003, respectively. Loss on disposal of AT division was $0 and $277,000 for the years
ended December 31, 2004 and 2003, respectively.



Income
Taxes.    We recognized a deferred tax benefit of $345,000 in 2004 and $559,000 in 2003, which offset the tax expense incurred in each of those years. The computations of our deferred tax assets and valuation allowance are
based on taxable income we expect to earn on sales of existing products, and projected interest and other income over the next three years. Realization of the $3.6 million of net deferred tax assets is dependent upon our ability to generate
sufficient future taxable income and the implementation of tax planning strategies. We believe it is more likely than not that the net deferred tax assets will be realized based on expected levels of future taxable income in the United States and
certain foreign jurisdictions and the implementation of tax planning strategies. Future taxable income of $9.0 million is required to realize the $3.6 million deferred tax asset at December 31, 2004. We had total net operating loss carryforwards of
approximately $197.9 million at December 31, 2004. Of these carryforwards, $45.1 million relates to stock option exercises and $58.4 million relates to acquired N2H2 net operating losses, which currently have a full valuation allowance, and when
realized for financial statement purposes will not result in a reduction in income tax expense. Rather, the benefit from the stock option exercises will be recorded as an increase to additional paid-in capital and the benefit from the N2H2 net
operating loss carryforwards will be recorded as a decrease to goodwill. Of the remaining benefit associated with the carryforwards, approximately $85.4 million have yet to be recognized as a benefit in the consolidated statement of operations.
However, there are no assurances that these carryforwards will be available to offset future income tax expense when taxable income is realized.



Comparison of Years Ended December 31, 2003 and 2002.



The comparison of years ended December 31, 2003 and 2002 reflects the classification of the AT division as discontinued operations.



Revenue.    Our revenue increased 23.0% to $76.2
million in 2003, up from $62.0 million in 2002. The increase in revenue in 2003 was driven by growth across all product lines. Our Sidewinder G2 Firewall product line revenue increase was due to demand for our next generation firewall released in
early 2003. Our Web filtering product line revenue increase was due to continued traction through our OEM relationships and the incremental Bess and Sentian revenue contributed as a result of the N2H2, Inc. acquisition late in the year. Our SafeWord
product lines revenue increase was driven by sustained demand for high assurance solutions.



Gross Profit.    Gross profit as a percentage of revenue decreased from 92.4% in 2002 to 90.0% in 2003. This decline was driven by increased sales volume on products containing a hardware
component, primarily the Sidewinder appliance sales, which have a lower gross profit margin than our software products.



Operating Expenses.    Operating expenses consist of selling and marketing, research and development, general and
administrative expenses, and separation costs. Total operating expenses increased 6.9% to $59.4 million for the full year 2003, up from $55.6 million in 2002. This increase was driven primarily by an inflationary increase in payroll and related
costs and inflationary increases in allocated corporate costs. As a percentage of revenue, total operating expenses were 78.0% for the full year 2003 compared to 89.7% in 2002. This improvement was primarily driven by revenue growth outpacing the
growth of operating expenses during 2003 compared to 2002.



Selling and Marketing.    Selling and marketing expenses consist primarily of salaries, commissions, and benefits related to personnel engaged in selling, marketing and customer support functions, along with costs
related to advertising, promotions, public relations, travel and allocations of corporate costs, which include information technology, facilities and human resources expenses. Selling and marketing expenses increased 10.7% to $38.7 million in 2003,
up from $35.0 million in 2002. This increase was driven primarily by an inflationary increase in payroll and related costs, an increase in commission expense due to expanding revenues,



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and inflationary increases in allocated corporate costs. As a percentage of revenue, selling and marketing expenses were 50.8% in 2003 compared to 56.5% in
2002. This improvement was primarily driven by revenue growth outpacing the growth of selling and marketing expenses during 2003 compared to 2002.



Research and Development.    Research and development expenses consist primarily of salaries and benefits for our product
development personnel and allocations of corporate costs, which include information technology, facilities and human resources expenses. Research and development expenses increased 1.8% to $15.2 million in 2003, up from $14.9 million in 2002. This
increase was driven primarily by inflationary increases in allocated corporate costs. As a percentage of revenue, research and development expenses were 19.9% for the year compared to 24.1% in 2002. This improvement was primarily driven by revenue
growth outpacing the growth of research and development expenses during 2003 compared to 2002.



General and Administrative.    General and administrative expenses consist primarily of salaries, benefits and related expenses for our executive, finance and legal personnel, directors and
officers insurance and allocations of corporate costs, which include information technology, facilities and human resources expenses. General and administrative expenses increased 8.3% to $5.5 million in 2003, up from $5.1 million in 2002. This
increase was driven primarily by an increase in directors and officers insurance premiums, inflationary increases in allocated corporate costs, and to a lesser extent, inflationary increases in payroll and benefits. As a percentage of revenue,
general and administrative expenses were 7.3% for the year compared to 8.2% in 2002. This improvement was primarily driven by revenue growth outpacing the growth of general and administrative expenses during 2003 compared to 2002.



Interest and Other Income.    Net interest and
other income was $141,000 in 2003, a decrease from $421,000 in 2002. The decrease reflects lower interest rates in 2003 as compared to 2002 and an increase in other expenses for personal property taxes.



Net Loss From Disposal of AT Division.    During
the fourth quarter of 2003, we determined that we would no longer invest in our AT division and exited the business. Net loss from discontinued operations was $757,000 and loss on disposal of AT division was $277,000 for the year ended December 31,
2003. Loss from operations improved 42.2% in 2003 compared to 2002 as a result of the gradual contraction of that division.



Income Taxes.    We recognized a deferred tax benefit of $559,000, which offset the tax expense incurred in 2003 and none in
2002. The computations of our deferred tax assets and valuation allowance are based on taxable income we expect to earn on sales of existing products, and projected interest and other income over the next three years. Realization of the $3.3 million
of net deferred tax assets is dependent upon our ability to generate sufficient future taxable income and the implementation of tax planning strategies. We believe it is more likely than not that the net deferred tax assets will be realized based on
historical earnings, expected levels of future taxable income in United States and certain foreign jurisdictions, and the implementation of tax planning strategies. Future taxable income of $8.3 million is required to realize the $3.3 million
deferred tax asset at December 31, 2003. We had total net operating loss carryforwards of approximately $196.1 million at December 31, 2003. Of these carryforwards, $39.0 million relates to stock option exercises and $58.4 million relates to
acquired N2H2 net operating losses, which currently have a full valuation allowance, and when realized for financial statement purposes will not result in a reduction in income tax expense. Rather, the benefit from the stock option exercises will be
recorded as an increase to additional paid-in capital and the benefit from the N2H2 net operating loss carryforwards will be recorded as a decrease to goodwill. Of the remaining benefit associated with the carryforwards, approximately $90.4 million
have yet to be recognized as a benefit in the consolidated statement of operations. However, there are no assurances that these carryforwards will be available to offset future income tax expense when taxable income is realized.



Liquidity and Capital Resources



At December 31, 2004, our principal source of liquidity was $52.3 million of
cash, cash equivalents and short term investments, representing an $18.6 million increase from December 31, 2003. The increase is



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primarily due to cash provided by operating activities, cash received from the exercise of stock options, and the sale of common stock through our employee
stock purchase plan, offset by capital additions. At December 31, 2004, we have net future payments under non-cancelable operating leases of $6.7 million and have no material commitments for capital expenditures. We expect to generate cash during
2005 as we expect revenue to continue to grow at a faster rate than operating expenses.



Since our inception, we have financed our operations primarily through sales of our equity securities, and more recently, from cash generated from operations.



Net cash provided by operating activities of $13.7 million for the twelve
months ended December 31, 2004, was comprised of net income from continuing operations of $12.8 million, offset by net non-cash related expenses of $3.1 million, a $5.6 million increase in current assets, and a $3.4 million increase in liabilities.
Net cash provided by operations was driven by the increase in revenue outpacing our increase in operating expenses. Terms for cash collections received from customers and cash payments made to vendors were consistent with normal business practices.



Net cash provided by investing activities of $4.8 million for
the twelve months ended December 31, 2004, was comprised primarily of net proceeds from sales/maturities of investments of $7.2 million, offset by $1.6 million of cash used for net capital additions, which were made up of computer equipment,
technology upgrades, and leasehold improvements, and $802,000 used for intangible and other asset additions.



Net cash provided by financing activities of $7.2 million for the twelve months ended December 31, 2004 consisted primarily of proceeds received from the
exercise of stock options and the sale of common stock through our employee stock purchase plan.



As of December 31, 2004, we had working capital of $51.4 million. We anticipate using available cash to fund growth in operations, invest in capital
equipment, acquire businesses and to license technology or products related to our line of business. We expect to spend approximately $3.5 million on capital expenditures in 2005.



A summary of our total contractual cash obligations as of December 31, 2004 is as follows (in thousands):



|                                   |  |       |       |                        |   |                   |  |                    |       |                 |   |     |  |   |   
|---------------------------------- |  | ----- | ----- | ---------------------- | - | ----------------- |  | ------------------ | ----- | --------------- | - | --- |  | - | --
|                                   |  |       |       | Payments Due by Period
|                                   |  | Total |       | Less ThanOne Year      |   | One toThree Years |  | Three toFive Years |       | After FiveYears
|Operating leases, net of subleases |  | $     | 6,730 |                        | $ | 3,256             |  | $                  | 3,108 |                 | $ | 349 |  | $ | 17



We believe that we
have sufficient financial resources available to fund our current working capital and capital expenditure requirements for at least the next twelve months. We intend to continue to invest our cash in excess of current operating requirements in
interest bearing, short term investments.



Disclosures about Off-Balance
Sheet Arrangements



We did not have any off-balance sheet
arrangements as of December 31, 2004 or as of December 31, 2003.



Critical
Accounting Policies and Estimates



Our discussion of the
financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States. The preparation of our financial
statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of any contingent assets and liabilities at the date of the financial
statements. Management regularly reviews its estimates and assumptions, which are based on historical factors and other factors that are believed to be relevant under the circumstances. Actual results may differ from these estimates under different
assumptions, estimates, or conditions.



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Critical accounting policies are defined as those that are reflective of significant judgments and
uncertainties, and potentially result in materially different results under different assumptions and conditions. See Note 1 of the Notes to Consolidated Financial Statements for additional discussion of the application of these and other accounting
policies.



Revenue
Recognition.    Our revenue is derived from sales of our software licenses, hardware, royalties and maintenance arrangements to provide product upgrades and customer support. We recognize revenue in accordance with Statement
of Position (SOP) 97-2, Software Revenue Recognition, as modified by SOP 98-9. Revenue from products is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed and determinable, and
collection is probable. Maintenance revenue for providing product upgrades and customer support is deferred and recognized ratably over the service period.



For arrangements with multiple elements we allocate revenue to the various elements based on the fair value of each element sold. We determine the fair
value of each element based on its selling price when sold separately. Evidence of fair value includes the approved price list and discount schedule and the actual prices charged for comparable arrangements. These price lists and discount schedules
may change from time to time in response to factors including market conditions, value of services and product provided and competitive positioning. Historically, we have not offered significant discounts off of our list prices.



Further, it is our policy that our distributors and resellers are not allowed
to hold inventory with the exception of international resellers who are allowed to hold inventories of Safeword for Citrix (and other Safeword for products). This is a low price-point product with disproportionately high
overseas freight costs. As such, we allow the reseller to carry a balance of inventory and provide end-user sell-through reporting. Revenue is recognized at the point that we receive evidence of end-user sell-through.



Allowance for Doubtful Accounts.    We make
estimates regarding the collectibility of our accounts receivables. When we evaluate the adequacy of our allowance for doubtful accounts, we consider multiple factors including historical bad debt experience, the need for specific customer reserves,
the aging of our receivables, customer creditworthiness, changes in our customer payment cycles, and current economic trends. Historically, our allowance for doubtful accounts has been adequate based on actual results. If the financial condition of
our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.



Valuation of Long-Lived Assets, Including Goodwill and Other Intangible Assets.    Intangible assets consist of patents,
trademarks, capitalized software costs, a purchased customer list, a purchased control list, capitalized developed technology and goodwill, all of which are recorded at cost or fair value. Patents, trademarks, customer and control lists, and
capitalized developed technology are amortized using the straight-line method over the estimated useful lives of the assets, which range up to 17 years. See accounting policy of capitalized software costs under Research and Development in Note 1 of
Notes to Consolidated Financial Statements. Goodwill is not amortized, but is tested for impairment at least annually at the reporting unit level. If impairment is indicated, a write-down is recorded as an impairment loss in income from operations.



We review our long-lived assets and identified finite-lived
intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, except for goodwill as noted above. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to undiscounted future net cash flows expected to be generated by the assets. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying
amount of the assets exceeds the fair value of the assets.



Deferred Tax Assets.    We account for income taxes using the liability method, which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events
that have been included in our financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based



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on the difference between the financial statement and tax basis of assets and liabilities, using enacted tax rates in effect for the year in which the
differences are expected to reverse. Deferred tax assets are reduced by a valuation allowance when it is more likely than not that some component or all of the deferred tax assets will not be realized. The computations of our deferred tax assets and
valuation allowance are based on taxable income we expect to earn on sales of existing products and projected interest and other income over the next three years. The amount of the deferred tax assets considered realizable could be reduced in the
near term if estimates of future taxable income are reduced.



SFAS No. 109, Accounting for Income Taxes, requires the consideration of a valuation allowance for deferred tax assets if it is more likely than not that benefits of deferred tax assets will not be realized.
Realization of the $3.6 million of net deferred tax assets is dependent upon our ability to generate sufficient future taxable income and the implementation of tax planning strategies. However, the amount of the deferred tax assets considered
realizable could be reduced in the near term if estimates of future taxable income are reduced or we are unable to implement our tax strategies.



Inflation



To date, we have not been significantly affected by inflation.



Recently Issued Accounting Standards



In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 151, Inventory Costs
(SFAS No. 151). SFAS No. 151 requires abnormal amounts of inventory costs related to idle facility, freight handling and wasted material expenses to be recognized as current period charges. Additionally, SFAS No. 151 requires that allocation of
fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The standard is effective for fiscal years beginning after June 15, 2005. We believe the adoption of SFAS No. 151 will not have a
material impact on our consolidated financial statements.



In
December 2004, the FASB issued Statement of Financial Accounting Standards No. 123(R), Accounting for Stock-Based Compensation (SFAS No. 123R). SFAS No. 123R establishes standards for accounting for transactions in which an entity
exchanges its equity instruments for goods or services. SFAS No. 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123R requires that the fair value of
such equity instruments be recognized as expense in the historical financial statements as services are performed. Prior to SFAS No. 123R, only certain pro forma disclosures of fair value were required. SFAS No. 123R is effective as of the beginning
of our first interim or annual reporting period that begins after June 15, 2005, which is our third quarter of 2005.



SFAS No. 123R permits public companies to adopt requirements using one of two methods: (1) A modified prospective method in which compensation
cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to
the effective date of SFAS 123R that remain unvested on the effective date. (2) A modified retrospective method which includes the requirements of the modified prospective method described above, but also permits entities to restate
based on the amounts previously recognized under FAS 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption. We are currently in the process of evaluating the two methods
and have not yet determined which method will be used. The adoption of this new accounting pronouncement will have a material impact on our consolidated financial statements.



On October 22, 2004, the President signed into law the American Jobs Creation Act of 2004 (the Bill). We are currently in
the process of evaluating the Bill.



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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, a strengthening of the dollar could make our products less competitive in foreign markets and our accounts
receivable more difficult to collect.



We invest our cash in a
variety of financial instruments, including bank time deposits and commercial paper. Investments in fixed rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely
impacted due to a rise in interest rates. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities which have seen a
decline in market value due to changes in interest rates. Our investment securities are held as available-for-sale.



We believe our operations are currently not subject to significant market risks for foreign currency exchange rates, interest rates, or other relevant
market price risks of a material nature.



ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



Our financial statements required by this item are set forth as a separate section of this report. See Part IV, Item 15 of this Form 10-K.



ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND                    FINANCIAL
DISCLOSURE



Not applicable.



ITEM 9A.    CONTROLS AND PROCEDURES



Evaluation of Disclosure Controls and Procedures



We carried out an evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of
our disclosure controls and procedures pursuant to Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the Exchange Act.) Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that as of December 31, 2004, the end of period covered by this report, our disclosure controls and procedures were effective at the reasonable assurance level to timely alert them to material information relating to Secure Computing (including its
consolidated subsidiaries) required to be included in our Exchange Act filings.



Changes in Internal Control Over Financial Reporting



During the quarter ended December 31, 2004, there have been no significant changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.



Managements Report
on Internal Control Over Financial Reporting



Our
management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Our internal control system was designed to provide reasonable assurance to our
management and board of directors regarding the preparation and fair presentation of published financial statements. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be
effective can provide only reasonable assurance with respect to financial statement preparation and presentation.



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Under the supervision and with the participation of our management, including our Chief Executive Officer
and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission. Based on our evaluation under the framework in Internal ControlIntegrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2004.



Our managements assessment of the effectiveness of our internal control
over financial reporting as of December 31, 2004 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which is included herein on page 53.



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PART III



ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT



Incorporated herein by reference is the information under the heading Election of Directors and Section 16(a) Beneficial Ownership
Reporting Compliance, in the Registrants Proxy Statement to be filed on or about March 31, 2005. See also Part I, Item 1, Executive Officers of this Form 10-K.



We maintain a Code of Business Conduct and Ethics applicable to all our employees. We have also adopted a Code of Ethics for
Finance that is applicable to our chief executive officer, chief financial officer, controller, and finance personnel performing functions related to financial reporting. A copy of our Code of Business Conduct and Ethics and our Code of Ethics for
Finance, as well as our corporate governance guidelines and the committee charters for each of the committees of the Board of Directors, can be obtained from our Internet website at www.securecomputing.com under the Investor Relations
page and will be made available free of charge to any shareholder upon request. We intend to disclose any waivers from, or amendments to, the Code of Business Conduct and Ethics and Code of Ethics for Finance by posting a description of such waiver
or amendment on our Internet website. However, we have never granted a waiver from either the Code of Business Conduct and Ethics and Code of Ethics for Finance.



ITEM 11.    EXECUTIVE COMPENSATION



Incorporated herein by reference is the information appearing in the Registrants Proxy Statement which the Registrant anticipates filing on or about March 31, 2005, under the headings Election of
Directors, Report of the Compensation Committee, Executive Officer Compensation Program, Summary Compensation Table, Option Grants in Last Fiscal Year, Aggregated Option Exercises in Last
Fiscal Year and Fiscal Year-End Option Values, Employment Contracts, Termination of Employment and Change-in-Control Arrangements, and Performance Evaluation.



ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT



Incorporated herein by reference is the information appearing under the heading Security Ownership of Principal Stockholders and Management in
the Registrants Proxy Statement that the Registrant anticipates filing on or about March 31, 2005.



ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS



Incorporated herein by reference is the information appearing under the heading Certain Transactions in the Registrants Proxy Statement
that the Registrant anticipates filing on or about March 31, 2005.



ITEM 14.    PRINCIPAL ACCOUNTANT FEES AND SERVICES



Incorporated herein by reference is the information appearing under the heading Relationship with Independent Registered Public Accounting
Firm in the Registrants Proxy Statement that the Registrant anticipates filing on or about March 31, 2005.



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PART IV



ITEM 15.    EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K



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



|   |  |                                                                                                                                                                                                                                                          
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|1. |  | Consolidated Financial Statements:                                                                                                                                                                                                                       
|   | 
|   |  | Consolidated Balance Sheets as of December 31, 2004 and 2003                                                                                                                                                                                             
|   |  | Consolidated Statements of Operations for the years ended December 31, 2004, 2003 and 2002                                                                                                                                                               
|   |  | Consolidated Statements of Stockholders Equity for the years ended December 31, 2004, 2003 and 2002                                                                                                                                                     
|   |  | Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002                                                                                                                                                               
|   |  | Notes to Consolidated Financial Statements                                                                                                                                                                                                               
|   |  | Report of Independent Registered Public Accounting Firm                                                                                                                                                                                                  
|   |  | Report of Independent Registered Public Accounting Firm  Section 404                                                                                                                                                                                    
|   | 
|2. |  | Consolidated Financial Statement Schedule:                                                                                                                                                                                                               
|   | 
|   |  | Schedule II - Valuation and Qualifying Accounts. Such schedule should be read in conjunction with the consolidated financial statements.
All other supplemental schedules are omitted because of the absence of conditions under which they are required.



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



On December 16, 2004, we filed a report on Form 8-K pursuant to Item 5.02, Departure of Directors or Principal Officers; Election of Directors;
Appointment of Principal Officers, filing the press release issued December 13, 2004 announcing the resignation of Tim McGurran as President, Chief Operating Officer and member of the Board of Directors of Secure Computing Corporation. John
McNulty, Chief Executive Officer and Chairman, has assumed Mr. McGurrans responsibilities.



|(c) | Exhibits:
|--- | ---------



The following exhibits are filed as part of this Annual Report on Form 10-K for the fiscal year ended December 31, 2004:



|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  | Description                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|        | 
|2.1     |  | Agreement and Plan of Merger, dated as of July 28, 2003, among Secure Computing Corporation, Nitro Acquisition Corp., and N2H2, Inc. is incorporated by reference to the corresponding exhibit
to our Registration Statement of Form S-4 (Registration Number 333-107804).                                                                                                                                                                                                                                                                
|        | 
|3.1     |  | Restated Certificate of Incorporation, effective March 6, 1996, as amended by the Certificate of Amendment of Certificate of Incorporation effective December 11, 1988, the Certificate of
Designations of Series E 4% Cumulative Preferred Stock effective January 26, 2000; and the Certificate of Designations of Series F 4% Cumulative Convertible Preferred Stock effective June 30, 2000 is incorporated by reference to the corresponding
exhibit to our Amended Quarterly Report on Form 10-Q for the period ended June 30, 2000.
|        | 
|3.2     |  | By-Laws of the Registrant are incorporated by reference to Exhibit 3.3 to our Registration Statement on Form S-1 (Registration Number 33-97838).                                                                                                                                                                                                                                                                                                                                                                                          
|        | 
|4.1     |  | Specimen of common stock certificate is incorporated by reference to the corresponding exhibit to Amendment No. 2 to our Registration Statement on Form S-1 (Registration Number
33-97838).                                                                                                                                                                                                                                                                                                                                               
|        | 
|4.2     |  | Amended and Restated 1995 Omnibus Stock Plan is incorporated by reference to the Exhibit 10.1 to our Current Report on Form 8-K filed on October 8, 1999.                                                                                                                                                                                                                                                                                                                                                                                 



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|        |  |                                                                                                                                                                                                                                               
|------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  | Description                                                                                                                                                                                                                                   
|        | 
|4.3     |  | 2002 Stock Option Plan is incorporated by reference to Exhibit 99.3 to our Registration Statement on Form S-8 (Registration Number 333-103595) and to Exhibit 99.1 to our Registration
Statement on Form S-8 (Registration Number 333-115583).
|        | 
|10.1    |  | Employment Agreement with John McNulty is incorporated by reference to the corresponding exhibit of our Quarterly Report of Form 10-K for the period ended March 31, 1999.                                                                    
|        | 
|10.2    |  | Employment Agreement with Timothy Steinkopf is incorporated by reference to the corresponding exhibit of our Quarterly Report of Form 10-K for the period ended June 30, 2001.                                                                
|        | 
|10.3    |  | Employment Agreement with Vince Schiavo is incorporated by reference to Exhibit 10.1 of our Quarterly Report of Form 10-K for the period ended June 30, 2001.                                                                                 
|        | 
|10.4    |  | Employment Agreement with Michael Gallagher.                                                                                                                                                                                                  
|        | 
|10.5    |  | Employment Agreement with Mary Budge.                                                                                                                                                                                                         
|        | 
|23.1    |  | Consent of Ernst & Young LLP.                                                                                                                                                                                                                 
|        | 
|24.1    |  | Power of Attorney. (See page 54.)                                                                                                                                                                                                             
|        | 
|31.1    |  | Certification of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.                                                                                                                                               
|        | 
|31.2    |  | Certification of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.                                                                                                                                               
|        | 
|32.1    |  | Certification by Chairman, President and Chief Executive Officer Pursuant to Section 906 of Sarbanes-Oxley Act of 2002.                                                                                                                       
|        | 
|32.2    |  | Certification by Senior Vice President and Chief Financial Officer Pursuant to Section 906 of Sarbanes-Oxley Act of 2002.                                                                                                                     



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SECURE COMPUTING CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share
amounts)



|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|--------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | -------- | - | ---------------- | - | -------- | -
|                                                                                                                                  |  | December 31,2004 |          |   | December 31,2003 |  
|ASSETS                                                                                                                            |  |                  |          |   |                  |   |          |  
|Current assets                                                                                                                    |  |                  |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                         |  | $                | 37,899   |   |                  | $ | 12,101   |  
|Investments                                                                                                                       |  |                  | 14,407   |   |                  |   | 21,580   |  
|Accounts receivable (net of reserves of 2004 - $450; 2003 - $868)                                                                 |  |                  | 20,263   |   |                  |   | 17,148   |  
|Inventories                                                                                                                       |  |                  | 2,793    |   |                  |   | 1,227    |  
|Deferred income taxes                                                                                                             |  |                  | 3,604    |   |                  |   | 3,259    |  
|Other current assets                                                                                                              |  |                  | 5,228    |   |                  |   | 3,973    |  
|Current assets from discontinued operations                                                                                       |  |                  | 260      |   |                  |   | 545      |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|Total current assets                                                                                                              |  |                  | 84,454   |   |                  |   | 59,833   |  
|                                                                                                                                  |  |                 
|Property and equipment                                                                                                            |  |                  |          |   |                  |   |          |  
|Computer equipment and software                                                                                                   |  |                  | 18,100   |   |                  |   | 16,652   |  
|Furniture and fixtures                                                                                                            |  |                  | 2,445    |   |                  |   | 2,388    |  
|Leasehold improvements                                                                                                            |  |                  | 2,415    |   |                  |   | 2,375    |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|                                                                                                                                  |  |                  | 22,960   |   |                  |   | 21,415   |  
|Accumulated depreciation                                                                                                          |  |                  | (18,919  | ) |                  |   | (16,411  | )
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|                                                                                                                                  |  |                  | 4,041    |   |                  |   | 5,004    |  
|                                                                                                                                  |  |                 
|Goodwill                                                                                                                          |  |                  | 39,329   |   |                  |   | 40,416   |  
|Intangible assets(net of accumulated amortization of 2004 - $1,262;2003 - $603)                                                   |  |                  | 2,482    |   |                  |   | 2,568    |  
|Other assets                                                                                                                      |  |                  | 608      |   |                  |   | 654      |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|Total assets                                                                                                                      |  | $                | 130,914  |   |                  | $ | 108,475  |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|                                                                                                                                  |  |                 
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                              |  |                  |          |   |                  |   |          |  
|Current liabilities                                                                                                               |  |                  |          |   |                  |   |          |  
|Accounts payable                                                                                                                  |  | $                | 2,578    |   |                  | $ | 2,861    |  
|Accrued payroll                                                                                                                   |  |                  | 4,090    |   |                  |   | 3,539    |  
|Acquisition reserve                                                                                                               |  |                  | 879      |   |                  |   | 1,757    |  
|Other accrued expenses                                                                                                            |  |                  | 1,601    |   |                  |   | 1,024    |  
|Deferred revenue                                                                                                                  |  |                  | 23,915   |   |                  |   | 21,663   |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|Total current liabilities                                                                                                         |  |                  | 33,063   |   |                  |   | 30,844   |  
|                                                                                                                                  |  |                 
|Acquisition reserve, net of current portion                                                                                       |  |                  | 493      |   |                  |   | 1,839    |  
|Deferred revenue, net of current portion                                                                                          |  |                  | 5,532    |   |                  |   | 3,778    |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|Total liabilities                                                                                                                 |  |                  | 39,088   |   |                  |   | 36,461   |  
|                                                                                                                                  |  |                 
|Stockholders equity                                                                                                              |  |                  |          |   |                  |   |          |  
|Convertible preferred stock, par value $.01 per share:                                                                            |  |                  |          |   |                  |   |          |  
|Authorized  2,000,000 shares; issued and outstanding shares -December 31, 2004 and 2003  none                                   |  |                  |         |   |                  |   |         |  
|Common stock, par value $.01 per share:                                                                                           |  |                  |          |   |                  |   |          |  
|Authorized  50,000,000 shares; issued and outstanding shares  December 31, 2004  35,797,695 and December 31, 2003 
34,953,772 |  |                  | 358      |   |                  |   | 350      |  
|Additional paid-in capital                                                                                                        |  |                  | 197,244  |   |                  |   | 190,090  |  
|Accumulated deficit                                                                                                               |  |                  | (105,072 | ) |                  |   | (117,907 | )
|Accumulated other comprehensive loss                                                                                              |  |                  | (704     | ) |                  |   | (519     | )
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|Total stockholders equity                                                                                                        |  |                  | 91,826   |   |                  |   | 72,014   |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|Total liabilities and stockholders equity                                                                                        |  | $                | 130,914  |   |                  | $ | 108,475  |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  



See accompanying
notes.



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SECURE COMPUTING CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share
amounts)



|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|------------------------------------------------ |  | ----------------------- | ------ | ---- | - | ------ | ---- |  | - | ------ | -
|                                                 |  | Year ended December 31, |       
|                                                 |  | 2004                    |        | 2003 |   |        | 2002 | 
|Revenue                                          |  | $                       | 93,378 |      | $ | 76,213 |      |  | $ | 61,960 |  
|Cost of revenue                                  |  |                         | 12,335 |      |   | 7,621  |      |  |   | 4,707  |  
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Gross profit                                     |  |                         | 81,043 |      |   | 68,592 |      |  |   | 57,253 |  
|                                                 |  |                         |       
|Operating expenses                               |  |                         |        |      |   |        |      |  |   |        |  
|Selling and marketing                            |  |                         | 46,253 |      |   | 38,729 |      |  |   | 34,989 |  
|Research and development                         |  |                         | 16,106 |      |   | 15,179 |      |  |   | 14,912 |  
|General and administrative                       |  |                         | 6,456  |      |   | 5,535  |      |  |   | 5,113  |  
|Separation costs                                 |  |                         |       |      |   |       |      |  |   | 568    |  
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|                                                 |  |                         | 68,815 |      |   | 59,443 |      |  |   | 55,582 |  
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Operating income                                 |  |                         | 12,228 |      |   | 9,149  |      |  |   | 1,671  |  
|Other non-recurring expense                      |  |                         |       |      |   |       |      |  |   | (7,258 | )
|Interest and other income                        |  |                         | 607    |      |   | 141    |      |  |   | 421    |  
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Net income (loss) from continuing operations     |  |                         | 12,835 |      |   | 9,290  |      |  |   | (5,166 | )
|Loss from operations of discontinued AT division |  |                         |       |      |   | (757   | )    |  |   | (1,310 | )
|Loss on disposal of AT division                  |  |                         |       |      |   | (277   | )    |  |   |       |  
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Net income (loss)                                |  | $                       | 12,835 |      | $ | 8,256  |      |  | $ | (6,476 | )
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Basic income (loss) per share:                   |  |                         |        |      |   |        |      |  |   |        |  
|Continuing operations                            |  | $                       | 0.36   |      | $ | 0.29   |      |  | $ | (0.18  | )
|Discontinued operations                          |  |                         |       |      |   | (0.03  | )    |  |   | (0.04  | )
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Basic income (loss) per share                    |  | $                       | 0.36   |      | $ | 0.26   |      |  | $ | (0.22  | )
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Weighted average shares outstanding - basic      |  |                         | 35,576 |      |   | 31,986 |      |  |   | 29,307 |  
|                                                 |  |                         |       
|Diluted income (loss) per share:                 |  |                         |        |      |   |        |      |  |   |        |  
|Continuing operations                            |  | $                       | 0.34   |      | $ | 0.28   |      |  | $ | (0.18  | )
|Discontinued operations                          |  |                         |       |      |   | (0.03  | )    |  |   | (0.04  | )
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Diluted income (loss) per share                  |  | $                       | 0.34   |      | $ | 0.25   |      |  | $ | (0.22  | )
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Weighted average shares outstanding - diluted    |  |                         | 37,256 |      |   | 33,654 |      |  |   | 29,307 |  



See accompanying
notes.



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##### Table of Contents

SECURE COMPUTING CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

(in thousands, except
share amounts)



|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|---------------------------------------------------------- |  | --------------- |  | ------------ | - | ------------------------- | ---------- | ------------------ | - | --- | ---------------------------------- | - | ------- | ------------------------- | - | -------- | - |  | - | ---- | - |  | - | ------ | -
|                                                           |  | Preferred Stock |  | Common Stock |   | Additional Paid-InCapital |            | AccumulatedDeficit |   |     | AccumulatedOther ComprehensiveLoss |   |         | Total StockholdersEquity |  
|                                                           |  | Shares          |  | ParValue     |   | Shares                    |            | ParValue           |   |     |                                    |  
|BALANCE, December 31, 2001                                 |  |                |  | $            |  |                           | 28,830,992 |                    | $ | 288 |                                    | $ | 148,585 |                           | $ | (119,687 | ) |  | $ | (490 | ) |  | $ | 28,696 |  
|Comprehensive loss:                                        |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|Net loss for the year                                      |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   | (6,476   | ) |  |   |     |   |  |   | (6,476 | )
|Foreign currency translation adjustment                    |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   |         |   |  |   | (113 | ) |  |   | (113   | )
|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|Total comprehensive loss                                   |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   | (6,589 | )
|Exercise of employee stock options                         |  |                |  |              |  |                           | 191,506    |                    |   | 2   |                                    |   | 1,149   |                           |   |         |   |  |   |     |   |  |   | 1,151  |  
|Employee stock purchase plan activity                      |  |                |  |              |  |                           | 361,607    |                    |   | 3   |                                    |   | 1,405   |                           |   |         |   |  |   |     |   |  |   | 1,408  |  
|Purchase of Gauntlet, net of stock registration fees       |  |                |  |              |  |                           | 300,354    |                    |   | 4   |                                    |   | 4,993   |                           |   |         |   |  |   |     |   |  |   | 4,997  |  
|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|BALANCE, December 31, 2002                                 |  |                |  |              |  |                           | 29,684,459 |                    |   | 297 |                                    |   | 156,132 |                           |   | (126,163 | ) |  |   | (603 | ) |  |   | 29,663 |  
|Comprehensive income:                                      |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|Net income for the year                                    |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   | 8,256    |   |  |   |     |   |  |   | 8,256  |  
|Foreign currency translation adjustment                    |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   |         |   |  |   | 90   |   |  |   | 90     |  
|Unrealized loss on investments                             |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   |         |   |  |   | (6   | ) |  |   | (6     | )
|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|Total comprehensive income                                 |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   | 8,340  |  
|Exercise of employee stock options                         |  |                |  |              |  |                           | 1,073,964  |                    |   | 11  |                                    |   | 4,238   |                           |   |         |   |  |   |     |   |  |   | 4,249  |  
|Employee stock purchase plan activity                      |  |                |  |              |  |                           | 297,106    |                    |   | 3   |                                    |   | 1,349   |                           |   |         |   |  |   |     |   |  |   | 1,352  |  
|Litigation settlements                                     |  |                |  |              |  |                           | 2,029,729  |                    |   | 20  |                                    |   | 8,375   |                           |   |         |   |  |   |     |   |  |   | 8,395  |  
|Purchase of N2H2, net of cash issued for fractional shares |  |                |  |              |  |                           | 1,868,514  |                    |   | 19  |                                    |   | 19,996  |                           |   |         |   |  |   |     |   |  |   | 20,015 |  
|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|BALANCE, December 31, 2003                                 |  |                |  |              |  |                           | 34,953,772 |                    |   | 350 |                                    |   | 190,090 |                           |   | (117,907 | ) |  |   | (519 | ) |  |   | 72,014 |  
|Comprehensive income:                                      |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|Net income for the year                                    |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   | 12,835   |   |  |   |     |   |  |   | 12,835 |  
|Foreign currency translation adjustment                    |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   |          |   |  |   | (183 | ) |  |   | (183   | )
|Unrealized loss on investments                             |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   |         |   |  |   | (2   | ) |  |   | (2     | )
|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|Total comprehensive income                                 |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   | 12,650 |  
|Exercise of employee stock options                         |  |                |  |              |  |                           | 678,451    |                    |   | 6   |                                    |   | 5,787   |                           |   |         |   |  |   |     |   |  |   | 5,793  |  
|Employee stock purchase plan activity                      |  |                |  |              |  |                           | 165,472    |                    |   | 2   |                                    |   | 1,367   |                           |   |         |   |  |   |     |   |  |   | 1,369  |  
|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|BALANCE, December 31, 2004                                 |  |                |  | $            |  |                           | 35,797,695 |                    | $ | 358 |                                    | $ | 197,244 |                           | $ | (105,072 | ) |  | $ | (704 | ) |  | $ | 91,826 |  
|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  



See accompanying
notes.



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SECURE COMPUTING CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                                                    |  |                         |         |   |      |   |         |      |  |   |        |  
|------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------ | -
|                                                                                                                    |  | Year Ended December 31, |        
|                                                                                                                    |  | 2004                    |         |   | 2003 |   |         | 2002 | 
|Operating activities                                                                                                |  |                         |         |   |      |   |         |      |  |   |        |  
|Net income (loss)                                                                                                   |  | $                       | 12,835  |   |      | $ | 8,256   |      |  | $ | (6,476 | )
|Loss from discontinued operations                                                                                   |  |                         |        |   |      |   | 1,034   |      |  |   | 1,310  |  
|                                                                                                                    |  |                         |         |   |      |   |         |      |  |   |        |  
|Net income (loss) from continuing operations                                                                        |  |                         | 12,835  |   |      |   | 9,290   |      |  |   | (5,166 | )
|Adjustments to reconcile net income (loss) from continuing operations to net cash provided by operating activities: |  |                         |         |   |      |   |         |      |  |   |        |  
|Depreciation                                                                                                        |  |                         | 2,515   |   |      |   | 2,711   |      |  |   | 2,758  |  
|Amortization                                                                                                        |  |                         | 887     |   |      |   | 353     |      |  |   | 239    |  
|Loss on disposals of property and equipment                                                                         |  |                         | 1       |   |      |   | 14      |      |  |   | 121    |  
|Loss on disposals of intangible assets                                                                              |  |                         | 47      |   |      |   | 95      |      |  |   |       |  
|Deferred income taxes                                                                                               |  |                         | (345    | ) |      |   | (559    | )    |  |   |       |  
|Changes in operating assets and liabilities, net of acquisitions:                                                   |  |                         |         |   |      |   |         |      |  |   |        |  
|Accounts receivable                                                                                                 |  |                         | (2,795  | ) |      |   | (4,589  | )    |  |   | 90     |  
|Inventories                                                                                                         |  |                         | (1,566  | ) |      |   | (342    | )    |  |   | (128   | )
|Other current assets                                                                                                |  |                         | (1,255  | ) |      |   | (2,079  | )    |  |   | (513   | )
|Accounts payable                                                                                                    |  |                         | (133    | ) |      |   | 956     |      |  |   | (176   | )
|Payroll related accruals                                                                                            |  |                         | 551     |   |      |   | 78      |      |  |   | (256   | )
|Accrued liabilities and reserves                                                                                    |  |                         | (1,033  | ) |      |   | (1,553  | )    |  |   | 218    |  
|Litigation settlement accrual                                                                                       |  |                         |        |   |      |   |        |      |  |   | 7,258  |  
|Deferred revenue                                                                                                    |  |                         | 4,006   |   |      |   | 1,116   |      |  |   | (3,482 | )
|                                                                                                                    |  |                         |         |   |      |   |         |      |  |   |        |  
|Net cash provided by operating activities                                                                           |  |                         | 13,715  |   |      |   | 5,491   |      |  |   | 963    |  
|                                                                                                                    |  |                         |        
|Investing activities                                                                                                |  |                         |         |   |      |   |         |      |  |   |        |  
|Proceeds from sales/maturities of investments                                                                       |  |                         | 17,528  |   |      |   | 2,506   |      |  |   | 8,831  |  
|Purchases of investments                                                                                            |  |                         | (10,355 | ) |      |   | (20,705 | )    |  |   | (7,088 | )
|Purchase of property and equipment, net                                                                             |  |                         | (1,553  | ) |      |   | (1,970  | )    |  |   | (2,095 | )
|(Increase) decrease in intangibles and other assets                                                                 |  |                         | (802    | ) |      |   | (235    | )    |  |   | 236    |  
|Cash acquired in N2H2 purchase                                                                                      |  |                         |        |   |      |   | 4,260   |      |  |   |       |  
|                                                                                                                    |  |                         |         |   |      |   |         |      |  |   |        |  
|Net cash provided by investing activities                                                                           |  |                         | 4,818   |   |      |   | (16,144 | )    |  |   | (116   | )
|                                                                                                                    |  |                         |        
|Financing activities                                                                                                |  |                         |         |   |      |   |         |      |  |   |        |  
|Proceeds from issuance of common stock                                                                              |  |                         | 7,162   |   |      |   | 5,601   |      |  |   | 2,559  |  
|                                                                                                                    |  |                         |        
|Effect of foreign currency translation                                                                              |  |                         | (182    | ) |      |   | 90      |      |  |   | (113   | )
|Net cash provided by (used in) discontinued operations                                                              |  |                         | 285     |   |      |   | (987    | )    |  |   | (1,199 | )
|                                                                                                                    |  |                         |         |   |      |   |         |      |  |   |        |  
|Net (decrease) increase in cash and cash equivalents                                                                |  |                         | 25,798  |   |      |   | (5,949  | )    |  |   | 2,094  |  
|Cash and cash equivalents, beginning of year                                                                        |  |                         | 12,101  |   |      |   | 18,050  |      |  |   | 15,956 |  
|                                                                                                                    |  |                         |         |   |      |   |         |      |  |   |        |  
|Cash and cash equivalents, end of year                                                                              |  | $                       | 37,899  |   |      | $ | 12,101  |      |  | $ | 18,050 |  
|                                                                                                                    |  |                         |         |   |      |   |         |      |  |   |        |  
|                                                                                                                    |  |                         |        
|Supplemental Cash Flow Disclosure:                                                                                  |  |                         |         |   |      |   |         |      |  |   |        |  
|Common stock issued for purchase of N2H2, Inc.                                                                      |  |                         |        |   |      | $ | 20,019  |      |  |   |       |  
|Common stock issued for litigation settlements                                                                      |  |                         |        |   |      | $ | 8,395   |      |  |   |       |  
|Common stock issued for purchase of Gauntlet                                                                        |  |                         |        |   |      |   |        |      |  | $ | 5,000  |  



See accompanying
notes.



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##### Table of Contents

SECURE COMPUTING CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



|1. | Summary of Significant Accounting Policies
|-- | ------------------------------------------



Organization



We develop network security solutions that create trusted connections between organizations and their customers, partners, and employeesthereby
enabling them to exchange critical information safely, helping them confidently build their businesses. Our technologies enable our customers to secure the sharing of information resources at every connection point, while implementing a balance
between security and accessibility according to their policy objectives. We work closely with our customers to provide them with reliable access control and innovative new features that are comprehensive, easy to manage and highly effective in
securing the connections between people, applications and networks.



Our partners and customers include the majority of the Dow Jones Global 50 Titans and numerous organizations in the Fortune 1000, as well as banking, financial services, healthcare, telecommunications, manufacturing, public utilities,
schools, and federal, state and local governments. We have close relationships with the largest agencies of the United States government, both federal and local. Our customer list also includes numerous international organizations and foreign
governments. Overseas, our customers are concentrated primarily in Europe, Japan, China, the Pacific Rim, and Latin America.



Basis of Consolidation



The consolidated financial statements include the accounts of Secure Computing Corporation and our wholly-owned subsidiaries. All intercompany balances
and transactions have been eliminated in consolidation.



Use of Estimates



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



Reclassifications



Certain previously reported amounts have been reclassified to conform to the current presentation format with no
impact on net income (loss).



Revenue Recognition



Our revenue is derived from sales of our software licenses, hardware,
royalties and maintenance arrangements to provide product upgrades and customer support. We recognize revenue in accordance with Statement of Position (SOP) 97-2, Software Revenue Recognition, as modified by SOP 98-9. Revenue from
products is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed and determinable, and collection is probable. Maintenance revenue for providing product upgrades and customer support is deferred and
recognized ratably over the service period.



For arrangements
with multiple elements we allocate revenue to the various elements based on the fair value of each element sold. We determine the fair value of each element based on its selling price when sold separately. Evidence of fair value includes the
approved price list and discount schedule and the actual prices charged for comparable arrangements. These price lists and discount schedules may change from time to time in response to factors including market conditions, value of services and
product provided and competitive positioning. Historically, we have not offered significant discounts off of our list prices.



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Further, it is our policy that our distributors and resellers are not allowed to hold inventory with the
exception of international resellers who are allowed to hold inventories of Safeword for Citrix (and other Safeword for products). This is a low price-point product with disproportionately high overseas freight costs. As
such, we allow the reseller to carry a balance of inventory and provide end-user sell-through reporting. Revenue is recognized at the point that we receive evidence of end-user sell-through.



Cash Equivalents



We consider all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.
Cash equivalents are carried at cost, which approximates fair value.



Investments



We account for investments with
the provisions of Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. SFAS No. 115 addresses the accounting and reporting for investments in fixed maturity
securities and for equity securities with readily determinable fair values. Currently, all of our investments are classified as available-for-sale. Available-for-sale investments are carried at fair value as determined by quoted market prices, with
unrealized gains and losses, net of tax, reported as a separate component of stockholders equity. The cost basis of investments that are sold or matured is determined using the specific identification method. Interest and dividends on
investments classified as available-for-sale are included in interest income. The gross realized gains and losses for the sale or maturity of available-for-sale investments were not material in all periods presented.



Accounts Receivable



Accounts receivable are initially recorded at fair value upon the sale of products or services to our customers. We make
estimates regarding the collectibility of our accounts receivables. When we evaluate the adequacy of our allowance for doubtful accounts, we consider multiple factors including historical bad debt experience, the need for specific customer reserves,
the aging of our receivables, customer creditworthiness, changes in our customer payment cycles, and current economic trends. The provision for doubtful accounts is included in the selling and marketing expense on the consolidated statement of
operations. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.



Inventories



Inventories consist mainly of purchased components and prepaid licenses and are valued at the lower of cost or market using the first-in, first-out (FIFO)
method.



Property and Equipment



Property and equipment are carried at cost. Depreciation is calculated using
the straight-line method with estimated useful lives ranging from 3 to 8 years. Leasehold improvements are depreciated over the lesser of the useful life of the asset or the term of the lease.



Other Current Assets and Other Assets



Other current assets are carried at cost and consist of unbilled
receivables, interest receivable, and prepaid expenses for items such as directors and officers liability insurance, trade shows, royalties, and foreign taxes to be either expensed or collected within 12 months. Other assets are carried at cost and
include rent deposits, employee notes receivable, and prepaid foreign value-added tax to be collected after 12 months.



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Income Taxes



We account for income taxes using the liability method, which requires recognition of deferred tax liabilities and assets for the expected future tax
consequences of events that have been included in our financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax basis of assets and
liabilities, using enacted tax rates in effect for the year in which the differences are expected to reverse. Deferred tax assets are reduced by a valuation allowance when it is more likely than not that some component or all of the deferred tax
assets will not be realized.



Goodwill and Other Intangible Assets



Intangible assets consist of patents, trademarks,
capitalized software costs, purchased customer lists, a purchased control list, capitalized developed technology and goodwill, all of which are recorded at cost or fair value. Patents, trademarks, customer and control lists, and capitalized
developed technology are amortized using the straight-line method over the estimated useful lives of the assets, which range up to 17 years. See accounting policy of capitalized software costs below under Research and Development.



Goodwill is not amortized, but is tested for impairment at the reporting unit
level at least annually. If impairment is indicated, a write-down is recorded as an impairment loss in income from operations. An impairment charge is recognized only when the calculated fair value of a reporting unit, including goodwill, is less
than its carrying amount. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, we completed the required impairment tests of goodwill and indefinite lived intangible assets as of November 30, 2004 and 2003 and
determined the fair value to be in excess of the carrying value of these assets. Therefore, goodwill was not impaired and no impairment charge was reported.



Long-Lived Assets



We review our long-lived assets and identified finite-lived intangible assets for impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable, except for goodwill as noted above. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to undiscounted future net cash flows expected to be
generated by the assets. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. There were no such impairments during
the period presented.



Other Accrued Expenses



At December 31, 2004, other accrued expenses consisted of costs related to
professional fees, foreign taxes and accrued marketing CO-OP funds. At December 31, 2003, other accrued expenses consisted of costs related to professional fees and foreign taxes.



Financial Instruments



Carrying amounts of financial instruments held by us, which include cash equivalents, short-term investments, restricted cash, accounts receivable,
accounts payable and accrued expenses, approximate fair value due to their short-term nature.



Concentrations of Credit Risk



Financial instruments that potentially subject us to concentrations of credit risk consist primarily of accounts receivable. We perform ongoing credit evaluations of our customers, generally require customers to prepay for maintenance and
maintain reserves for potential losses. Our customer base is primarily composed of businesses throughout the United States, Europe and Asia.



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Foreign Currency Translation and Transactions



Foreign assets and liabilities were translated using the exchange rates in effect at the balance sheet date. Results of
operations were translated using average exchange rates throughout the year. Translation gains or losses have been reported in other comprehensive income as a component of stockholders equity. Cumulative foreign currency translation loss
balances were $696,000 and $513,000 at December 31, 2004 and 2003, respectively. Any gains or losses resulting from foreign currency transactions are included in the consolidated statements of operations and were not significant during the periods
presented.



Selling and Marketing



Selling and marketing expenses consist primarily of salaries,
commissions, and benefits related to personnel engaged in selling, marketing and customer support functions, along with costs related to advertising, promotions, public relations and shipping and handling.



Research and Development



Research and development expenditures are charged to operations as incurred.
Statement of Financial Accounting Standards (SFAS) No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, requires capitalization of certain software development costs subsequent to the
establishment of technological feasibility. Based on our product development process, technological feasibility is established upon completion of a working model. Costs that we incur between completion of the working model and the point at which the
product is generally available for sale are capitalized and amortized over their estimated useful life of three years.



Comprehensive Income (Loss)



The components of our comprehensive income (loss) are net income (loss), foreign currency translation adjustments, and unrealized loss on investments.
Comprehensive income (loss) for all periods presented is included in our consolidated statements of stockholders equity.



Stock Options



At December 31, 2004, we have eight stock option-based compensation plans, which are described more fully in Note 9. We account for those plans in
accordance with the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in the consolidated statements of operations, as all
options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income (loss) and net income (loss) per share if we had applied
the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation (in thousands, except per share data):



|                                                                                                                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                                                            |  | Year Ended December 31, |        
|                                                                                                                                            |  | 2004                    |         |   | 2003 |   |         | 2002 | 
|Net income (loss), as reported                                                                                                              |  | $                       | 12,835  |   |      | $ | 8,256   |      |  | $ | (6,476  | )
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax
effects |  |                         | (11,728 | ) |      |   | (11,326 | )    |  |   | (11,841 | )
|                                                                                                                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|Pro forma net income (loss)                                                                                                                 |  | $                       | 1,107   |   |      | $ | (3,070  | )    |  | $ | (18,317 | )
|                                                                                                                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|Net income (loss) per share:                                                                                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|Basic  as reported                                                                                                                         |  | $                       | 0.36    |   |      | $ | 0.26    |      |  | $ | (0.22   | )
|Basic  pro forma                                                                                                                           |  | $                       | 0.03    |   |      | $ | (0.10   | )    |  | $ | (0.63   | )
|Diluted  as reported                                                                                                                       |  | $                       | 0.34    |   |      | $ | 0.25    |      |  | $ | (0.22   | )
|Diluted  pro forma                                                                                                                         |  | $                       | 0.03    |   |      | $ | (0.10   | )    |  | $ | (0.63   | )



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The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing
model with the following weighted average assumptions:



|                        |  |         |   |  |         |   |  |         |  
|----------------------- |  | ------- | - |  | ------- | - |  | ------- | -
|                        |  | 2004    |   |  | 2003    |   |  | 2002    |  
|Assumptions used:       |  |         |   |  |         |   |  |         |  
|Volatility              |  | 97      | % |  | 107     | % |  | 104     | %
|Risk-free interest rate |  | 3.6     | % |  | 3.0     | % |  | 3.8     | %
|Expected life           |  | 5 years |   |  | 5 years |   |  | 5 years |  
|Dividend-yield          |  |        |   |  |        |   |  |        |  



The Black-Scholes
option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions,
including the expected stock price volatility. Because changes in the subjective input assumptions can materially affect the fair value estimate, in our opinion, the existing models do not necessarily provide a reliable single value of our options
and may not be representative of the future effects on reported net income (loss) or the future stock price of our company. For purposes of pro forma disclosure, the estimated fair value of the options is amortized to expense over the options
vesting periods.



Net Income (Loss) Per Share



In accordance with SFAS No. 128, Earnings Per Share, basic net
income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by dividing net income (loss) by the combination of
dilutive common share equivalents, which consist solely of stock options, and the weighted average number of common shares outstanding.



Recently Issued Accounting Standards



In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 151, Inventory Costs. SFAS No. 151 requires abnormal amounts
of inventory costs related to idle facility, freight handling and wasted material expenses to be recognized as current period charges. Additionally, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be
based on the normal capacity of the production facilities. The standard is effective for fiscal years beginning after June 15, 2005. We believe the adoption of SFAS No. 151 will not have a material impact on our consolidated financial statements.



In December 2004, the FASB issued SFAS No. 123(R),
Accounting for Stock-Based Compensation. SFAS No. 123R establishes standards for accounting for transactions in which an entity exchanges its equity instruments for goods or services. SFAS No. 123R focuses primarily on accounting for
transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123R requires that the fair value of such equity instruments be recognized as expense in the historical financial statements as services are
performed. Prior to SFAS No. 123R, only certain pro forma disclosures of fair value were required. SFAS No. 123R is effective as of the beginning of our first interim or annual reporting period that begins after June 15, 2005, which is our third
quarter of 2005.



SFAS No. 123R permits public companies to
adopt requirements using one of two methods: (1) A modified prospective method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123R for all share-based payments granted
after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date. (2) A modified retrospective method which
includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under FAS 123 for purposes of pro forma disclosures either (a) all prior periods presented
or (b) prior interim periods of the year of adoption. We are currently in the process of evaluating the two methods and have not yet determined which method will be used. The adoption of this new accounting pronouncement will have a material impact
on our consolidated financial statements.



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On October 22, 2004, the President signed into law the American Jobs Creation Act of 2004 (the Bill). We
are currently in the process of evaluating the Bill.



|2. | Discontinued Operations
|-- | -----------------------



During the fourth quarter of 2003, we discontinued our Advanced Technology (AT) division. In October 2003, our management determined that we would
no longer invest in this business and announced our decision to exit the division. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, this segment is reflected as discontinued operations in
our consolidated financial statements. All prior period statements have been reclassified accordingly, including the reallocation of selling and marketing charges to the AT division. Continued cash flows from discontinued operations pertains to the
collection of balances due on contracts that have been completed and are expected to be collected within the next 12 months.



A summary statement of operations for the discontinued AT division is as follows (in thousands):



|                                            |  |                         |   |      |   |        |      |  |   |        |  
|------------------------------------------- |  | ----------------------- | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                            |  | Year Ended December 31, |  
|                                            |  | 2004                    |   | 2003 |   |        | 2002 | 
|Revenues                                    |  | $                       |  |      | $ | 2,052  |      |  | $ | 3,877  |  
|Gross profit                                |  |                         |  |      |   | 340    |      |  |   | 1,004  |  
|Loss from operations                        |  |                         |  |      |   | (757   | )    |  |   | (1,310 | )
|Loss on disposal of discontinued operations |  |                         |  |      |   | (277   | )    |  |   |       |  
|                                            |  |                         |   |      |   |        |      |  |   |        |  
|Loss from discontinued operations           |  | $                       |  |      | $ | (1,034 | )    |  | $ | (1,310 | )
|                                            |  |                         |   |      |   |        |      |  |   |        |  



|3. | Acquisition of N2H2, Inc.
|-- | -------------------------



On October 13, 2003, we acquired 100% of the outstanding common shares of N2H2, Inc. The results of N2H2s operations have been included in the
consolidated financial statements since that date. N2H2 provided Internet filtering and monitoring solutions that are designed to allow Internet users to monitor and filter content categories thereby increasing productivity, reducing bandwidth
consumption, and limiting potential legal liability. N2H2 had two product lines: Sentian for corporate and government markets and Bess for schools, libraries, and non-for-profit organizations. As a result of the acquisition, we are expected to
expand our market share of web filtering services in the markets for Bess and are expected to reduce costs through the economies of scale.



The aggregate purchase price was $20.5 million consisting primarily of 1,868,514 shares of common stock valued at $17.2 million, 422,000 options with a
value of $2.9 million, and direct costs of the acquisition of $505,000. The value of the common shares issued was determined based on the average market price of our common shares over the period including two days before and after the date that the
terms of the acquisition were agreed to and announced.



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The following table summarizes the estimated fair values of the assets acquired and liabilities assumed
at the date of acquisition (in thousands):



|                                                                     |  |       |  |   |       
|-------------------------------------------------------------------- |  | ----- |  | - | ------
|Current assets                                                       |  |       |  | $ | 6,300 
|Property and equipment                                               |  |       |  |   | 115   
|Goodwill                                                             |  |       |  |   | 26,452
|Intangible assets subject to amortization:                           |  |       |  |   |       
|Customer list (36 month useful life)                                 |  | 1,141 |  |   |       
|Control list (24 month useful life)                                  |  | 271   |  |   |       
|Capitalized developed technology (18 month useful life)              |  | 42    |  |   |       
|                                                                     |  |       |  |   |       
|                                                                     |  |       |  |   | 1,454 
|Other long-term assets                                               |  |       |  |   | 140   
|                                                                     |  |       |  |   |       
|Total assets acquired                                                |  |       |  |   | 34,461
|                                                                     |  |      
|Current liabilities                                                  |  |       |  |   | 508   
|Acquisition reserve                                                  |  |       |  |   | 4,418 
|Revenue deferred from on-going contractual obligations at fair value |  |       |  |   | 9,516 
|                                                                     |  |       |  |   |       
|Total liabilities assumed                                            |  |       |  |   | 14,442
|                                                                     |  |       |  |   |       
|Net assets acquired                                                  |  |       |  | $ | 20,019
|                                                                     |  |       |  |   |       



We allocated the
purchase price on a preliminary basis using the information then available. The allocation of the purchase prices to the assets and liabilities acquired was finalized in 2004. The primary adjustments to the preliminary allocation were to adjust the
acquisition reserve for severance related items and to adjust the allowance for doubtful accounts for collected N2H2 trade receivables. The final purchase price allocation resulted in a $920,000 decrease to goodwill. We accrued approximately $4.4
million in acquisition related expenses, which included legal and accounting fees, excess capacity fees, directors and officers insurance policy premium, severance costs and other related costs, of which $1.3 million remains as an accrual as of
December 31, 2004.



The following unaudited pro forma
financial information was prepared in accordance with SFAS No. 141 and assumes the acquisition had occurred at the beginning of the periods presented. The unaudited pro forma financial information is provided for informational purposes only. These
pro forma results are based upon the respective historical financial statements of the respective companies, and do not incorporate, nor do they assume, any benefits from cost savings or synergies of operations of the combined company. The pro forma
results are not necessarily indicative of what would have occurred if the acquisition had actually been completed as of the beginning of the periods presented, nor are they necessarily indicative of future consolidated results. The pro forma results
include the estimated amortization of acquired definite lived intangibles.



The unaudited combined results of continuing operations are as follows (in thousands, except per share data):



|                                      |  |                         |        |      |   |         |  
|------------------------------------- |  | ----------------------- | ------ | ---- | - | ------- | -
|                                      |  | Year ended December 31, |       
|                                      |  | 2003                    |        | 2002 |  
|Revenue                               |  | $                       | 85,930 |      | $ | 73,229  |  
|Net income (loss)                     |  | $                       | 7,574  |      | $ | (11,080 | )
|Net income (loss) per share  basic   |  | $                       | 0.24   |      | $ | (0.36   | )
|Net income (loss) per share  diluted |  | $                       | 0.23   |      | $ | (0.36   | )



|4. | Acquisition of the Gauntlet Firewall and VPN Business
|-- | ------------------------------------------------------



In February 2002, we completed our acquisition of the assets of the Gauntlet firewall and VPN business from Network Associates, Inc. As a result of the
acquisition, we expect to be the worldwide leader in application-layer firewalls. The purchase price, excluding stock registration fees, was 300,354 shares of common stock



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valued at $5.0 million. The value of the common shares was determined based on the average market price of our common shares over the period including the
five days before the terms of the acquisition were agreed to and announced. The transaction was accounted for as a purchase in accordance with SFAS No. 141, Business Combinations. Accordingly, the net assets and results of operations
have been included in our consolidated financial statements from the date of acquisition. Allocation of the acquisition purchase price was based on the fair value of the assets acquired and liabilities assumed as follows: $1.0 million allocated to
assets acquired, consisting of net accounts receivable and computer equipment; $11.9 million allocated to liabilities assumed, consisting of support services obligations, acquisition costs, and related accruals; and $15.9 million allocated to
goodwill. We allocated the purchase price on a preliminary basis using the information then available. The allocation of the purchase price to the assets and liabilities acquired was finalized in 2003. The primary adjustment to the preliminary
allocation was to adjust the acquisition reserve for severance related items. The final purchase price allocation resulted in a $1.2 million decrease to goodwill. At December 31, 2004, a balance of $40,000 for liabilities assumed remained compared
to $342,000 as of December 31, 2003.



The unaudited combined
results of continuing operations for the year ended December 31, 2002 are $63.2 million in revenue, net loss of $6.5 million and net loss per sharebasic and diluted of $0.19 per share. This unaudited pro forma financial information was
prepared in accordance with SFAS No. 141 and assumes the acquisition had occurred at the beginning of the periods presented. The unaudited pro forma financial information is provided for informational purposes only and does not purport to be
indicative of our future results. These pro forma results are based upon the respective historical financial statements of the respective companies, and do not incorporate, nor do they assume, any benefits from cost savings or synergies of
operations of the combined company.



|5. | Investments
|-- | -----------



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



|                                                 |  |                    |         |   |      |   |        |  
|------------------------------------------------ |  | ------------------ | ------- | - | ---- | - | ------ | -
|                                                 |  | As of December 31, |        
|                                                 |  | 2004               |         |   | 2003 |  
|Money market funds                               |  | $                  | 16,296  |   |      | $ | 6,993  |  
|Commercial paper                                 |  |                    | 14,176  |   |      |   | 8,486  |  
|Federal agencies                                 |  |                    | 1,995   |   |      |   | 2,000  |  
|Government securities                            |  |                    |        |   |      |   | 1,990  |  
|Taxable auction rate securities                  |  |                    | 5,825   |   |      |   | 5,000  |  
|Certificates of deposit                          |  |                    | 281     |   |      |   | 763    |  
|Corporate bonds                                  |  |                    |        |   |      |   | 3,341  |  
|                                                 |  |                    |         |   |      |   |        |  
|Total investments                                |  |                    | 38,573  |   |      |   | 28,573 |  
|Amounts classified as cash equivalents           |  |                    | (24,166 | ) |      |   | (6,993 | )
|                                                 |  |                    |         |   |      |   |        |  
|Total short-term investments and restricted cash |  | $                  | 14,407  |   |      | $ | 21,580 |  
|                                                 |  |                    |         |   |      |   |        |  



All short-term
investments mature within one year. Unrealized losses on available-for-sale investments at December 31, 2004 and 2003 were $8,000 and $6,000, respectively and are reported as a component of other comprehensive income (loss) in the statement of
stockholders equity. We have restricted cash pledged in the form of certificates of deposit and money market funds against our letters of credit of $275,000 and $321,000, respectively, at December 31, 2004. In 2003, we had restricted cash
pledged in the form of certificates of deposit against our letters of credit of $760,000.



|6. | Letters of Credit
|-- | -----------------



As of December 31, 2004, we have four letter of credit agreements totaling $596,000. One letter of credit for $275,000 and $310,000, as of December 31,
2004 and 2003, respectively, is with a bank to secure rental space for our San Jose, CA office and automatically renews for a one year period each year through March 31,



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2008. Another letter of credit agreement for $250,000 and $450,000, as of December 31, 2004 and 2003, respectively is with a bank to secure rental space for
our Seattle, WA office and automatically renews for a one year period each year through August 31, 2005. Two remaining letters of credit totaling $71,000 as of December 31, 2004 are to secure business with an international customer, which
expire April 2008.



|7. | Goodwill and Other Intangible Assets
|-- | ------------------------------------



The changes in goodwill during 2004 and 2003 were as follows (in thousands):



|                                                      |  |   |        |  
|----------------------------------------------------- |  | - | ------ | -
|Balance as of January 1, 2003                         |  | $ | 15,195 |  
|Finalization of purchase price allocation of Gauntlet |  |   | (1,231 | )
|Acquisition of N2H2                                   |  |   | 26,452 |  
|                                                      |  |   |        |  
|Balance as of December 31, 2003                       |  |   | 40,416 |  
|Reversal of Gauntlet reserves                         |  |   | (167   | )
|Finalization of purchase price allocation of N2H2     |  |   | (920   | )
|                                                      |  |   |        |  
|Balance as of December 31, 2004                       |  | $ | 39,329 |  
|                                                      |  |   |        |  



Identified intangible
assets subject to amortization are as follows (in thousands):



|                                 |  |                         |       |                         |   |        |     |  |               |       |                         |   |       |     |   |      |   |  |   |      
|-------------------------------- |  | ----------------------- | ----- | ----------------------- | - | ------ | --- |  | ------------- | ----- | ----------------------- | - | ----- | --- | - | ---- | - |  | - | -----
|                                 |  | As of December 31, 2004 |       | As of December 31, 2003
|                                 |  | CarryingValue           |       | AccumulatedAmortization |   |        | Net |  | CarryingValue |       | AccumulatedAmortization |   |       | Net
|Customer list                    |  | $                       | 1,141 |                         | $ | (460   | )   |  | $             | 681   |                         | $ | 1,141 |     | $ | (79  | ) |  | $ | 1,062
|Control lists                    |  |                         | 771   |                         |   | (220   | )   |  |               | 551   |                         |   | 271   |     |   | (28  | ) |  |   | 243  
|Capitalized developed technology |  |                         | 42    |                         |   | (34    | )   |  |               | 8     |                         |   | 42    |     |   | (6   | ) |  |   | 36   
|Patents and trademarks           |  |                         | 1,237 |                         |   | (280   | )   |  |               | 957   |                         |   | 1,135 |     |   | (220 | ) |  |   | 915  
|Capitalized software             |  |                         | 553   |                         |   | (268   | )   |  |               | 285   |                         |   | 582   |     |   | (270 | ) |  |   | 312  
|                                 |  |                         |       |                         |   |        |     |  |               |       |                         |   |       |     |   |      |   |  |   |      
|Total                            |  | $                       | 3,744 |                         | $ | (1,262 | )   |  | $             | 2,482 |                         | $ | 3,171 |     | $ | (603 | ) |  | $ | 2,568
|                                 |  |                         |       |                         |   |        |     |  |               |       |                         |   |       |     |   |      |   |  |   |      



Total amortization
expense was $887,000, $353,000 and $239,000 for the years ended December 31, 2004, 2003 and 2002, respectively. Of the total amortization expense, $219,000, $161,000, and $108,000 pertained to capitalized software costs for the years ended December
31, 2004, 2003, and 2002. Estimated amortization expense for each of the five succeeding fiscal years based on current intangible assets is expected to be $871,000, $623,000, $208,000, $57,000 and $52,000, respectively.



|8. | Stock Plans
|-- | -----------



1995 Omnibus Stock Option Plan



In September 1995, our Board of Directors and stockholders approved our 1995 Omnibus Stock Plan. Under the terms of this Plan, key employees and
non-employees may be granted options to purchase up to 11,494,131 shares of our Common Stock. The majority of options granted under this plan have ten year terms and vest either annually over three years, or fully vest at the end of three years.
Beginning in 2003, all new stock options granted under this plan vest 25% after the first year and then monthly over the following three years.



2002 Stock Option Plan



In July 2002, our Board of Directors approved our 2002 Stock Option Plan. Under the terms of this Plan, key employees and non-employees may be granted
options to purchase up to 3,500,000 shares of our Common Stock. The options granted in 2002 have ten year terms and vest either annually over three years, or fully vest at the end of three years. Directors and Executive officers are not eligible for
this plan. Beginning in 2003, all new stock options granted under this plan vest 25% after the first year and then monthly over the following three years.



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N2H2 Stock Option Plans



In connection with our acquisition of N2H2 in October 2003, we assumed all of the outstanding N2H2 stock options under the
1997 Stock Option Plan, 1999 Stock Option Plan, 1999 Non-Employee Director Plan, 1999/2000 Transition Plan, the 2000 Stock Option Plan, and the Howard Philip Welt Plan (the N2H2 Plans), which were converted into options to purchase
approximately 420,000 shares of our common stock. All stock options assumed were exercisable and vested. These options were assumed at prices between $1.55 and $258.63 per share, with a weighted average exercise price of $9.45 per share. The options
granted under these plans have ten year terms and vest 25% after the first year and then monthly over the following three years.



A summary of changes in outstanding options and common shares reserved under our stock option plans is as follows:



|                                 |  |                           |   |  |                     |   |  |                                          |      
|-------------------------------- |  | ------------------------- | - |  | ------------------- | - |  | ---------------------------------------- | -----
|                                 |  | Shares Availablefor Grant |   |  | Options Outstanding |   |  | Weighted AverageExercise Price per Share
|Balance at December 31, 2001     |  | 957,987                   |   |  | 6,703,542           |   |  | $                                        | 9.86 
|Shares authorized                |  | 1,000,000                 |   |  |                    |   |  |                                          |     
|Granted                          |  | (1,715,944                | ) |  | 1,715,944           |   |  |                                          | 10.68
|Exercised                        |  |                          |   |  | (191,506            | ) |  |                                          | 6.02 
|Canceled                         |  | 508,965                   |   |  | (508,965            | ) |  |                                          | 13.04
|                                 |  |                           |   |  |                     |   |  |                                          |      
|Balance at December 31, 2002     |  | 751,008                   |   |  | 7,719,015           |   |  | $                                        | 9.93 
|Granted                          |  | (1,045,150                | ) |  | 1,045,150           |   |  |                                          | 6.97 
|Assumed upon acquisition of N2H2 |  | 182,260                   |   |  | 419,646             |   |  |                                          | 9.45 
|Exercised                        |  |                          |   |  | (1,075,585          | ) |  |                                          | 5.31 
|Canceled                         |  | 538,013                   |   |  | (538,013            | ) |  |                                          | 10.79
|                                 |  |                           |   |  |                     |   |  |                                          |      
|Balance at December 31, 2003     |  | 426,129                   |   |  | 7,570,213           |   |  | $                                        | 10.09
|Shares authorized                |  | 2,500,000                 |   |  |                    |   |  |                                          |     
|Granted                          |  | (1,762,850                | ) |  | 1,762,850           |   |  |                                          | 9.28 
|Exercised                        |  |                          |   |  | (679,403            | ) |  |                                          | 6.45 
|Expired                          |  | (6,872                    | ) |  |                    |   |  |                                          |     
|Canceled                         |  | 464,451                   |   |  | (464,451            | ) |  |                                          | 14.09
|                                 |  |                           |   |  |                     |   |  |                                          |      
|Balance at December 31, 2004     |  | 1,620,860                 |   |  | 8,189,209           |   |  | $                                        | 9.99 
|                                 |  |                           |   |  |                     |   |  |                                          |      



The following table
summarizes information about the stock options outstanding at December 31, 2004:



|                       |  |                     |  |                                                    |  |                                 |       |                    |           |                                 |   |      
|---------------------- |  | ------------------- |  | -------------------------------------------------- |  | ------------------------------- | ----- | ------------------ | --------- | ------------------------------- | - | -----
|                       |  | Options Outstanding |  | Options Exercisable                               
|Range of ExercisePrice |  | Number Outstanding  |  | Weighted AverageRemaining Contractual Life (Years) |  | Weighted Average Exercise Price |       | Number Exercisable |           | Weighted Average Exercise Price
|$   0.01 - $    3.02   |  | 319,745             |  | 6.6                                                |  | $                               | 2.86  |                    | 108,558   |                                 | $ | 2.61 
|$   3.03 - $    6.04   |  | 1,348,030           |  | 5.9                                                |  |                                 | 4.14  |                    | 1,008,510 |                                 |   | 4.12 
|$   6.05 - $    9.07   |  | 1,565,203           |  | 7.4                                                |  |                                 | 7.84  |                    | 649,782   |                                 |   | 6.91 
|$   9.08 - $  12.09    |  | 2,731,196           |  | 6.7                                                |  |                                 | 10.03 |                    | 1,873,914 |                                 |   | 10.22
|$ 12.10 - $  15.12     |  | 724,938             |  | 6.9                                                |  |                                 | 13.46 |                    | 563,701   |                                 |   | 13.48
|$ 15.13 - $  18.14     |  | 1,271,747           |  | 6.6                                                |  |                                 | 16.09 |                    | 536,274   |                                 |   | 16.89
|$ 18.15 - $  21.17     |  | 107,500             |  | 6.2                                                |  |                                 | 18.57 |                    | 106,500   |                                 |   | 18.55
|$ 21.18 - $  24.21     |  | 98,383              |  | 4.7                                                |  |                                 | 22.13 |                    | 97,383    |                                 |   | 22.13
|$ 24.22 - $  27.22     |  | 8,000               |  | 4.5                                                |  |                                 | 25.82 |                    | 8,000     |                                 |   | 25.82
|$ 27.23 - $258.63      |  | 14,467              |  | 5.1                                                |  |                                 | 74.52 |                    | 14,467    |                                 |   | 74.52
|                       |  |                     |  |                                                    |  |                                 |       |                    |           |                                 |   |      
|$   0.59 - $258.63     |  | 8,189,209           |  | 6.7                                                |  | $                               | 9.99  |                    | 4,967,089 |                                 | $ | 10.10
|                       |  |                     |  |                                                    |  |                                 |       |                    |           |                                 |   |      



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Options outstanding under our stock plans expire at various dates from 2005 to 2014. The number of
options exercisable as of December 31, 2004, 2003 and 2002, was 4,967,089, 4,099,834, and 3,482,203 at weighted average exercise prices of $10.10, $9.88 and $8.38, respectively. The weighted average fair value of options granted and the weighted
average remaining contractual life of options granted during 2004, 2003 and 2002 are $9.99, $10.09 and $9.93 and 6.7, 6.8 and 7.4 years, respectively.



Employee Stock Purchase Plan



We have an employee stock purchase plan, which enables employees to contribute up to 10% of their compensation toward the purchase of our common stock at
the end of the participation period at a purchase price equal to 85% of the lower of the fair market value of the common stock on the first or last day of the participation period. Common stock reserved for future employee purchases under the plan
totals 1,032,584 shares at December 31, 2004. Common stock issued under the plan totaled approximately 165,000 in 2004, 297,000 in 2003 and 362,000 in 2002.



|9. | Defined Contribution Plans
|-- | --------------------------



We have a voluntary defined contribution plan under Section 401(k) of the Internal Revenue Code that covers substantially all United States employees. The
401(k) plan provides a discretionary year-end employer matching contribution on employee deferral contributions made during the plan year up to 6% of the participants contributions. We also have a voluntary defined contribution profit sharing
plan that covers substantially all employees. Contributions to the latter are limited to the employers discretionary annual contribution. No employer contributions were made to either plan during 2004, 2003 or 2002.



|10. | Income Taxes
|--- | ------------



There was no income tax expense for the years ended December 31, 2004, 2003 or 2002. The components for the provision for income taxes were as follows (in
thousands):



|              |  |                         |      |   |      |   |      |      |  |   |  
|------------- |  | ----------------------- | ---- | - | ---- | - | ---- | ---- |  | - | -
|              |  | Year ended December 31,
|              |  | 2004                    |      |   | 2003 |   |      | 2002
|Current:      |  |                         |      |   |      |   |      |      |  |   |  
|Federal       |  | $                       |     |   |      | $ |     |      |  | $ | 
|State         |  |                         | 62   |   |      |   | 49   |      |  |   | 
|International |  |                         | 283  |   |      |   | 510  |      |  |   | 
|              |  |                         |     
|Deferred:     |  |                         |      |   |      |   |      |      |  |   |  
|Federal       |  |                         | (345 | ) |      |   | (559 | )    |  |   | 
|State         |  |                         |     |   |      |   |     |      |  |   | 
|International |  |                         |     |   |      |   |     |      |  |   | 
|              |  |                         |      |   |      |   |      |      |  |   |  
|Total         |  | $                       |     |   |      | $ |     |      |  | $ | 
|              |  |                         |      |   |      |   |      |      |  |   |  



The effective tax rate
differs from the statutory tax rate primarily as a result of the following (in thousands):



|                                        |  |                         |        |   |      |   |        |      |  |   |        |  
|--------------------------------------- |  | ----------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                        |  | Year ended December 31, |       
|                                        |  | 2004                    |        |   | 2003 |   |        | 2002 | 
|Income taxes at statutory rate          |  | $                       | 4,264  |   |      | $ | 2,807  |      |  | $ | (2,173 | )
|State taxes, net of federal benefit     |  |                         | 249    |   |      |   | 211    |      |  |   | (468   | )
|Foreign taxes                           |  |                         | 203    |   |      |   | 423    |      |  |   | (107   | )
|Change in valuation allowance           |  |                         | (1,543 | ) |      |   | (701   | )    |  |   | 3,518  |  
|Use of net operating loss carryforwards |  |                         | (3,120 | ) |      |   | (3,084 | )    |  |   | (651   | )
|Other                                   |  |                         | (53    | ) |      |   | 344    |      |  |   | (119   | )
|                                        |  |                         |        |   |      |   |        |      |  |   |        |  
|Income tax expense                      |  | $                       |       |   |      | $ |       |      |  | $ |       |  
|                                        |  |                         |        |   |      |   |        |      |  |   |        |  



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Deferred income tax assets and liabilities result from temporary differences between the carrying values
of assets and liabilities for financial statement and income tax purposes. Significant components of our net deferred tax assets are as follows (in thousands):



|                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|---------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                     |  | Year ended December 31, |        
|                                                     |  | 2004                    |         |   | 2003 |   |         | 2002 | 
|Deferred tax assets:                                 |  |                         |         |   |      |   |         |      |  |   |         |  
|Accrued liabilities                                  |  | $                       | 1,086   |   |      | $ | (26     | )    |  | $ | 3,839   |  
|Liabilities                                          |  |                         | 239     |   |      |   | 252     |      |  |   | 209     |  
|Tax over book amortization                           |  |                         | (612    | ) |      |   | (37     | )    |  |   | (247    | )
|Book over tax depreciation                           |  |                         | 93      |   |      |   | 171     |      |  |   | 171     |  
|Income tax credits                                   |  |                         | 478     |   |      |   | 478     |      |  |   | 478     |  
|Net operating loss carryforward                      |  |                         | 79,172  |   |      |   | 78,425  |      |  |   | 53,958  |  
|                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|Total deferred tax assets before valuation allowance |  |                         | 80,456  |   |      |   | 79,263  |      |  |   | 58,408  |  
|Less valuation allowance                             |  |                         | (76,852 | ) |      |   | (76,004 | )    |  |   | (55,708 | )
|                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|Net deferred tax assets                              |  | $                       | 3,604   |   |      | $ | 3,259   |      |  | $ | 2,700   |  
|                                                     |  |                         |         |   |      |   |         |      |  |   |         |  



SFAS No. 109,
Accounting for Income Taxes, requires the consideration of a valuation allowance for deferred tax assets if it is more likely than not that benefits of deferred tax assets will not be realized. Realization of the $3.6 million
of net deferred tax assets is dependent upon our ability to generate sufficient future taxable income and the implementation of tax planning strategies. We believe it is more likely than not that the net deferred tax assets will be realized based
expected levels of future taxable income in the United States and certain foreign jurisdictions, and the implementation of tax planning strategies. However, the amount of the deferred tax assets considered realizable could be reduced in the near
term if estimates of future taxable income are reduced or we are unable to implement our tax strategies.



At December 31, 2004, we had net operating loss (NOL) carryforwards of $197.9 million that are available to offset taxable income through 2024 and will
start to expire in 2005. These carryforwards are subject to the limitations of Internal Revenue Code Section 382. This section provides limitations on the availability of net operating losses to offset current taxable income if significant ownership
changes have occurred for federal tax purposes. Included in the NOL is approximately $45.1 million related to disqualifying dispositions of stock option exercises, which currently have a full valuation allowance, and when realized for financial
statement purposes will not result in a reduction in income tax expense. Rather, the benefit will be recorded as an increase to additional paid-in capital. Also included in the NOL is approximately $58.4 million related to acquired N2H2 NOL
carryforwards, which currently have a full valuation allowance, and when realized for financial statement purposes will not result in a reduction in income tax expense. Rather, the benefit will be recorded as a decrease to goodwill.



No provision has been made for United States federal income taxes on certain
undistributed earnings of foreign subsidiaries that we intend to permanently invest or that may be remitted substantially tax-free. The total of undistributed earnings that would be subject to federal income tax if remitted under existing law is
approximately $1.7 million at December 31, 2004.



Federal
income taxes were not paid in 2004, 2003 or 2002. Foreign taxes paid in 2004, 2003 and 2002 were approximately $340,000, $447,000, and $408,000, respectively.



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|11. | Leases
|--- | ------



We lease office space for all of our locations. Renewal options exist for our Concord, CA, and Seattle, WA offices. Future lease payments for all
operating leases, excluding executory costs such as management and maintenance fees and property tax, are as follows (in thousands):



|           |  |                         |       |          |   |      |                             |  |   |      
|---------- |  | ----------------------- | ----- | -------- | - | ---- | --------------------------- |  | - | -----
|           |  | Future LeaseObligations |       | Sublease |   |      | Net Future LeaseObligations
|2005       |  | $                       | 3,562 |          | $ | (306 | )                           |  | $ | 3,256
|2006       |  |                         | 1,783 |          |   | (116 | )                           |  |   | 1,667
|2007       |  |                         | 1,441 |          |   |     |                             |  |   | 1,441
|2008       |  |                         | 308   |          |   |     |                             |  |   | 308  
|2009       |  |                         | 41    |          |   |     |                             |  |   | 41   
|Thereafter |  |                         | 17    |          |   |     |                             |  |   | 17   
|           |  |                         |       |          |   |      |                             |  |   |      
|           |  | $                       | 7,152 |          | $ | (422 | )                           |  | $ | 6,730
|           |  |                         |       |          |   |      |                             |  |   |      



Rent expense including
executory costs, net of sublease income was $3.9 million, $3.8 million, and $3.6 million, for the years ended December 31, 2004, 2003 and 2002, respectively. Sublease income is shown on the consolidated results of operation as a reduction of general
and administrative expenses.



|12. | Contingencies
|--- | -------------



In December 2002, we were named as the defendant in an rental property lawsuit brought by Salvio Pacheco Square LLP in the United States Superior Court of
Contra Costa County. The complaint alleges that we had violated our one-time cancellation provision in a lease for our Concord, CA office and asked for relief in the form of compensatory and other damages. The Court entered a judgment in favor of
the plaintiff in June 2004 in the amount of $1.1 million. We believe that the allegations included in the complaint are wholly without merit, have filed an appeal to the judgment, and intend to defend this litigation vigorously. It is not possible
to predict the timing or outcome of this litigation, however, if we do not prevail in the appeal process, we could incur costs for approximately $1.1 to 2 million.



We are engaged in other certain legal proceedings and claims arising in the ordinary course of our business. The ultimate
liabilities, if any, which may result from these or other pending or threatened legal actions against us cannot be determined at this time. However, in the opinion of management, the facts known at the present time do not indicate that such
litigation will have a material effect on our consolidated financial position or results of operation.



|13. | Litigation Settlements
|--- | ----------------------



In April 1999, purported securities class action complaints were filed in the United States District Court for the Northern District of California against
us and certain of our officers and directors. Each complaint alleged that defendants made false and misleading statements about our business condition and prospects during a purported class period of November 10, 1998 through March 31, 1999, and
asserts claims for violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. In July 2002, we reached a settlement of the class action complaint. In November 2002, the Court granted final approval of the
settlement for $10.1 million. $2.8 million in cash was covered by our insurance. The $7.3 million balance of the settlement, reflected on the consolidated statement of operations as other non-recurring expense, was contributed by us in common stock
on April 16, 2003, the date of distribution. Total shares distributed were 1,951,807.



On February 11, 2002, Herbert Silverberg filed a shareholder derivative action captioned Silverberg v. McGurran, et al., Case No. CV 805193 in California Superior Court in Santa Clara County against certain of
our current and former officers and directors. We were named as nominal defendant. Plaintiff alleged that defendants breached their fiduciary duties by making false and misleading statements about our business



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condition and prospects during the period of November 10, 1998 through March 31, 1999. On April 29, 2002, the Court dismissed the complaint with leave to
amend. The parties subsequently negotiated a settlement of $300,000 by which plaintiff dismissed the action with prejudice. On March 11, 2003 the Court granted final approval of the settlement, which was contributed by us in common stock. Total
shares distributed were 77,922.



|14. | Net Income (Loss) Per Share
|--- | ---------------------------



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



|                                                                                               |  |                         |        |      |   |        |  |   |        |  
|---------------------------------------------------------------------------------------------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | -
|                                                                                               |  | Year Ended December 31, |       
|                                                                                               |  | 2004                    |        | 2003 |   | 2002   | 
|Net income (loss) applicable to common stockholders                                            |  | $                       | 12,835 |      | $ | 8,256  |  | $ | (6,476 | )
|                                                                                               |  |                         |        |      |   |        |  |   |        |  
|Shares used in computing basic net income (loss) per share applicable to common stockholders   |  |                         | 35,576 |      |   | 31,986 |  |   | 29,307 |  
|Outstanding dilutive stock options                                                             |  |                         | 1,680  |      |   | 1,668  |  |   |       |  
|                                                                                               |  |                         |        |      |   |        |  |   |        |  
|Shares used in computing diluted net income (loss) per share applicable to common stockholders |  |                         | 37,256 |      |   | 33,654 |  |   | 29,307 |  
|Basic net income (loss) applicable to common stockholders                                      |  | $                       | 0.36   |      | $ | 0.26   |  | $ | (0.22  | )
|Diluted net income (loss) applicable to common stockholders                                    |  | $                       | 0.34   |      | $ | 0.25   |  | $ | (0.22  | )



Potential common
shares of 2,533,000, 4,379,000 and 3,594,000 related to our outstanding stock options were excluded from the computation of diluted earnings per share for 2004, 2003 and 2002, respectively, as inclusion of these shares would have been anti-dilutive.



|15. | Segment Information
|--- | -------------------



As described in Note 2, we discontinued our AT division and have reclassified the results of operations of AT division as discontinued operations.
Therefore, we operate only one business segment called enterprise security solutions.



International sales accounted for 31%, 30% and 28% of total revenue for the years 2004, 2003 and 2002, respectively. Major foreign markets for our products include Europe, Japan, China, the Pacific Rim, and Latin
America. In each country, we have independent channel partners that are responsible for marketing, selling, and supporting our products to resellers and end users within their defined territories. The following table summarizes our domestic and
international sales (in thousands):



|                    |  |                         |        |      |   |        |  |   |       
|------------------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------
|                    |  | Year ended December 31,
|                    |  | 2004                    |        | 2003 |   | 2002  
|Revenues:           |  |                         |        |      |   |        |  |   |       
|Domestic sales      |  | $                       | 64,431 |      | $ | 53,673 |  | $ | 44,842
|International sales |  |                         | 28,947 |      |   | 22,540 |  |   | 17,118
|                    |  |                         |        |      |   |        |  |   |       
|                    |  | $                       | 93,378 |      | $ | 76,213 |  | $ | 61,960
|                    |  |                         |        |      |   |        |  |   |       



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|16. | Summarized Quarterly Financial Information (unaudited)
|--- | ------------------------------------------------------



|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|------------------------------------------------------------- |  | --------------------------------------------------- | ------ | - | -------- | - | ------ | ------------- |  | - | ------------ | - |  | - | ------ | -
|                                                              |  | Quarter Ended (in thousands, except per share data) |       
|                                                              |  | March 31,                                           |        |   | June 30, |   |        | September 30, |  |   | December 31, |  
|2004                                                          |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Revenue                                                       |  | $                                                   | 21,216 |   |          | $ | 22,118 |               |  | $ | 24,530       |   |  | $ | 25,514 |  
|Gross profit                                                  |  |                                                     | 18,703 |   |          |   | 19,468 |               |  |   | 20,792       |   |  |   | 22,080 |  
|Net income from continuing operations                         |  |                                                     | 2,205  |   |          |   | 2,518  |               |  |   | 3,565        |   |  |   | 4,547  |  
|Net income for discontinued operations                        |  |                                                     |       |   |          |   |       |               |  |   |             |   |  |   |       |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Net income                                                    |  | $                                                   | 2,205  |   |          | $ | 2,518  |               |  | $ | 3,565        |   |  | $ | 4,547  |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Basic income per share:                                       |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Continuing operations                                         |  |                                                     | 0.06   |   |          |   | 0.07   |               |  |   | 0.10         |   |  |   | 0.13   |  
|Discontinued operations                                       |  |                                                     |       |   |          |   |       |               |  |   |             |   |  |   |       |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Basic income per share                                        |  | $                                                   | 0.06   |   |          | $ | 0.07   |               |  | $ | 0.10         |   |  | $ | 0.13   |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Diluted income per share:                                     |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Continuing operations                                         |  |                                                     | 0.06   |   |          |   | 0.07   |               |  |   | 0.10         |   |  |   | 0.12   |  
|Discontinued operations                                       |  |                                                     |       |   |          |   |       |               |  |   |             |   |  |   |       |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Diluted income per share                                      |  | $                                                   | 0.06   |   |          | $ | 0.07   |               |  | $ | 0.10         |   |  | $ | 0.12   |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|                                                              |  |                                                     |        |  
|2003                                                          |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Revenue                                                       |  | $                                                   | 16,179 |   |          | $ | 17,630 |               |  | $ | 19,474       |   |  | $ | 22,930 |  
|Gross profit                                                  |  |                                                     | 14,844 |   |          |   | 15,727 |               |  |   | 17,608       |   |  |   | 20,413 |  
|Net income from continuing operations                         |  |                                                     | 962    |   |          |   | 1,225  |               |  |   | 2,776        |   |  |   | 4,327  |  
|Net loss from discontinued operations/disposal of AT division |  |                                                     | (391   | ) |          |   | (216   | )             |  |   | (150         | ) |  |   | (277   | )
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Net income                                                    |  | $                                                   | 571    |   |          | $ | 1,009  |               |  | $ | 2,626        |   |  | $ | 4,050  |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Basic income (loss) per share:                                |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Continuing operations                                         |  |                                                     | 0.03   |   |          |   | 0.04   |               |  |   | 0.08         |   |  |   | 0.13   |  
|Discontinued operations                                       |  |                                                     | (0.01  | ) |          |   | (0.01  | )             |  |   |             |   |  |   | (0.01  | )
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Basic income per share                                        |  | $                                                   | 0.02   |   |          | $ | 0.03   |               |  | $ | 0.08         |   |  | $ | 0.12   |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Diluted income (loss) per share:                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Continuing operations                                         |  |                                                     | 0.03   |   |          |   | 0.04   |               |  |   | 0.08         |   |  |   | 0.12   |  
|Discontinued operations                                       |  |                                                     | (0.01  | ) |          |   | (0.01  | )             |  |   |             |   |  |   | (0.01  | )
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Diluted income per share                                      |  | $                                                   | 0.02   |   |          | $ | 0.03   |               |  | $ | 0.08         |   |  | $ | 0.11   |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  



|17. | Subsequent Event
|--- | ----------------



In February 2005, we made a strategic investment in a privately-held technology company. As a result of this $2.7 million investment, we have a 15 percent
ownership stake in this company.



Two of our board members, one
of whom is a board member of the investee, are individual investors of the investee. Due to their involvement with the investee, these two board members recused themselves from our decision to make the investment.



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Report of Independent Registered Public Accounting Firm



The Board of Directors and Stockholders of Secure Computing Corporation



We have audited the accompanying consolidated balance sheets of Secure Computing Corporation
as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement
schedule listed in the Index at Item 15(a). These consolidated 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 the standards of the
Public Company Accounting Oversight Board (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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Secure Computing Corporation at December 31, 2004 and 2003, and
the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement
schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.



We have also audited, in accordance with the Public Company Accounting Oversight Board (United States), the effectiveness of Secure
Computing Corporations internal control over financial reporting as of December 31, 2004 based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission
and our report dated March 7, 2005 expressed an unqualified opinion thereon.



/s/ Ernst & Young LLP



Minneapolis, Minnesota

March 7, 2005



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Report of Independent Registered Public Accounting Firm



The Board of Directors and Stockholders of Secure Computing Corporation



We have audited managements assessment, included in the section in Item 9(a) entitled
Managements Report on Internal Control Over Financial Reporting that Secure Computing Corporation maintained effective internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control
 Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Secure Computings management is responsible for maintaining effective internal control over financial reporting and for its
assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on managements assessment and an opinion on the effectiveness of the companys internal control over financial
reporting based on our audit.



We conducted our audit in accordance with
standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in
all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and
performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.



A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the
maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of
financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.



Because of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies
and procedures may deteriorate.



In our opinion, managements assessment
that Secure Computing Corporation maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also in our opinion, Secure Computing Corporation
maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.



We have also audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets as of December 31,
2004 and 2003, and the related consolidated statements of operations, stockholders equity, and cash flows for each of the three years in the period ended December 31, 2004, of Secure Computing Corporation, and our report dated March 7, 2005
expressed an unqualified opinion thereon.



/s/ Ernst & Young LLP



Minneapolis, MN

March 7, 2005



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Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended,
the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



|                     |  |  |  |                              |  |                        |  |                                                
|-------------------- |  |  |  | ---------------------------- |  | ---------------------- |  | -----------------------------------------------
|                     |  |  |  | SECURE COMPUTING CORPORATION
|                     |  |  | 
|Date: March 11, 2005 |  |  |  | By                           |  | /s/    JOHN E.
MCNULTY
|                     |  |  |  |                              |  |                        |  | John E. McNulty                                
|                     |  |  |  |                              |  |                        |  | Chairman, President and Chief Executive Officer



Power of Attorney



KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints John McNulty and Timothy Steinkopf or either of them, his or her true and lawful attorneys-in-fact and agents, with full power of substitution and re-substitution, for him or her and in his or her name, place and
stead, in any and all capacities to sign any and all amendments to this Report on Form 10-K, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto the
attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he or she might or could do
in person, hereby ratifying and confirming all that the attorneys-in-fact and agents, or either of them, or their, his or her substitutes or substitute, may lawfully do or cause to be done by virtue hereof.



Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the Registrant and in the capacities indicated on March 11, 2005.



|                                                          |  |                                                                                               
|--------------------------------------------------------- |  | ----------------------------------------------------------------------------------------------
|Signature                                                 |  | Title                                                                                         
|                                                          | 
|/s/    JOHN E.
MCNULTYJohn E.
McNulty                     |  | Chairman, President and Chief Executive Officer (Principal Executive Officer)                 
|                                                          | 
|/s/    TIMOTHY J. STEINKOPFTimothy J. Steinkopf           |  | Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)
|                                                          | 
|/s/    ROBERT J.
FRANKENBERGRobert J.
Frankenberg         |  | Director                                                                                      
|                                                          | 
|/s/    JAMES F.
JORDANJames F.
Jordan                     |  | Director                                                                                      
|                                                          | 
|/s/    STEPHEN M.
PURICELLIStephen M.
Puricelli           |  | Director                                                                                      
|                                                          | 
|/s/    ERIC P.
RUNDQUISTEric P.
Rundquist                 |  | Director                                                                                      
|                                                          | 
|/s/    ALEXANDER ZAKUPOWSKY,
JR.Alexander Zakupowsky,
Jr. |  | Director                                                                                      



54



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##### Table of Contents

SCHEDULE II

VALUATION AND QUALIFYING ACCOUNTS

YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002



|                                    |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        
|----------------------------------- |  | ---------------------------- | --------- | --------------------------------------- | - | --------------- |  | - | ---------------------- | - |  | - | -------
|Description                         |  | Balance at Beginning of Year |           | Additions Charged to Costs and Expenses |   | Less Deductions |  |   | Balance at End of Year
|Year ended December 31, 2004:       |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        
|Allowance for doubtful accounts (1) |  | $                            | 868,000   |                                         | $ | 214,000         |  | $ | (632,000               | ) |  | $ | 450,000
|                                    |  |                              |           |                                        
|Year ended December 31, 2003:       |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        
|Sales return allowance              |  | $                            | 74,000    |                                         | $ |                |  | $ | (74,000                | ) |  | $ |       
|Allowance for doubtful accounts(2)  |  |                              | 440,000   |                                         |   | 659,000         |  |   | (231,000               | ) |  |   | 868,000
|                                    |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        
|Total                               |  | $                            | 514,000   |                                         | $ | 659,000         |  | $ | (305,000               | ) |  | $ | 868,000
|                                    |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        
|                                    |  |                              |           |                                        
|Year ended December 31, 2002:       |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        
|Sales return allowance              |  | $                            | 582,000   |                                         | $ |                |  | $ | (508,000               | ) |  | $ | 74,000 
|Allowance for doubtful accounts     |  |                              | 822,000   |                                         |   | 246,000         |  |   | (628,000               | ) |  |   | 440,000
|                                    |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        
|Total                               |  | $                            | 1,404,000 |                                         | $ | 246,000         |  | $ | (1,137,000             | ) |  | $ | 514,000
|                                    |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        

---

|(1) | The amount listed in deductions for allowance for doubtful accounts includes $320,000 for acquired N2H2 receivables that were collected in 2004, but had been reserved for in 2003.
Amount was adjusted as part of the finalization of the purchase price of N2H2 noted in footnote 7 above and therefore, did not impact earnings.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | The amount listed in additions charged to costs and expenses for allowance for doubtful accounts includes $402,000 for acquired N2H2 receivables, which did not have an expense
impact in 2003.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



55