##### Table of Contents

---

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



---

FORM 10-Q



---

(Mark One)

|x | Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
|- | ---------------------------------------------------------------------------------------

For the Quarterly Period Ended June 30, 2006

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



---

SECURE COMPUTING CORPORATION

(Exact name of registrant as specified in its charter)



---



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 52-1637226                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. employer identification no.)
|                                                               | 
|4810 Harwood Road, San Jose, CA                                |  | 95124                               
|(Address of principal executive offices)                       |  | (Zip code)                          

(408) 979-6100

Registrants telephone number, including area code

Not Applicable

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



---

Indicate by check mark if the
Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes ̈No  x

Indicate by check mark if the Registrant is not
required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ̈No  x

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 whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerate filer ̈Accelerated
filer  x    Non-accelerated filer ̈

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act.):    Yes ̈No  x

Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practical date: Common Stock, $.01 par
value  54,198,152 issued and outstanding as of August 1, 2006.



---



---

##### Table of Contents

SECURE COMPUTING CORPORATION

INDEX



|                              |  |                                                                                                                              |  |         
|----------------------------- |  | ---------------------------------------------------------------------------------------------------------------------------- |  | --------
|                              |  |                                                                                                                              |  | Page No.
|PART I. FINANCIAL INFORMATION |  |                                                                                                                             
|                              |  |                                                                                                                             
|Item 1                        |  | Condensed Consolidated Financial Statements:                                                                                 |  |         
|                              |  |                                                                                                                             
|                              |  | Condensed Consolidated Balance Sheets as of June 30, 2006 (Unaudited) and December 31, 2005                                  |  | 3       
|                              |  |                                                                                                                             
|                              |  | Condensed Consolidated Statements of Operations (Unaudited) for the three months and six months ended June 30, 2006 and 2005 |  | 4       
|                              |  |                                                                                                                             
|                              |  | Condensed Consolidated Statements of Cash Flows (Unaudited) for the six months ended June 30, 2006 and 2005                  |  | 5       
|                              |  |                                                                                                                             
|                              |  | Notes to the Condensed Consolidated Financial Statements (Unaudited)                                                         |  | 6-14    
|                              |  |                                                                                                                             
|Item 2                        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                        |  | 15-20   
|                              |  |                                                                                                                             
|Item 3                        |  | Quantitative and Qualitative Disclosures About Market Risk                                                                   |  | 20-21   
|                              |  |                                                                                                                             
|Item 4                        |  | Controls and Procedures                                                                                                      |  | 21      
|                              | 
|PART II. OTHER INFORMATION    |  |                                                                                                                             
|                              |  |                                                                                                                             
|Item 1                        |  | Legal Proceedings                                                                                                            |  | 22      
|                              |  |                                                                                                                             
|Item 2                        |  | Changes in Securities                                                                                                        |  | 22      
|                              |  |                                                                                                                             
|Item 3                        |  | Defaults upon Senior Securities                                                                                              |  | 22      
|                              |  |                                                                                                                             
|Item 4                        |  | Submission of Matters to a Vote of Security Holders                                                                          |  | 22      
|                              |  |                                                                                                                             
|Item 5                        |  | Other Information                                                                                                            |  | 23      
|                              |  |                                                                                                                             
|Item 6                        |  | Exhibits and Reports on Form 8-K                                                                                             |  | 23-24   
|                              |  |                                                                                                                             
|                              |  | Signatures                                                                                                                   |  | 25      



2



---

##### Table of Contents

PART I - FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

SECURE COMPUTING CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)



|                                                                                                                 |  |                           |         |   |                              |   |         |  
|---------------------------------------------------------------------------------------------------------------- |  | ------------------------- | ------- | - | ---------------------------- | - | ------- | -
|                                                                                                                 |  | June 30, 2006 (Unaudited) |         |   | December 31, 2005 (See Note) |  
|ASSETS                                                                                                           |  |                           |         |   |                              |   |         |  
|Current assets                                                                                                   |  |                           |         |   |                              |   |         |  
|Cash and cash equivalents                                                                                        |  | $                         | 71,158  |   |                              | $ | 50,039  |  
|Investments                                                                                                      |  |                           | 31,403  |   |                              |   | 31,140  |  
|Accounts receivable, net                                                                                         |  |                           | 30,527  |   |                              |   | 29,795  |  
|Inventory, net                                                                                                   |  |                           | 3,810   |   |                              |   | 2,174   |  
|Deferred income taxes                                                                                            |  |                           | 3,682   |   |                              |   | 3,604   |  
|Other current assets                                                                                             |  |                           | 10,368  |   |                              |   | 4,869   |  
|                                                                                                                 |  |                           |         |   |                              |   |         |  
|Total current assets                                                                                             |  |                           | 150,948 |   |                              |   | 121,621 |  
|Property and equipment, net                                                                                      |  |                           | 10,480  |   |                              |   | 3,841   |  
|Goodwill                                                                                                         |  |                           | 313,429 |   |                              |   | 39,230  |  
|Intangibles, net                                                                                                 |  |                           | 45,200  |   |                              |   | 1,814   |  
|Deferred income taxes                                                                                            |  |                           | 13,154  |   |                              |   |        |  
|Other assets                                                                                                     |  |                           | 3,500   |   |                              |   | 5,257   |  
|                                                                                                                 |  |                           |         |   |                              |   |         |  
|Total assets                                                                                                     |  | $                         | 536,711 |   |                              | $ | 171,763 |  
|                                                                                                                 |  |                           |         |   |                              |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                             |  |                           |         |   |                              |   |         |  
|Current liabilities                                                                                              |  |                           |         |   |                              |   |         |  
|Accounts payable                                                                                                 |  | $                         | 4,580   |   |                              | $ | 2,997   |  
|Accrued payroll                                                                                                  |  |                           | 7,385   |   |                              |   | 4,690   |  
|Other accrued expenses                                                                                           |  |                           | 6,450   |   |                              |   | 2,377   |  
|Acquisition reserve                                                                                              |  |                           | 3,378   |   |                              |   | 389     |  
|Deferred revenue                                                                                                 |  |                           | 51,388  |   |                              |   | 29,097  |  
|                                                                                                                 |  |                           |         |   |                              |   |         |  
|Total current liabilities                                                                                        |  |                           | 73,181  |   |                              |   | 39,550  |  
|Acquisition reserve, net of current portion                                                                      |  |                           | 1,801   |   |                              |   | 364     |  
|Deferred revenue, net of current portion                                                                         |  |                           | 16,941  |   |                              |   | 9,966   |  
|Deferred tax liability                                                                                           |  |                           | 18,723  |   |                              |   |        |  
|                                                                                                                 |  |                           |         |   |                              |   |         |  
|Total liabilities                                                                                                |  |                           | 110,646 |   |                              |   | 49,880  |  
|                                                                                                                 |  |                          
|Convertible preferred stock, par value $.01 per share:                                                           |  |                           |         |   |                              |   |         |  
|Authorized  2,000,000; issued and outstanding  700,000 at June 30, 2006 and none at December 31, 2005          |  |                           | 63,758  |   |                              |   |        |  
|                                                                                                                 |  |                          
|Stockholders equity                                                                                             |  |                           |         |   |                              |   |         |  
|Common stock, par value $.01 per share:                                                                          |  |                           |         |   |                              |   |         |  
|Authorized  100,000,000; issued and outstanding  June 30, 2006  54,195,859 and December 31, 2005 
37,021,089 |  |                           | 541     |   |                              |   | 370     |  
|Additional paid-in capital                                                                                       |  |                           | 454,171 |   |                              |   | 205,970 |  
|Accumulated deficit                                                                                              |  |                           | (90,735 | ) |                              |   | (83,698 | )
|Accumulated other comprehensive loss                                                                             |  |                           | (1,670  | ) |                              |   | (759    | )
|                                                                                                                 |  |                           |         |   |                              |   |         |  
|Total stockholders equity                                                                                       |  |                           | 362,307 |   |                              |   | 121,883 |  
|                                                                                                                 |  |                           |         |   |                              |   |         |  
|Total liabilities and stockholders equity                                                                       |  | $                         | 536,711 |   |                              | $ | 171,763 |  
|                                                                                                                 |  |                           |         |   |                              |   |         |  

---

|      |  |                                                                                                                                                                                                                                                                   
|----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE: |  | The balance sheet at December 31, 2005 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by U.S.
generally accepted accounting principles for complete financial statements.

See accompanying notes to the condensed consolidated financial statements.



3



---

##### Table of Contents

SECURE COMPUTING CORPORATION

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited, in thousands, except share amounts)



|                                                     |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|---------------------------------------------------- |  | --------------------------- | ------ | - | ------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                                     |  | Three Months Ended June 30, |        |   | Six Months Ended June 30, |  
|                                                     |  | 2006                        |        |   | 2005                      |   |        | 2006 |  |   | 2005    |  
|Revenues:                                            |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Products                                             |  | $                           | 24,527 |   |                           | $ | 18,763 |      |  | $ | 53,702  |   |  | $ | 37,600 |  
|Services                                             |  |                             | 14,219 |   |                           |   | 7,350  |      |  |   | 27,661  |   |  |   | 14,092 |  
|                                                     |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Total revenues                                       |  |                             | 38,746 |   |                           |   | 26,113 |      |  |   | 81,363  |   |  |   | 51,692 |  
|                                                     |  |                             |        |  
|Cost of revenues:                                    |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Products                                             |  |                             | 6,047  |   |                           |   | 3,257  |      |  |   | 14,876  |   |  |   | 6,933  |  
|Services                                             |  |                             | 2,624  |   |                           |   | 1,278  |      |  |   | 5,004   |   |  |   | 2,587  |  
|Amortization of purchased intangibles                |  |                             | 1,253  |   |                           |   |       |      |  |   | 1,976   |   |  |   |       |  
|                                                     |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Total cost of revenues                               |  |                             | 9,924  |   |                           |   | 4,535  |      |  |   | 21,856  |   |  |   | 9,520  |  
|                                                     |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Gross profit                                         |  |                             | 28,822 |   |                           |   | 21,578 |      |  |   | 59,507  |   |  |   | 42,172 |  
|                                                     |  |                             |        |  
|Operating expenses:                                  |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Selling and marketing                                |  |                             | 17,829 |   |                           |   | 10,829 |      |  |   | 33,625  |   |  |   | 20,954 |  
|Research and development                             |  |                             | 7,802  |   |                           |   | 4,001  |      |  |   | 14,726  |   |  |   | 8,285  |  
|General and administrative                           |  |                             | 2,912  |   |                           |   | 1,872  |      |  |   | 5,917   |   |  |   | 3,800  |  
|Amortization of purchased intangibles                |  |                             | 2,989  |   |                           |   | 130    |      |  |   | 4,680   |   |  |   | 266    |  
|Litigation settlement                                |  |                             |       |   |                           |   |       |      |  |   | 2,500   |   |  |   |       |  
|                                                     |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|                                                     |  |                             | 31,532 |   |                           |   | 16,832 |      |  |   | 61,448  |   |  |   | 33,305 |  
|                                                     |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Operating (loss)/income                              |  |                             | (2,710 | ) |                           |   | 4,746  |      |  |   | (1,941  | ) |  |   | 8,867  |  
|                                                     |  |                             |        |  
|Other income                                         |  |                             | 1,361  |   |                           |   | 332    |      |  |   | 1,901   |   |  |   | 400    |  
|                                                     |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|(Loss)/income before taxes                           |  |                             | (1,349 | ) |                           |   | 5,078  |      |  |   | (40     | ) |  |   | 9,267  |  
|                                                     |  |                             |        |  
|Income tax benefit/(expense)                         |  |                             | 8,008  |   |                           |   | (132   | )    |  |   | 7,356   |   |  |   | (259   | )
|                                                     |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Net income                                           |  | $                           | 6,659  |   |                           | $ | 4,946  |      |  | $ | 7,316   |   |  | $ | 9,008  |  
|                                                     |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Preferred stock accretion                            |  |                             | (937   | ) |                           |   |       |      |  |   | (1,750  | ) |  |   |       |  
|Charge from beneficial conversion of preferred stock |  |                             |       |   |                           |   |       |      |  |   | (12,603 | ) |  |   |       |  
|                                                     |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Net income/(loss) applicable to common shareholders  |  | $                           | 5,722  |   |                           | $ | 4,946  |      |  | $ | (7,037  | ) |  | $ | 9,008  |  
|                                                     |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Basic earnings/(loss) per share                      |  | $                           | 0.11   |   |                           | $ | 0.14   |      |  | $ | (0.13   | ) |  | $ | 0.25   |  
|                                                     |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Weighted average shares outstanding - basic          |  |                             | 54,108 |   |                           |   | 36,057 |      |  |   | 52,915  |   |  |   | 35,943 |  
|                                                     |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Diluted earnings/(loss) per share                    |  | $                           | 0.11   |   |                           | $ | 0.13   |      |  | $ | (0.13   | ) |  | $ | 0.24   |  
|                                                     |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Weighted average shares outstanding - diluted        |  |                             | 60,994 |   |                           |   | 37,207 |      |  |   | 52,915  |   |  |   | 36,940 |  
|                                                     |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  

See accompanying notes to the condensed consolidated financial statements.



4



---

##### Table of Contents

SECURE COMPUTING CORPORATION

CONDENSED CONSOLIDATED STATEMENT OF CASHFLOWS

(Unaudited, in thousands)



|                                                                                  |  |                           |         |   |      |   |        |  
|--------------------------------------------------------------------------------- |  | ------------------------- | ------- | - | ---- | - | ------ | -
|                                                                                  |  | Six Months Ended June 30, |        
|                                                                                  |  | 2006                      |         |   | 2005 |  
|Operating activities                                                              |  |                           |         |   |      |   |        |  
|Net income                                                                        |  | $                         | 7,316   |   |      | $ | 9,008  |  
|                                                                                  |  |                          
|Adjustments to reconcile net income to net cash provided by operating activities: |  |                           |         |   |      |   |        |  
|Depreciation                                                                      |  |                           | 1,842   |   |      |   | 1,067  |  
|Amortization of intangible assets                                                 |  |                           | 6,848   |   |      |   | 465    |  
|(Gain)/loss on disposals of property and equipment                                |  |                           | (41     | ) |      |   | 385    |  
|Loss on disposals of intangible assets                                            |  |                           |        |   |      |   | 5      |  
|Utilization of acquired NOL                                                       |  |                           | (108    | ) |      |   |       |  
|Deferred income taxes                                                             |  |                           | (7,316  | ) |      |   |       |  
|Share-based compensation                                                          |  |                           | 3,683   |   |      |   |       |  
|Changes in operating assets and liabilities, excluding effects of acquisition:    |  |                           |         |   |      |   |        |  
|Accounts receivable                                                               |  |                           | 13,185  |   |      |   | (454   | )
|Inventories                                                                       |  |                           | 568     |   |      |   | (144   | )
|Other current assets                                                              |  |                           | 174     |   |      |   | 78     |  
|Accounts payable                                                                  |  |                           | 794     |   |      |   | (488   | )
|Payroll related accruals                                                          |  |                           | (760    | ) |      |   | 30     |  
|Accrued liabilities and reserves                                                  |  |                           | (6,899  | ) |      |   | (136   | )
|Deferred revenue                                                                  |  |                           | 282     |   |      |   | 1,848  |  
|                                                                                  |  |                           |         |   |      |   |        |  
|Net cash provided by operating activities                                         |  |                           | 19,568  |   |      |   | 11,664 |  
|                                                                                  |  |                          
|Investing activities                                                              |  |                           |         |   |      |   |        |  
|Proceeds from sales/maturities of investments                                     |  |                           | 12,423  |   |      |   | 5,777  |  
|Purchases of investments                                                          |  |                           | (12,336 | ) |      |   | (7,600 | )
|Purchase of property and equipment, net                                           |  |                           | (6,355  | ) |      |   | (906   | )
|Decrease/(increase) in intangibles and other assets                               |  |                           | 1,553   |   |      |   | (2,773 | )
|Cash paid for business acquisition, net of cash acquired                          |  |                           | (69,096 | ) |      |   |       |  
|                                                                                  |  |                           |         |   |      |   |        |  
|Net cash used for investing activities                                            |  |                           | (73,811 | ) |      |   | (5,502 | )
|                                                                                  |  |                          
|Financing activities                                                              |  |                           |         |   |      |   |        |  
|Proceeds from issuance of preferred stock, net of transaction fees                |  |                           | 69,945  |   |      |   |       |  
|Proceeds from issuance of common stock                                            |  |                           | 6,325   |   |      |   | 3,080  |  
|                                                                                  |  |                           |         |   |      |   |        |  
|Net cash provided by financing activities                                         |  |                           | 76,270  |   |      |   | 3,080  |  
|                                                                                  |  |                          
|Effect of exchange rates                                                          |  |                           | (908    | ) |      |   | 11     |  
|                                                                                  |  |                           |         |   |      |   |        |  
|Net increase in cash and cash equivalents                                         |  |                           | 21,119  |   |      |   | 9,253  |  
|Cash and cash equivalents, beginning of period                                    |  |                           | 50,039  |   |      |   | 37,899 |  
|                                                                                  |  |                           |         |   |      |   |        |  
|Cash and cash equivalents, end of period                                          |  | $                         | 71,158  |   |      | $ | 47,152 |  
|                                                                                  |  |                           |         |   |      |   |        |  
|                                                                                  |  |                          
|Supplemental Cash Flow Disclosure                                                 |  |                           |         |   |      |   |        |  
|Common stock issued for purchase of CyberGuard Corporation                        |  | $                         | 188,476 |   |      |   |       |  
|Release of deferred tax asset valuation as a reduction to goodwill                |  | $                         | 9,520   |   |      |   |       |  

See accompanying notes to the condensed consolidated financial statements.



5



---

##### Table of Contents

SECURE COMPUTING CORPORATION

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Organization

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 using trusted connections. Securing these connections, and providing the highest level of industry-recognized security, is at the heart of our mission. We operate our business within one operating segment
called enterprise security solutions.

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. At the same time, the flexibility of our product line allows us to
serve the needs of smaller enterprises, school districts and regional government agencies with products designed and priced to suit the small to medium business (SMB) market segment. 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 are using 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 our customers to achieve
this security, and implement a balance between security and accessibility according to their security policy.

2. Condensed Consolidated Financial
Statements

The accompanying condensed consolidated financial statements have been prepared by us without audit and reflect all
adjustments (consisting of normal and recurring adjustments and accruals) which are, in our opinion, necessary to present a fair statement of the results for the interim periods presented. The consolidated financial statements include our accounts
and those of our subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. The statements have been prepared in accordance with the regulations of the Securities and Exchange Commission, but omit certain
information and footnote disclosures necessary to present the statements in accordance with U.S. generally accepted accounting principles. The results of operations for the interim periods presented are not necessarily indicative of the results to
be expected for the full fiscal year. Certain previously reported amounts have been reclassified to conform to the current presentation format with no impact on net income. The December 31, 2005 Condensed Consolidated Balance Sheet is derived
from our audited Consolidated Balance Sheet as of December 31, 2005. These condensed financial statements should be read in conjunction with the Consolidated Financial Statements and footnotes thereto included in our Annual Report of Form 10-K
for the year ended December 31, 2005, as filed with the Securities and Exchange Commission.

3. Summary of Significant Accounting Policies

Revenue Recognition

We derive our
revenue primarily from two sources: (i) sales of products, including hardware, subscriptions, software licenses, and royalties and (ii) sales of services, including maintenance arrangements to provide upgrades and customer support,
professional services, and contracted development work. 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. Subscription-based contracts are generally for 12, 24 or 36 months in duration. Subscription revenue along with maintenance
revenue for providing product upgrades and customer support are deferred and recognized ratably over the service period beginning with the month the subscription or service begins.

When arrangements contain multiple elements and vendor specific objective evidence of fair value exists for all undelivered elements, we recognize
revenue for the delivered elements using the residual method. For arrangements containing multiple elements where vendor specific objective evidence of fair value does not exist for all undelivered elements, we defer revenue for the delivered and
undelivered elements until all elements have been delivered.



6



---

##### Table of Contents

3. Summary of Significant Accounting Policies (continued)

We sell our products either directly to an end-user, or indirectly through our channel of resellers and distributors (our channel partners). When
selling through our channel we require our channel partners to provide evidence of end-user sell-through. If we are unable to obtain end-user evidence at the time we fulfill the order from a channel partner, we do not recognize revenue until
the channel partner supplies end-user information, the product has been shipped, and all other criteria of SOP 97-2 have been met, with the exception of sales to our distributors who stock our SnapGear product line, for which we recognize revenue
upon shipment of product, net of estimated returns.

Selling and Marketing

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

Comprehensive Income

During the three months ended June 30, 2006, total comprehensive income amounted to $5.9 million compared to $4.9 million for the same period of
2005. During the six months ended June 30, 2006, total comprehensive income amounted to $6.4 million compared to $9.0 million for the six months ended June 30, 2005. The components of our comprehensive income are net income, foreign
currency translation adjustments, and unrealized gain or loss on investments. Results of operations were translated using average exchange rates throughout the period. Translation gains or losses are accumulated as a separate component of
stockholders equity and included in comprehensive income.

Share-Based Compensation

Prior to January 1, 2006, we accounted for share-based employee compensation plans under the measurement and recognition provisions of Accounting
Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, as permitted by Statement of Financial Accounting Standard (SFAS) No. 123, Accounting for Stock-Based
Compensation. Accordingly, we recorded no share-based employee compensation expense for options granted under our current stock option plans during the three months and six months ended June 30, 2005 as all options granted under those
plans had exercise prices equal to the fair market value of our common stock on the date of grant. We also recorded no compensation expense in those periods in connection with our Employee Stock Purchase Plan as the purchase price of the stock was
not less than 85% of the lower of the fair market value of our common stock at the beginning of each offering period or at the end of each purchase period. In accordance with SFAS No. 123 and SFAS No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure, we provided pro forma net income or loss and net income or loss per share disclosures for each period prior to the adoption of SFAS No. 123(R), Share-Based Payment, as if we had
applied the fair value-based method in measuring compensation expense for our share-based compensation plans.

Effective January 1,
2006, we adopted the fair value recognition provisions of SFAS No. 123(R), using the modified prospective transition method. Under that transition method, we recognized compensation expense for share-based payments that vested during the three
months and six months ended June 30, 2006 using the following valuation methods: (a) for share-based payments granted prior to, but not yet vested as of, January 1, 2006, the grant date fair value was estimated in accordance with the
original provisions of SFAS No. 123, and (b) for share-based payments granted on or after January 1, 2006, the grant date fair value was estimated in accordance with the provisions of SFAS No. 123(R). Because we elected to use
the modified prospective transition method, results for prior periods have not been restated. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment, which
provides supplemental implementation guidance for SFAS No. 123(R). We have applied the provisions of SAB No. 107 in our adoption of SFAS No. 123(R). See Note 11 for information on the impact of our adoption of SFAS No. 123(R) and
the assumptions we use to calculate the fair value of share-based employee compensation.

Recently Issued Accounting Standards

In July 2006, the FASB issued Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, an Interpretation of SFAS
No. 109, Accounting for Income Taxes. FIN 48 creates a single model to address uncertainty in tax positions and clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to
meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal
years beginning after December 15, 2006. We are currently assessing the impact of adoption of FIN 48.



7



---

##### Table of Contents

4. Acquisition of CyberGuard

On January 12, 2006, we acquired 100% of the outstanding common shares of CyberGuard Corporation. The results of CyberGuards operations have been included in the condensed consolidated financial statements
since that date. CyberGuard provided network security solutions designed to protect enterprises that use the Internet for electronic commerce and secure communication. CyberGuards products included firewall, VPN (Virtual Private Network),
secure content management and security management technologies. This acquisition strengthens our position as one of the market leaders in Unified Threat Management (UTM), for enterprise UTM appliances, and strengthens our position in the Secure
Content Management space. Additionally, we will have a larger presence in the Global 5000 enterprise markets as well as the U.S. Federal Government.

The aggregate purchase price was $310.7 million consisting primarily of 32.6 million shares of common stock valued at $188.5 million, $2.73 in cash issued for each outstanding share of CyberGuard common stock
valued at $88.9 million, 3.0 million options with a value of $29.3 million and direct costs of the acquisition of $4.0 million. 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. We financed $70.0 million of the CyberGuard acquisition through the issuance of equity securities. See Note 5 for details on the
equity financing.

The acquisition was accounted for under the purchase method of accounting, and accordingly, the assets and liabilities
acquired were recorded at their estimated fair values at the effective date of the acquisition and the results of operations have been included in the unaudited condensed consolidated statements of operations since the acquisition date. In
accordance with SFAS No. 142, Goodwill and Other Intangible Assets, goodwill and indefinite lived trademarks recorded as a result of the acquisition will be subject to an annual impairment test and will not be amortized. The
following table summarizes the estimated preliminary fair values of the assets acquired and liabilities assumed at the date of acquisition (in thousands):



|                                                                    |  |        |  |                    |         |  
|------------------------------------------------------------------- |  | ------ |  | ------------------ | ------- | -
|                                                                    |  |        |  | As of Jan. 12,2006 |        
|Cash paid net of cash acquired                                      |  |        |  | $                  | (69,096 | )
|Current assets                                                      |  |        |  |                    | 18,543  |  
|Property and equipment                                              |  |        |  |                    | 2,085   |  
|Other long-term and indefinite lived assets                         |  |        |  |                    | 10,570  |  
|Goodwill                                                            |  |        |  |                    | 283,611 |  
|Intangible assets subject to amortization:                          |  |        |  |                    |         |  
|Customer relationships (60 month useful life)                       |  | 28,610 |  |                    |         |  
|Tradenames (6 month useful life)                                    |  | 390    |  |                    |         |  
|Tradenames (12 month useful life)                                   |  | 290    |  |                    |         |  
|Acquired developed technology (12 month useful life)                |  | 2,080  |  |                    |         |  
|Acquired developed technology (36 month useful life)                |  | 1,160  |  |                    |         |  
|Acquired developed technology (48 month useful life)                |  | 6,930  |  |                    |         |  
|                                                                    |  |        |  |                    |         |  
|                                                                    |  |        |  |                    | 39,460  |  
|                                                                    |  |        |  |                    |         |  
|Total assets acquired                                               |  |        |  |                    | 285,173 |  
|Current liabilities                                                 |  |        |  |                    | 9,326   |  
|Acquisition reserve                                                 |  |        |  |                    | 10,338  |  
|Revenue deferred from ongoing contractual obligations at fair value |  |        |  |                    | 28,984  |  
|Deferred tax liability  long term                                  |  |        |  |                    | 18,723  |  
|                                                                    |  |        |  |                    |         |  
|Fair value of assets and liabilities assumed and accrued            |  |        |  | $                  | 217,802 |  
|                                                                    |  |        |  |                    |         |  

The following table presents our consolidated results of operations on an unaudited proforma basis
as if the acquisitions had taken place at the beginning of the periods presented:



|                                             |  |                             |        |                           |   |        |  |      |        |  |   |       
|-------------------------------------------- |  | --------------------------- | ------ | ------------------------- | - | ------ |  | ---- | ------ |  | - | ------
|                                             |  | Three Months Ended June 30, |        | Six Months Ended June 30,
|                                             |  | 2006                        |        | 2005                      |   | 2006   |  | 2005
|Total revenues                               |  | $                           | 38,746 |                           | $ | 43,323 |  | $    | 83,140 |  | $ | 85,606
|                                             |  |                             |        |                          
|Net income                                   |  | $                           | 6,659  |                           | $ | 2,705  |  | $    | 7,337  |  | $ | 4,235 
|                                             |  |                             |        |                          
|Net income applicable to common shareholders |  | $                           | 5,722  |                           | $ | 1,768  |  | $    | 5,484  |  | $ | 2,382 
|                                             |  |                             |        |                           |   |        |  |      |        |  |   |       
|Basic earnings per share                     |  | $                           | 0.11   |                           | $ | 0.03   |  | $    | 0.11   |  | $ | 0.05  
|                                             |  |                             |        |                           |   |        |  |      |        |  |   |       
|Diluted earnings per share                   |  | $                           | 0.11   |                           | $ | 0.03   |  | $    | 0.09   |  | $ | 0.04  
|                                             |  |                             |        |                           |   |        |  |      |        |  |   |       



8



---

##### Table of Contents

4. Acquisition of CyberGuard (continued)

The unaudited pro forma data gives effect to actual operating results prior to the acquisitions, and adjustments to reflect interest income foregone,
increased intangible amortization, and income taxes. No effect has been given to cost reductions or operating synergies in this presentation. As a result, the unaudited pro forma results of operations are for comparative purposes only and are not
necessarily indicative of the results that would have been obtained if the acquisition had occurred as of the beginning of the periods presented or that may occur in the future.

5. Equity Financing

On January 12, 2006, we received from Warburg Pincus Private Equity IX,
L.P., a global private equity fund, $70.0 million in gross proceeds from the issuance of 700,000 of perpetual convertible Series A preferred stock (the preferred stock), a warrant to acquire 1.0 million shares of our common stock that vested on
that date and an election of a member to our Board of Directors. Based on a quoted market price, as of January 12, 2006 and the fair value of the warrant as determined using the Black-Scholes model, we valued the preferred stock at $62.0
million and the warrant at $8.0 million. The proceeds from this transaction were used to finance most of the cash portion of the CyberGuard acquisition as noted in Note 4 above.

The preferred stock is convertible at $13.51 per share. Holders of our preferred stock will be entitled to receive benefits not available to holders of
our common stock. These benefits include, but are not limited to, the following: beginning in July 2010, shares of preferred stock will be entitled to receive semi-annual dividends, which may be paid in cash or added to the preferred stock
liquidation preference, equal to 5% of the preferred stock liquidation preference per year and each share of preferred stock has an initial liquidation preference of $100 which accretes daily at an annual rate of 5%, compounded semi-annually, until
July 2010.

The warrant is exercisable at a price of $14.74 per share and expires on January 12, 2013. When the market price of our
common stock is above their exercise price, the warrants become dilutive and are immediately included in the computation of diluted earnings per share using the treasury stock method.

The preferred stock was initially reflected on our financial statements at $62.0 million, which is a discount of $8.0 million from its initial
liquidation value of $70.0 million due to the fair value of warrants on the effective date. The liquidation value of the preferred stock accretes daily at an annual rate of 5%, compounded semi-annually. This accretion is recorded as a reduction of
earnings attributable to common shareholders ratably for a period of 54 months after date of issuance.

We incurred a beneficial conversion
charge of $12.6 million upon the issuance of the preferred stock since the effective conversion price, after adjusting for the value of the warrants, was less than market price on date of issuance, January 12, 2006. However, in August 2005 when
the terms of the preferred stock issuance to Warburg Pincus in the Securities Purchase Agreement were negotiated, the average market price of the common stock was, in fact, less than the conversion price.

6. 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) applicable to common shareholders 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 of stock options, warrants, and preferred stock as if-converted to common stock and the weighted average
number of common shares outstanding. Potential common shares of 6.3 million and 3.1 million in the three months ended June 30, 2006 and 2005, respectively and 4.2 million in the six months ended June 30, 2005, related to our
outstanding stock options, were excluded from the computation of diluted earnings per share as inclusion of these shares would have been anti-dilutive. All potential common share equivalents for the six months ended June 30, 2006 were excluded
from the computation of diluted earnings per share as inclusion of these shares would have been anti-dilutive.



9



---

##### Table of Contents

6. Net Income/(Loss) Per Share (continued)

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



|                                                                    |  |                             |        |                           |   |        |  |   |        |   |  |   |       
|------------------------------------------------------------------- |  | --------------------------- | ------ | ------------------------- | - | ------ |  | - | ------ | - |  | - | ------
|                                                                    |  | Three Months Ended June 30, |        | Six Months Ended June 30,
|                                                                    |  | 2006                        |        | 2005                      |   | 2006   |  |   | 2005  
|Net income/(loss) applicable to common shareholders                 |  | $                           | 5,722  |                           | $ | 4,946  |  | $ | (7,037 | ) |  | $ | 9,008 
|                                                                    |  |                             |        |                           |   |        |  |   |        |   |  |   |       
|Shares used in computing basic net income/(loss) per share          |  |                             | 54,108 |                           |   | 36,057 |  |   | 52,915 |   |  |   | 35,943
|Effect of outstanding dilutive stock options                        |  |                             | 1,575  |                           |   | 1,150  |  |   |       |   |  |   | 997   
|Effect of preferred stock as-if converted                           |  |                             | 5,311  |                           |   |       |  |   |       |   |  |   |      
|                                                                    |  |                             |        |                           |   |        |  |   |        |   |  |   |       
|Shares used in computing diluted net income/(loss) per share        |  |                             | 60,994 |                           |   | 37,207 |  |   | 52,915 |   |  |   | 36,940
|Basic net income/(loss) per share applicable to common shareholders |  | $                           | 0.11   |                           | $ | 0.14   |  | $ | (0.13  | ) |  | $ | 0.25  
|                                                                    |  |                             |        |                           |   |        |  |   |        |   |  |   |       
|Diluted net income/(loss) per share                                 |  | $                           | 0.11   |                           | $ | 0.13   |  | $ | (0.13  | ) |  | $ | 0.24  
|                                                                    |  |                             |        |                           |   |        |  |   |        |   |  |   |       

7. Contingencies

In December 2002, we were named as the defendant in a rental property lawsuit brought by Salvio Pacheco Square LLP in the Superior Court of California,
County of Contra Costa. The complaint alleges that we breached a commercial lease at our Concord, CA office and asked for declaratory relief, and compensatory and other damages. The Superior Court entered judgment in favor of
plaintiff in June 2004 in the amount of $1.1 million and found we had breached the lease. We appealed to the First Appellate District, California Court of Appeal. The Court of Appeal denied our appeal in April 2006. In addition to the
judgment entered by the Superior Court in June 2004, we incurred additional costs of $1.4 million as damages for the rental and other costs due on the balance of the lease, interest on the judgment and unpaid amounts due under the lease and
plaintiffs attorneys fees and costs. As a result of the April 2006 denial of our appeal, we accrued $2.5 million as of March 31, 2006 for the settlement of this litigation. The settlement of $2.5 million was subsequently paid in
July 2006.

8. Income Taxes

During the
three months ended June 30, 2006, we recorded an income tax benefit of $8.0 million. Of this $8.0 million income tax benefit, a non-cash benefit of $7.3 million is related to the reversal of the previously recorded tax valuation allowance on
our non-acquired net operating losses as we have determined it to be more likely than not that a portion of our existing deferred tax assets will be realized; the remainder of the income tax benefit is related to current income tax components such
as the utilization of net operating losses, alternative minimum income tax, and state and foreign income taxes. This is compared with $132,000 of income tax expense recorded in the three months ended June 30, 2005 which consisted of $51,000 for
alternative minimum tax expense and $81,000 for various foreign income tax expenses.

During the six months ended June 30, 2006, we
recorded an income tax benefit of $7.4 million. Of this $7.4 million income tax benefit, a non-cash benefit of $7.3 million is related to the reversal of the previously recorded tax valuation allowance on our non-acquired net operating losses as we
have determined it to be more likely than not that a portion of our existing deferred tax assets will be realized; the remainder of the income tax benefit is related to current income tax components such as the utilization of net operating losses,
alternative minimum income tax, and state and foreign income taxes. This is compared with $259,000 of income tax expense recorded in the six months ended June 30, 2005 which consisted of $121,000 for alternative minimum tax expense and $138,000
for various foreign income tax expenses.

Federal alternative minimum tax was provided on the portion of our alternative minimum taxable
income which could not be entirely offset by the alternative tax net operating loss deduction carryforward which we have available. For the three months ended June 30, 2006, $9.5 million of the reversal of the previously recorded tax valuation
allowance related to acquired net operating losses was recorded as a decrease to goodwill in the balance sheet and not as a benefit to tax expense in the income statement.

In accordance with FAS No. 109, we have determined that it is more likely than not that the net deferred tax assets of $16.8 million at
June 30, 2006 will be realized based on expected levels of future taxable income in the United States. Our expectations regarding future profitability may change due to future market conditions, changes in tax laws and other factors. Future
taxable income of $43.8 million is required to realize the $16.8 million net deferred tax asset at June 30, 2006. We have recorded $18.7 million of deferred tax liabilities related to purchased intangible assets recognized for financial
reporting purposes.



10



---

##### Table of Contents

9. Related Party Transaction

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% ownership stake in this company. This investment is reported in other
assets on our consolidated balance sheets and is evaluated for impairment annually.

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.

10. Segment Information

We view our operations and
manage our business as one segment called enterprise security solutions. Major foreign markets for our products and services include Europe, Japan, China, the Pacific Rim, and Latin America. In each market, we have independent channel partners who
are responsible for marketing, selling and supporting our products and services to resellers and end-users within their defined territories. International sales accounted for 44% and 32% of total revenue for the three months ended June 30, 2006
and 2005, respectively and 45% and 32% for the six months ended June 30, 2006 and 2005, respectively. The following table summarizes our domestic and international revenue (in thousands):



|              |  |                             |        |                           |   |        |  |      |        |  |   |       
|------------- |  | --------------------------- | ------ | ------------------------- | - | ------ |  | ---- | ------ |  | - | ------
|              |  | Three Months Ended June 30, |        | Six Months Ended June 30,
|              |  | 2006                        |        | 2005                      |   | 2006   |  | 2005
|Revenues:     |  |                             |        |                           |   |        |  |      |        |  |   |       
|Domestic      |  | $                           | 21,698 |                           | $ | 17,757 |  | $    | 44,711 |  | $ | 35,386
|International |  |                             | 17,048 |                           |   | 8,356  |  |      | 36,652 |  |   | 16,306
|              |  |                             |        |                           |   |        |  |      |        |  |   |       
|              |  | $                           | 38,746 |                           | $ | 26,113 |  | $    | 81,363 |  | $ | 51,692
|              |  |                             |        |                           |   |        |  |      |        |  |   |       

11. Share-Based Compensation

Description of Plans

2002 Stock Incentive Plan

Under our 2002 Stock Incentive Plan (2002 Plan), we are permitted to grant incentive and
non-qualified stock options, restricted stock awards, restricted stock units, stock appreciation rights and other similar types of stock awards, such as phantom stock rights, to our employees and non-employee directors. There were a total of
5.0 million shares authorized under the 2002 Plan at June 30, 2006. All options granted under the 2002 Plan through June 30, 2006 have exercise prices equal to the fair market value of our stock on the date of grant. Options granted
under the 2002 Plan have ten-year terms and typically vest 25% after the first year and then monthly over the following three years. Outstanding awards that were originally granted under several predecessor plans also remain in effect in accordance
with their terms. The 2002 Plan and its predecessor plans are described more fully in our fiscal 2005 Annual Report on Form 10-K.

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, 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 $10.06 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. The N2H2 Stock Option Plans are described more fully in our fiscal 2005 Annual Report on Form 10-K.

CyberGuard Stock Option Plans

In
connection with our acquisition of CyberGuard in January 2006, we assumed all of the outstanding CyberGuard stock options under the 1994 and 1998 Stock Option Plans which were converted into options to purchase approximately 3,039,545 shares of our
common stock. All outstanding stock options assumed were exercisable and vested. These options were assumed at prices between $1.56 and $15.07 per share, with a weighted average exercise price of $7.21 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.



11



---

##### Table of Contents

11. Share-Based Compensation (continued)

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. The Employee Stock Purchase Plan is described more fully in our fiscal 2005 Annual Report on Form 10-K.

Impact of the Adoption of SFAS No. 123(R)

See Note 3 for a description of our adoption
of SFAS No. 123(R), on January 1, 2006. A summary of the share-based compensation expense for stock options, restricted stock and our Employee Stock Purchase Plan that we recorded in accordance with SFAS No. 123(R) for the three
months and six months ended June 30, 2006 is as follows (in thousands):



|                                        |  |                                  |       |                                |   |      
|--------------------------------------- |  | -------------------------------- | ----- | ------------------------------ | - | -----
|                                        |  | Three Months Ended June 30, 2006 |       | Six Months Ended June 30, 2006
|Cost of product revenues                |  | $                                | 82    |                                | $ | 153  
|Cost of service revenues                |  |                                  | 144   |                                |   | 269  
|Selling and marketing                   |  |                                  | 801   |                                |   | 1,470
|Research and development                |  |                                  | 498   |                                |   | 919  
|General and administrative              |  |                                  | 484   |                                |   | 872  
|                                        |  |                                  |       |                                |   |      
|Reduction of income before income taxes |  | $                                | 2,009 |                                | $ | 3,683
|                                        |  |                                  |       |                                |   |      
|Reduction of diluted earnings per share |  | $                                | 0.03  |                                | $ | 0.07 

Prior to the adoption of SFAS No. 123(R), we presented all tax benefits for deductions
resulting from the exercise of stock options as operating cash flows on our statement of cash flows. SFAS No. 123(R) requires the cash flows resulting from the tax benefits for tax deductions in excess of the compensation expense recorded for
those options (excess tax benefits) to be classified as financing cash flows. There were no excess tax benefits for the six months ended June 30, 2006.

Determining Fair Value

Valuation and Amortization Method.We estimate the fair value of stock options granted using the Black-Scholes option valuation model. For options granted before January 1, 2006, we amortize the fair value on an accelerated
basis. For options granted on or after January 1, 2006, we amortize the fair value on a straight-line basis. All options are amortized over the requisite service periods of the awards, which are generally the vesting periods. For restricted
stock, the fair value is calculated as the market price on date of grant and we amortize the fair value on a straight-line basis over the requisite service period of the award, which is generally the vesting period.

Expected Term. The expected term of options granted represents the period of time that they are expected to be outstanding. In light of new accounting guidance
under SFAS No. 123(R) and SAB No. 107, we reevaluated our expected term assumption used in estimating the fair value of employee options. We estimate the expected term of options granted based on historical exercise patterns, which we
believe are representative of future behavior. Our estimate of the expected life of new options granted to our employees is 3 years, consistent with prior periods. We have examined our historical pattern of option exercises in an effort to determine
if there were any discernable patterns of activity based on certain demographic characteristics. Demographic characteristics tested included age, salary level, job level and geographic location. We have determined that there were no meaningful
differences in option exercise activity based on the demographic characteristics tested.

Expected Volatility. Also in light of implementing SFAS
No. 123(R), we reevaluated our expected volatility assumption used in estimating the fair value of employee options. We estimate the volatility of our common stock at the date of grant based on historical volatility, consistent with SFAS
No. 123(R) and SAB No. 107. Our decision to use historical volatility instead of implied volatility was based upon analyzing historical data along with the lack of availability of history of actively traded options on our common stock.

Risk-Free Interest Rate.We base the risk-free interest rate that we use in the Black-Scholes option valuation model on the implied yield in effect
at the time of option grant on U.S. Treasury zero-coupon issues with equivalent remaining terms.

Dividends.We have never paid cash dividends on
our common stock and we do not anticipate paying cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-Scholes option valuation model.



12



---

##### Table of Contents

11. Share-Based Compensation (continued)

Forfeitures.SFAS No. 123(R) requires us to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical
data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. For purposes of calculating pro forma information under SFAS No. 123 for periods prior to fiscal 2006,
we accounted for forfeitures as they occurred.

We used the following assumptions to estimate the fair value of options granted and shares
purchased under our ESPP for the three months and six months ended June 30, 2006 and 2005, respectively:



|                                  |  |                             |   |  |                           |   |  |      |   |  |      |  
|--------------------------------- |  | --------------------------- | - |  | ------------------------- | - |  | ---- | - |  | ---- | -
|                                  |  | Three Months Ended June 30, |   |  | Six Months Ended June 30, |  
|                                  |  | 2006                        |   |  | 2005                      |   |  | 2006 |   |  | 2005 |  
|Stock Options  Assumptions used: |  |                             |   |  |                           |   |  |      |   |  |      |  
|Average expected terms (years)    |  | 3.0                         |   |  | 3.0                       |   |  | 3.0  |   |  | 3.0  |  
|Weighted-average volatility       |  | 83                          | % |  | 49                        | % |  | 83   | % |  | 46   | %
|Risk-free interest rate           |  | 5.0                         | % |  | 3.7                       | % |  | 4.9  | % |  | 3.7  | %
|Dividend yield                    |  |                            |   |  |                          |   |  |     |   |  |     |  
|ESPP  Assumptions used:          |  |                             |   |  |                           |   |  |      |   |  |      |  
|Average expected terms (years)    |  | 0.25                        |   |  | 0.25                      |   |  | 0.25 |   |  | 0.25 |  
|Weighted-average volatility       |  | 37.3                        | % |  | 43.9                      | % |  | 40.4 | % |  | 59.2 | %
|Risk-free interest rate           |  | 4.6                         | % |  | 3.0                       | % |  | 4.4  | % |  | 2.8  | %
|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 or the
future stock price of our company.

Share-Based Compensation Expense and Stock Option Activity

We recorded $2.0 million in share-based compensation expense, which includes $1.7 million for stock options, $100,000 for our Employee Stock
Purchase Plan and $195,000 for restricted stock for the three months ended June 30, 2006. For the six months ended June 30, 2006, we recorded $3.7 million in share-based compensation expense, which includes $3.2 million for stock
options, $198,000 for our Employee Stock Purchase Plan and $245,000 for restricted stock. At June 30, 2006, we had 241,000 non-vested restricted stock awards that had a weighted average grant date fair value of $11.56. As of June 30, 2006,
there was $19.3 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under all equity compensation plans. Total unrecognized compensation cost will be adjusted for future changes in
estimated forfeitures. We expect to recognize that cost over a weighted average period of 3.0 years.

A summary of stock option
activity under all stock option plans during the six months ended June 30, 2006 is as follows:



|                                       |  |               |   |  |                                         |       |                                                     |     |                          |   |           
|-------------------------------------- |  | ------------- | - |  | --------------------------------------- | ----- | --------------------------------------------------- | --- | ------------------------ | - | ----------
|                                       |  | Stock Options |   |  | WeightedAverage ExercisePrice per Share |       | Weighted Average Remaining Contractual Life (Years) |     | AggregateIntrinsic Value
|Outstanding at December 31, 2005       |  | 8,549,315     |   |  | $                                       | 10.06 |                                                     | 6.5 |                          | $ | 18,793,738
|Granted                                |  | 2,071,475     |   |  |                                         | 10.38 |                                                     | 9.6 |                          |   |          
|Assumed upon acquisition of CyberGuard |  | 3,039,545     |   |  |                                         | 7.21  |                                                     | 3.5 |                          |   |          
|Exercised                              |  | (788,241      | ) |  |                                         | 6.82  |                                                     |    |                          |   |          
|Cancelled/forfeited/expired            |  | (299,291      | ) |  |                                         | 11.54 |                                                     |    |                          |   |          
|                                       |  |               |   |  |                                         |       |                                                     |     |                          |   |           
|Outstanding at June 30, 2006           |  | 12,572,803    |   |  |                                         | 9.64  |                                                     | 6.3 |                          |   | 11,891,963
|Exercisable at June 30, 2006           |  | 8,488,253     |   |  | $                                       | 9.48  |                                                     | 4.9 |                          | $ | 11,374,047

The weighted average fair value of options granted during the six months ended June 30, 2006
was $5.99.



13



---

##### Table of Contents

11. Share-Based Compensation (continued)

We define in-the-money options at June 30, 2006 as options that had exercise prices that were lower than the $8.60 market price of our common stock
at that date. The aggregate intrinsic value of options outstanding at June 30, 2006 is calculated as the difference between the exercise price of the underlying options and the market price of our common stock for the 3.7 million shares
that were in-the-money at that date. There were 3.0 million in-the-money options exercisable at June 30, 2006.

We received
$6.3 million in cash from option exercises under all share-based payment arrangements for the six months ended June 30, 2006.

Comparable Disclosure

Prior to January 1, 2006, we accounted for our share-based
compensation plans under the recognition and measurement provisions of APB Opinion No. 25 and related Interpretations. No share-based employee compensation cost is reflected in the condensed consolidated statements of operations for the three
months and six months ended June 30, 2005, 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
and net income per share if we had applied the fair value recognition provisions of SFAS No. 123 to share-based employee compensation prior to January 1, 2006:



|                                                                                                                                            |  |                                  |        |   |                                |   |        |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------- | ------ | - | ------------------------------ | - | ------ | -
|                                                                                                                                            |  | Three Months Ended June 30, 2005 |        |   | Six Months Ended June 30, 2005 |  
|Net income, as reported                                                                                                                     |  | $                                | 4,946  |   |                                | $ | 9,008  |  
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax
effects |  |                                  | (2,557 | ) |                                |   | (5,093 | )
|                                                                                                                                            |  |                                  |        |   |                                |   |        |  
|Pro forma net income                                                                                                                        |  | $                                | 2,389  |   |                                | $ | 3,915  |  
|                                                                                                                                            |  |                                  |        |   |                                |   |        |  
|Net income per share:                                                                                                                       |  |                                  |        |   |                                |   |        |  
|Basic  as reported                                                                                                                         |  | $                                | 0.14   |   |                                | $ | 0.25   |  
|                                                                                                                                            |  |                                  |        |   |                                |   |        |  
|Basic  pro forma                                                                                                                           |  | $                                | 0.07   |   |                                | $ | 0.11   |  
|                                                                                                                                            |  |                                  |        |   |                                |   |        |  
|Diluted  as reported                                                                                                                       |  | $                                | 0.13   |   |                                | $ | 0.24   |  
|                                                                                                                                            |  |                                  |        |   |                                |   |        |  
|Diluted  pro forma                                                                                                                         |  | $                                | 0.06   |   |                                | $ | 0.11   |  
|                                                                                                                                            |  |                                  |        |   |                                |   |        |  

12. Subsequent Event  Announcement of the Acquisition of CipherTrust

On July 11, 2006, we announced that we had signed a definitive merger agreement to acquire all of the outstanding stock of CipherTrust, Inc.
(CipherTrust). Under the definitive agreement, total consideration of $273.6 million is comprised of $185.0 million in cash and 10.0 million shares of Secure common stock, plus a potential earn out payment of up to $10.0 million
payable in cash and in the form of a promissory note. Up to $135.0 million of the cash portion of the consideration is expected to be financed pursuant to a financing commitment letter from Citigroup Global Markets, Inc. and UBS Loan Finance, LLC
and UBS Securities LLC which was obtained on July 11, 2006. The facilities included in the financing commitment letter include senior secured first priority credit facilities consisting of (a)(i) a senior secured first priority term loan
facility of up to $90.0 million and (ii) a senior secured first priority revolving credit facility of up to $20.0 million and (b) a senior secured second priority term loan facility of up to $25.0 million. We intend to utilize the funds
available through such credit facilities to help finance a portion of the purchase price of the acquisition and related fees and expenses of the acquisition, as well as for general working capital and ongoing corporate purposes. The transaction is
expected to close by early September 2006, subject to customary closing conditions.

CipherTrust, a privately-held company, provides
innovative layered security solutions to stop inbound messaging threats such as spam, viruses, intrusions and phishing, and protects against outbound policy and compliance violations associated with sensitive data leakage.



14



---

##### Table of Contents

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

INFORMATION
REGARDING FORWARD-LOOKING STATEMENTS

The following discussion contains certain 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 the forward-looking statements below and in the other
documents that we file with the Securities Exchange Commission, such as our Annual Report of Form 10-K for the year ended December 31, 2005. 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. As the overall malicious threat environment continues to evolve, companies are investing valuable budget dollars in robust security
products. We are well positioned to provide customers with technologically advanced products to protect their networks from both known and unknown attacks. For the second consecutive year, all three of our product lines were nominated as finalists
by SC Magazines Reader Trust Awards. These nominations are based on responses from customers and thousands of IT professionals, and are indicative of our reputation for offering proven, world-class IT security solutions.

We operate our business within one operating segment called enterprise security solutions. The three product lines that represent the majority of our
revenue are our Firewall/Unified Threat Management (UTM) security appliances, our Secure Content (SCM) products, and our SafeWord®authentication products. For the three months ended June 30, 2006 UTM appliance revenue was 52% of total revenue, SCM revenue was 33% of total revenue, and authentication revenue was 15% of total
revenue. For the six months ended June 30, 2006, UTM appliance revenue was 53% of total revenue, SCM revenue was 30% of total revenue, and authentication revenue was 17% of total revenue. On a combined basis total revenue increased 48% and 57%
for the three and six months ended June 30, 2006 compared to the same periods in the prior year, driven by growth across all product lines.

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.

International sales accounted for 44% and 45% of total revenue during the three months and six months ended June 30, 2006, respectively. Major
foreign markets for our products include Europe, Japan, China, the Pacific Rim and Latin America. In each market, 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.

On January 12, 2006, we received from Warburg Pincus Private Equity IX, L.P., a global private equity fund, $70.0 million in proceeds from the issuance of 700,000 of convertible Series A preferred stock (the preferred stock), a warrant
to acquire 1.0 million shares of our common stock that vested on that date and an election of a member to our Board of Directors. Based on a quoted market price as of January 12, 2006 and the fair value of the warrant was determined using
the Black-Scholes model, we valued the preferred stock at $62.0 million and the warrant at $8.0 million. The proceeds from this transaction were used to finance most of the cash portion of the CyberGuard acquisition as noted in Note 4 above. The
preferred stock is convertible into shares of our common stock at an initial conversion price of $13.51. The warrant is exercisable at a price of $14.74 per share.



15



---

##### Table of Contents

In July 2006, we announced that we had signed a definitive merger agreement to acquire all of the
outstanding stock of CipherTrust, Inc. CipherTrust, a privately-held company, provides innovative layered security solutions to stop inbound messaging threats such as spam, viruses, intrusions and phishing, and protects against outbound policy and
compliance violations associated with sensitive data leakage. As a result of the acquisition, we are expected to be the leader in the enterprise gateway appliance market. The transaction is expected to close in early September 2006, subject to
customary closing conditions.

As of June 30, 2006, we had $102.6 million in cash, cash equivalents, and short-term investment and
generated $19.6 million in cash from operations during the six months ended June 30, 2006.

RESULTS OF OPERATIONS

Comparison of Three Months Ended June 30, 2006 and 2005.

Revenues. Our total revenues increased 48% to $38.7 million for the second quarter of 2006 up from $26.1 million in the same period of 2005. Our products revenues increased 31% to $24.5 million for the second quarter of 2006 up from
$18.8 million in the same period of 2005. Our services revenues increased 93% to $14.2 million for the second quarter of 2006 up from $7.3 million in the same period of 2005. The revenue growth was driven by a 63% increase in the UTM appliance
revenue, and a 40% increase in the SCM revenue, both of which were impacted by the CyberGuard acquisition. In addition, authentication revenue increased 20% compared to the prior year.

Gross Profit.Gross profit as a percentage of revenue was 74% in the second quarter of 2006 compared to 83% in the second quarter of 2005. This
decrease was driven primarily by the change in the overall mix of product sales as a result of the CyberGuard acquisition. In the second quarter of 2006 a significantly larger percentage of our sales contained a hardware cost component and therefore
yielded lower margins as compared to the same period in 2005 due to the incremental appliance revenues resulting from the CyberGuard acquisition. Gross profit for the second quarter of 2006 and 2005 included $226,000 and $0, respectively, of pre-tax
share-based compensation expense that we recorded as a result of our adoption of SFAS No. 123(R) on January 1, 2006. In addition, gross profit for the second quarter of 2006 and 2005 included the amortization of purchased intangibles of
$1.3 million and $0, respectively.

Operating Expenses. Operating expenses consist of selling and marketing, research and
development, general and administrative expenses, amortization of purchased intangible assets, and non-recurring litigation settlement costs. Total operating expenses increased 87% to $31.5 million for the second quarter of 2006 up from $16.8
million in the same period of 2005. This increase was driven primarily by increased headcount and related costs as a result of the CyberGuard acquisition. The 2006 second quarter operating expenses include the following: $3.0 million of intangible
amortization expense and $1.8 million of stock-based compensation expense. To a lesser extent, operating expenses increased as a result of inflationary increases in payroll and related costs, and increases in allocated corporate costs. As a
percentage of revenue, total operating expenses were 81% for the quarter compared to 64% in the same period of 2005.

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. Our customer support function, which provides support, training and installation services, is also responsible for
supporting our sales representatives and sales engineers throughout the sales cycle by providing them and our prospective customers with technical assistance. Selling and marketing expenses increased 65% to $17.8 million in the second quarter of
2006 up from $10.8 million in the same period of 2005. This increase was driven primarily by increased headcount and related costs as a result of the CyberGuard acquisition and to a lesser extent inflationary increases in payroll and related costs,
share-based compensation costs, and inflationary increases in allocated corporate costs. As a percentage of revenue, selling and marketing expense was 46% for the quarter compared to 41% in the same period of 2005.

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 95% to $7.8 million in the second quarter of 2006 up from $4.0 million in the same period of
2005. This increase was driven primarily by increased headcount and related costs as a result of the CyberGuard acquisition and to a lesser extent inflationary increases in payroll and related costs, share-based compensation costs, and inflationary
increases in allocated corporate costs. As a percentage of revenue, research and development expenses were 20% for the quarter compared to 15% in the same period of 2005.



16



---

##### Table of Contents

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 56% to $2.9 million in the second quarter of 2006 up from $1.9 million in the same period of 2005. This increase was driven primarily by increased headcount and related costs as a result of the CyberGuard
acquisition and to a lesser extent inflationary increases in payroll and related costs, share-based compensation costs, and inflationary increases in allocated corporate costs. As a percentage of revenue, general and administrative expenses were 7%
for the quarter consistent with the same period of 2005.

Amortization of Purchased Intangible Assets. Amortization of purchased
intangible assets consists of the amortization of the intangible assets related to the CyberGuard acquisition, described in Note 4 and to a lesser extent the N2H2 acquisition in 2003. Amortization of purchased intangible assets is $3.0 million for
the second quarter of 2006 compared to $130,000 in the same period of 2005.

Other Income.Other income was $1.4 million in the
second quarter of 2006, an increase from $332,000 in the same period of 2005. The increase is primarily a result of higher interest rates on higher average cash and short-term investment balances.

Income Taxes.During the three months ended June 30, 2006, we recorded an income tax benefit of $8.0 million. Of this $8.0 million income tax
benefit, a non-cash benefit of $7.3 million is related to the reversal of the previously recorded tax valuation allowance on our non-acquired net operating losses as we have determined it to be more likely than not that a portion of our existing
deferred tax assets will be realized; the remainder of the income tax benefit is related to current income tax components such as the utilization of net operating losses, alternative minimum income tax, state and foreign income taxes. This is
compared with $132,000 of income tax expense recorded in the three months ended June 30, 2005 which consisted of $51,000 for alternative minimum tax expense and $81,000 for various foreign income tax expenses. Federal alternative minimum
tax was provided on the portion of our alternative minimum taxable income which could not be entirely offset by the alternative tax net operating loss deduction carryforward which we have available. For the three months ended June 30, 2006,
$9.5 million of the reversal of the previously recorded tax valuation allowance related to acquired net operating losses was recorded as a decrease to goodwill in the balance sheet and not as a benefit to tax expense in the income statement.

In accordance with FAS No. 109, we have determined that it is more likely than not that the net deferred tax assets of $16.8 million
at June 30, 2006 will be realized based on expected levels of future taxable income in the United States. Our expectations regarding future profitability may change due to future market conditions, changes in tax laws and other factors. Future
taxable income of $43.8 million is required to realize the $16.8 million net deferred tax asset at June 30, 2006. We have recorded $18.7 million of deferred tax liabilities related to purchased intangible assets recognized for financial
reporting purposes.

Comparison of Six Months Ended June 30, 2006 and 2005.

Revenues. Our total revenues increased 57% to $81.4 million for the first six months of 2006 up from $51.7 million in the same period of 2005. Our
products revenues increased 43% to $53.7 million for first six months of 2006 up from $37.6 million in the same period of 2005. Our services revenues increased 96% to $27.7 million for the first six months of 2006 up from $14.1 million in the same
period of 2005. The revenue growth was driven by a 72% increase in the UTM appliance revenue, and a 52% increase in the SCM revenue, both of which were impacted by the CyberGuard acquisition. In addition, authentication revenue increased 28%
compared to the prior year.

Gross Profit.Gross profit as a percentage of revenue was 73% in the first six months of 2006 compared
to 82% in the same period of 2005. This decrease was driven primarily by the change in the overall mix of product sales as a result of the CyberGuard acquisition. In the first six months of 2006 a significantly larger percentage of our sales
contained a hardware cost component as compared to the same period in 2005 due to the incremental appliance revenues resulting from the CyberGuard acquisition. Gross profit for the first six months of 2006 included $422,000 of pre-tax share-based
compensation expense that we recorded as a result of our adoption of SFAS No. 123(R) on January 1, 2006. In addition, gross profit for the first six months of 2006 and 2005 included the amortization of purchased intangibles of $2.0 million
and $0, respectively.

Operating Expenses. Operating expenses consist of selling and marketing, research and development, general
and administrative expenses, amortization of purchased intangible assets, and non-recurring litigation settlement costs. Total operating expenses increased 85% to $61.4 million for the first six months of 2006 up from $33.3 million in the same
period of 2005. This increase was driven primarily by increased headcount and related costs as a result of the CyberGuard acquisition. In addition, the operating expenses in the first six months of 2006 include the following: $4.7 million of
intangible amortization expense, $3.3 million of stock-based compensation expense, $2.5 million of litigation settlement



17



---

##### Table of Contents

expense, $700,000 of duplicate costs related to the integration of the CyberGuard operations, and $300,000 of costs
related to moving into new office space in Minnesota. To a lesser extent, operating expenses increased as a result of inflationary increases in payroll and related costs, and increases in allocated corporate costs. As a percentage of revenue, total
operating expenses were 76% for the first six months of 2006 compared to 64% in the same period of 2005. This increase was driven by the inclusion of share-based compensation which was not present in the prior period and the increase in amortization
of intangibles as a result of the CyberGuard acquisition.

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. Our customer support function, which provides support, training and installation services, is also responsible for supporting our sales representatives and sales engineers
throughout the sales cycle by providing them and our prospective customers with technical assistance. Selling and marketing expenses increased 60% to $33.6 million in the first six of 2006 up from $21.0 million in the same period of 2005. This
increase was driven primarily by increased headcount and related costs as a result of the CyberGuard acquisition and to a lesser extent inflationary increases in payroll and related costs, share-based compensation costs, and inflationary increases
in allocated corporate costs. As a percentage of revenue, selling and marketing expense was 41% for the first six months of 2006 consistent with the same period of 2005.

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 78% to $14.7 million in the first six months of 2006 up from $8.3 million in the same period of 2005. This increase was driven primarily by increased
headcount and related costs as a result of the CyberGuard acquisition and to a lesser extent inflationary increases in payroll and related costs, share-based compensation costs, and inflationary increases in allocated corporate costs. As a
percentage of revenue, research and development expenses were 18% for the first six months of 2006 compared to 16% in the same period of 2005.

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 56% to $5.9 million in the first six months of 2006 up from $3.8 million in the same period of 2005. This
increase was driven primarily by increased headcount and related costs as a result of the CyberGuard acquisition and to a lesser extent inflationary increases in payroll and related costs, share-based compensation costs, and inflationary increases
in allocated corporate costs. As a percentage of revenue, general and administrative expenses were 7% for the first six months of 2006 consistent with the same period of 2005.

Amortization of Purchased Intangible Assets. Amortization of purchased intangible assets consists of the amortization of the intangible assets
related to the CyberGuard acquisition, described in Note 4 and to a lesser extent the N2H2 acquisition in 2003. Amortization of purchased intangible assets is $4.7 million for the first six months of 2006 compared to $266,000 in the same period of
2005.

Litigation Settlement. Litigation settlement expense of $2.5 million in the first six months of 2006 pertains to a charge
related to litigation brought by the landlord of our former Concord, CA office. This expense represents a judgment in favor of the plaintiff for $1.1 million and additional costs of $1.4 million we incurred related to damages.

Other Income.Other income was $1.9 million in the first six months of 2006, an increase from $400,000 in the same period of 2005. The increase is
a result of higher interest rates on higher average cash and short-term investment balances and a state sales tax liability charge in the prior year.

Income Taxes. During the six months ended June 30, 2006, we recorded an income tax benefit of $7.4 million. Of this $7.4 million income tax benefit, a non-cash benefit of $7.3 million is related to the
reversal of the previously recorded tax valuation allowance on our non-acquired net operating losses as we have determined it to be more likely than not that a portion of our existing deferred tax assets will be realized; the remainder of the income
tax benefit is related to current income tax components such as the utilization of net operating losses, alternative minimum income tax, state and foreign income taxes. This is compared with $259,000 of income tax expense recorded in the six months
ended June 30, 2005 which consisted of $121,000 for alternative minimum tax expense and $138,000 for various foreign income tax expenses. Federal alternative minimum tax was provided on the portion of our alternative minimum taxable income
which could not be entirely offset by the alternative tax net operating loss deduction carryforward which we have available. For the six months ended June 30, 2006, $9.5 million of the reversal of the previously recorded tax valuation allowance
related to acquired net operating losses was recorded as a decrease to goodwill in the balance sheet and not as a benefit to tax expense in the income statement.



18



---

##### Table of Contents

In accordance with FAS No. 109, we have determined that it is more likely than not that the net
deferred tax assets of $16.8 million at June 30, 2006 will be realized based on expected levels of future taxable income in the United States. Our expectations regarding future profitability may change due to future market conditions, changes
in tax laws and other factors. Future taxable income of $43.8 million is required to realize the $16.8 million net deferred tax asset at June 30, 2006. We have recorded $18.7 million of deferred tax liabilities related to purchased intangible
assets recognized for financial reporting purposes.

Worldwide net operating loss carryforwards totaled approximately $357.8 million at
June 30, 2006, comprised of $334.0 million domestic net operating loss carryforwards and $23.8 million of international net operating loss carryforwards. Of these carryforwards, $54.9 million relates to stock option exercises, $106.7 million
relates to acquired CyberGuard net operating losses, and $58.4 million relates to acquired N2H2 net operating losses, which currently have a partial valuation allowance, and when realized for financial statement purposes will not result in a
reduction in income tax expense. The benefit from the stock option exercises will be recorded as an increase to additional paid-in capital and the benefit from the CyberGuard and N2H2 net operating loss carryforwards will be recorded as a decrease
to goodwill. Of the remaining benefit associated with the carryforwards, approximately $94.0 million has yet to be recognized as a benefit in the consolidated statement of operations. However, there are no assurances that the tax benefit of these
carryforwards will be available to offset future income tax expense when taxable income is realized.

Estimates were used in the
determination of our provision for income taxes, current income taxes payable, as well as in our deferred tax asset and liability analysis. These estimates take into account current tax laws and our interpretation of these current tax laws within
the various taxing jurisdictions within which we operate. Changes in the tax laws or our interpretation of tax laws and the resolution of future audits could impact our provision for income taxes.

LIQUIDITY AND CAPITAL RESOURCES

Our cash, cash
equivalents and short term investments increased by $21.4 million from $81.2 million at December 31, 2005 to $102.6 million at June 30, 2006. The increase is primarily due to $19.6 million provided by operating activities and $6.3 million
from the exercise of stock options and sale of common stock through our employee stock purchase plan, offset by $6.4 million for capital additions.

Net cash provided by operating activities of $19.6 million for the six months ended June 30, 2006 was comprised of $7.3 million in net income, $4.9 million in net non-cash related expenses, $13.2 million decrease in accounts receivable
offset by a $6.9 million decrease in accrued liabilities and reserves. Terms for cash collections received from customers and cash payments made to vendors were consistent with normal business practices.

Net cash used for investing activities of $73.8 million during the six months ended June 30, 2006 consisted of a $69.1 million cash outlay for the
acquisition of CyberGuard, and $6.4 million for capital additions, which were primarily for furnishing our new St. Paul, MN facility, computer equipment and technology upgrades. We expect to use another $3.4 million during the remainder of 2006
mainly for computer equipment, technology upgrades and leasehold improvements.

Net cash provided by financing activities of $76.3 million
for the six months ended June 30, 2006 consisted primarily of proceeds received from the issuance of preferred stock, net of transaction fees, of $69.9 million, which was used to finance the CyberGuard acquisition and $6.3 million related to
the exercise of stock options and sale of common stock through our employee stock purchase plan.

As of June 30, 2006, we had working
capital of $77.8 million. We anticipate using available cash to fund growth in operations, invest in capital equipment and leasehold improvements, acquire businesses, and to license technology or products related to our line of business. In the
coming months we intend to utilize $70.0 million of our current available cash for the CipherTrust acquisition (see Note 12), which is expected to close by early September 2006, subject to customary closing conditions.

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. In addition to the cash and investments on hand we will have a $20.0 million revolving credit facility available pursuant to a financing commitment letter from Citigroup Global Markets, Inc. and UBS Loan Finance, LLC and UBS
Securities LLC which was obtained in July 2006. We intend to utilize the funds available through the credit facility for general working capital and ongoing corporate purposes as deemed necessary.



19



---

##### Table of Contents

CRITICAL ACCOUNTING POLICY

Share-based Compensation.Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R), Share-Based Payment, using the modified prospective transition
method and as such, prior results have not been restated. We estimate the fair value of options granted using the Black-Scholes option valuation model and the assumptions shown in Note 11 to the financial statements. We estimate the expected term of
options granted based on historical exercise patterns, which we believe are representative of future behavior. We estimate the volatility of our common stock at the date of grant based on historical volatility. Our decision to use historical
volatility instead of implied volatility was based upon analyzing historical data along with the lack of availability of history of actively traded options on our common stock. We base the risk-free interest rate that we use in the Black-Scholes
option valuation model on the implied yield in effect at the time of option grant on U.S. Treasury zero-coupon issues with equivalent remaining terms. We have never paid any cash dividends on our common stock and we do not anticipate paying any cash
dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-Scholes option valuation model. SFAS No. 123(R) requires us to estimate forfeitures at the time of grant and revise those estimates in
subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. For purposes of
calculating pro forma information under SFAS No. 123 for periods prior to fiscal 2006, we accounted for forfeitures as they occurred. For options granted before January 1, 2006, we estimated the fair value of options granted using the
Black-Scholes option valuation model and amortize the fair value on an accelerated basis. For options granted on or after January 1, 2006, we amortize the fair value on a straight-line basis. All options are amortized over the requisite service
periods of the awards, which are generally the vesting periods. We may elect to use different assumptions under the Black-Scholes option valuation model in the future, which could materially affect our net income or loss and net income or loss per
share. Operating results for the three months and six months ended June 30, 2006 include $2.0 and $3.7 million of share-based compensation expense, respectively. As of June 30, 2006, there was $19.3 million of total unrecognized
compensation cost related to non-vested share-based compensation arrangements granted under all equity compensation plans. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures. We expect to recognize that
cost over a weighted average period of 3.0 years.

FORWARD-LOOKING STATEMENTS

Certain statements made above, which are summarized below, are forward-looking statements that involve risks and uncertainties, and actual results may be
materially different. Factors that could cause actual results to differ include those identified below:

We have determined that it is
more likely than not that the net deferred tax assets of $16.8 million at June 30, 2006 will be realized based on expected levels of future taxable income in the United States.The amount of deferred tax assets considered realizable could
be reduced in the near term if estimates of future taxable income are reduced.

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. Several factors may affect the availability of sufficient cash resources to fund our product development and marketing and
sales plans for the next twelve months, including:



| |  |  | our ability to generate revenue as currently expected;
| | - |  | ------------------------------------------------------



| |  |  | unexpected expenses, such as increases in personnel and operating expenses;
| | - |  | ---------------------------------------------------------------------------



| |  |  | and the need for additional funds to react to changes in the marketplace.
| | - |  | -------------------------------------------------------------------------

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Previously, we developed products only
in the United States and billed worldwide customers only in U.S. dollars. However, with the acquisition of CyberGuard Corp. in January 2006, products are also developed in Germany and Australia and a portion of our sales in the first six months of
2006 were billed in foreign currencies. 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. For our sales 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. For our sales priced in a foreign currency, we face additional exposure to adverse movements in foreign
currency exchange rates. This exposure will decrease once we complete the integration of business operations and bill customers only in U.S. dollars.

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.



20



---

##### Table of Contents

We also hold an equity interest in a privately held technology company. This investment was recorded at
cost and is reported in other assets on our consolidated balance sheets. As of June 30, 2006 this investment had a carrying value of $2.7 million.

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 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Management of our company is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-15(e)
and 15d-15(e) of the Securities Exchange Act of 1934. As of June 30, 2006 an evaluation was performed, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of our disclosure controls and procedures. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of June 30, 2006, our disclosure controls and procedures
were effective at the reasonable assurance level to ensure that information required to be disclosed in the Quarterly Report on Form 10-Q was recorded, processed, summarized and reported within the time period required by the Securities and
Exchange Commissions rules and forms and accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.

Changes in Internal Control Over Financial Reporting

During the quarter ended June 30, 2006, there have been no changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control
over financial reporting, except that relating to the acquisition of CyberGuard Corporation as of June 30, 2006. See Note 4 to the condensed consolidated financial statements included in Item 1 for discussion of the acquisition and related
financial data. We are in the process of integrating the CyberGuard operations and will be incorporating these operations as part of our internal controls. However, for purposes of this evaluation, the impact of this acquisition on our internal
controls over financial reporting have been excluded.



21



---

##### Table of Contents

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

In December 2002, we were named as the defendant in a rental property lawsuit
brought by Salvio Pacheco Square LLP in the Superior Court of California, County of Contra Costa. The complaint alleges that we breached a commercial lease at our Concord, CA office and asked for declaratory relief, and compensatory and
other damages. The Superior Court entered judgment in favor of plaintiff in June 2004 in the amount of $1.1 million and found we had breached the lease. We appealed to the First Appellate District, California Court of Appeal. The Court of
Appeal denied our appeal in April 2006. In July 2006 we paid $2.5 million for settlement of this lawsuit.

On June 5, 2006,
Finjan Software, Ltd. filed a complaint entitled Finjan Software, Ltd. v. Secure Computing Corporation in the United States District Court for the District of Delaware against Secure Computing Corporation, CyberGuard Corporation, and Webwasher AG.
The complaint alleges that Secure Computing and its named subsidiaries infringe U.S. Patent No. 6,092,194 (194 Patent) based on the manufacture, use, and sale of the Webwasher Secure Content Management suite. Secure Computing
denies infringing any valid claims of the 194 Patent. The answer to the complaint was filed on July 26, 2006.

Item 2. Changes in Securities

None.

Item 3. Defaults upon Senior Securities

Not applicable

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

The following matters were voted on at our
Annual Meeting of Stockholders held on May 17, 2006:

a) The following directors were elected:



|                      |  |                               |  |          
|--------------------- |  | ----------------------------- |  | ---------
|                      |  | Number of Common Shares Voted
|Directors             |  | For                           |  | Withheld 
|Robert J. Frankenberg |  | 46,791,262                    |  | 3,959,811
|John McNulty          |  | 47,933,601                    |  | 2,817,472
|James Jordan          |  | 46,960,575                    |  | 3,790,498

These directors were elected to a three year term commencing upon their election. Directors: Eric
Rundquist, Alexander Zakupowsky, Richard Scott, Cary Davis, and Steven Purcelli continue in office until expiration of their respective roles.

b) The
following amendment to the 2002 Incentive Plan was approved:



|                                                                                                                    |  |                               |  |            |  |        
|------------------------------------------------------------------------------------------------------------------- |  | ----------------------------- |  | ---------- |  | -------
|                                                                                                                    |  | Number of Common Shares Voted
|2002 Stock Incentive Plan                                                                                           |  | For                           |  | Against    |  | Abstain
|Amendment to the 2002 Stock Incentive Plan to increase the the number of shares available for issuance by 1,500,000 |  | 26,636,934                    |  | 11,682,295 |  | 189,843

c) The following proposal was approved:



|                                                                                                  |  |                               |  |         |  |        
|------------------------------------------------------------------------------------------------- |  | ----------------------------- |  | ------- |  | -------
|                                                                                                  |  | Number of Common Shares Voted
|Independent Auditors                                                                              |  | For                           |  | Against |  | Abstain
|Ratification of Ernst & Young LLP as independent accountants for the year ended December 31, 2006 |  | 49,950,686                    |  | 604,976 |  | 195,410



22



---

##### Table of Contents

Item 5. Other Information

None

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits



|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|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) filed with the SEC on August 8, 2003.                                                                                                                                                                                                                           
|        | 
|2.2     |  | Agreement and Plan of Merger, dated as of August 17, 2005, by and among Secure Computing Corporation, Bailey Acquisition Corp., and CyberGuard Corporation is incorporated by reference to
Exhibit 2.1 to our Current Report on Form 8-K filed with the SEC on August 19, 2005.                                                                                                                                                                                                                                                           
|        | 
|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).                                                                                                                                                                                                                                                                                                                                                                                          
|        | 
|3.3     |  | Certificate of Designations, Preferences and Rights of Series A Convertible Preferred Stock is incorporated by reference to Exhibit 3.1 to our Current Report on Form 8-K filed with the SEC on
August 19, 2005.                                                                                                                                                                                                                                                                                                                          
|        | 
|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.                                                                                                                                                                                                                                                                                                                                                                                 
|        | 
|4.3     |  | 2002 Stock Option Plan is incorporated by reference to Exhibit 99.1 to our Registration Statement on Form S-8 (Registration Number 333-115583) filed with the SEC on January 19,
2006.                                                                                                                                                                                                                                                                                                                                                    
|        | 
|4.4     |  | CyberGuard Corporation Stock Incentive Plan is incorporated by reference to Exhibit 4.1 to CyberGuard Corporations Registration Statement on Form S-8 (Registration Number 33-88448) filed
with the SEC on January 13, 1995.                                                                                                                                                                                                                                                                                                             
|        | 
|4.5     |  | CyberGuard Corporation Third Amended and Restated Employee Stock Option Plan is incorporated by reference to CyberGuard Corporations Proxy Statement filed on December 13,
2003.                                                                                                                                                                                                                                                                                                                                                         
|        | 
|4.6     |  | Warrant by and among Secure Computing Corporation and Warburg Pincus IX, L.P. is incorporated by reference to Exhibit 4.1 to our Current Report on Form 8-K filed with the SEC on August 19,
2005.                                                                                                                                                                                                                                                                                                                                        
|        | 
|10.1    |  | Employment Agreement with John McNulty is incorporated by reference to the corresponding exhibit of our Quarterly Report of Form 10-Q 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-Q 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-Q for the period ended June 30, 2001.                                                                                                                                                                                                                                                                                                                                                                             
|        | 
|10.4    |  | Employment Agreement with Michael Gallagher is incorporated by reference to the corresponding exhibit of our Annual Report of Form 10-K for the period ended December 31,
2004.                                                                                                                                                                                                                                                                                                                                                           
|        | 
|10.5    |  | Employment Agreement with Mary Budge is incorporated by reference to the corresponding exhibit of our Annual Report of Form 10-K for the period ended December 31, 2004.                                                                                                                                                                                                                                                                                                                                                                  



23



---

##### Table of Contents

|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  | Description                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|10.6    |  | Securities Purchase Agreement, dated as of August 17, 2005, by and among Secure Computing Corporation and Warburg Pincus IX, L.P. is incorporated by reference to Exhibit 10.1 to our Current
Report on Form 8-K filed with the SEC on August 19, 2005.                                                                                                                                                                                                                                                                 
|        | 
|10.7    |  | Amendment No. 1 to the Securities Purchase Agreement by and among Secure Computing Corporation and Warburg Pincus IX, L.P. dated December 9, 2005 is incorporated by reference to Exhibit
99.1 to our Current Report on Form 8-K filed with the SEC on December 13, 2005.                                                                                                                                                                                                                                               
|        | 
|10.8    |  | Form of Indemnification Agreement between the Company, and Cary Davis dated January 31, 2006; Robert J. Frankenberg dated January 31, 2006; James Jordan dated February 1, 2006;
John McNulty dated February 1, 2006; Stephen Puricelli dated January 31, 2006; Eric Rundquist dated January 31, 2006; Richard Scott dated January 31, 2006; and Alexander Zakupowsky, Jr. dated February 1, 2006 is incorporated
by reference to Exhibit 10.6 to our Current Report on Form 8-K filed with the SEC on January 31, 2006.
|        | 
|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.                                                                                                                                                                                                                                                                                                                                                                                               

(b) Reports on Form 8-K:

None



24



---

##### Table of Contents

SECURE COMPUTING CORPORATION

SIGNATURES

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



|                             |  |     |  |                                                                
|---------------------------- |  | --- |  | ---------------------------------------------------------------
|SECURE COMPUTING CORPORATION |  |     |  |                                                                
|                             |  |    
|DATE: August 7, 2006         |  | By: |  | /s/ Timothy J. Steinkopf                                       
|                             |  |     |  | Timothy J. Steinkopf                                           
|                             |  |     |  | Senior Vice President of Operations and Chief Financial Officer
|                             |  |     |  | (Duly authorized officer and Principal Financial Officer)      



25