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 March 31, 2004



or



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

For the Transition Period From
 to
.



Commission file number 0-27074



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)



(800) 379-4944

---

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 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 an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No ̈



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  35,579,957 issued and outstanding as of April 27, 2004.



1



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SECURE COMPUTING CORPORATION



INDEX



|         |  |                                                                                                                |  |         
|-------- |  | -------------------------------------------------------------------------------------------------------------- |  | --------
|PART I.  |  | FINANCIAL INFORMATION                                                                                          |  | Page No.
|Item 1.  |  | Condensed Consolidated Financial Statements:                                                                   |  |         
|         |  |                                                                                                                |  |         
|         |  | Condensed Consolidated Statements of Operations (Unaudited) for the three months ended March 31, 2004 and
2003 |  | 4       
|         |  | Condensed Consolidated Statements of Cash Flows (Unaudited) for the three months ended March 31, 2004 and 2003 |  | 5       
|         |  |                                                                                                               
|         |  | Notes to the Condensed Consolidated Financial Statements (Unaudited)                                           |  | 6-8     
|         |  |                                                                                                               
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations.                         |  | 9-11    
|         |  |                                                                                                               
|Item 3.  |  | Quantitative and Qualitative Disclosures About Market Risk                                                     |  | 12      
|         |  |                                                                                                               
|Item 4.  |  | Controls and Procedures                                                                                        |  | 12      
|         |  |                                                                                                               
|PART II. |  | OTHER INFORMATION                                                                                              |  |         
|         |  |                                                                                                               
|Item 1.  |  | Legal Proceedings                                                                                              |  | 13      
|         |  |                                                                                                               
|Item 2.  |  | Changes in Securities                                                                                          |  | 13      
|         |  |                                                                                                               
|Item 3.  |  | Defaults upon Senior Securities                                                                                |  | 13      
|         |  |                                                                                                               
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                                            |  | 13      
|         |  |                                                                                                               
|Item 5.  |  | Other Information                                                                                              |  | 13      
|         |  |                                                                                                               
|Item 6.  |  | Exhibits and Reports on Form 8-K                                                                               |  | 13      
|         |  |                                                                                                               
|         |  | Signatures                                                                                                     |  | 14      



2



---



PART IFINANCIAL INFORMATION



Item 1. Condensed Consolidated Financial Statements



SECURE COMPUTING CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)



|                                                                                                                                                        |  |                           |          |   |                             |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- | -------- | - | --------------------------- | - | -------- | -
|                                                                                                                                                        |  | March 31,2004 (Unaudited) |          |   | December 31,2003 (See Note) |  
|Assets                                                                                                                                                  |  |                           |          |   |                             |   |          |  
|Cash and cash equivalents                                                                                                                               |  | $                         | 29,856   |   |                             | $ | 17,101   |  
|Investments                                                                                                                                             |  |                           | 11,019   |   |                             |   | 16,580   |  
|Accounts receivable, net                                                                                                                                |  |                           | 14,820   |   |                             |   | 17,148   |  
|Inventory, net                                                                                                                                          |  |                           | 1,872    |   |                             |   | 1,227    |  
|Other current assets                                                                                                                                    |  |                           | 8,016    |   |                             |   | 7,232    |  
|Current assets from discontinued operations                                                                                                             |  |                           | 285      |   |                             |   | 545      |  
|                                                                                                                                                        |  |                           |          |   |                             |   |          |  
|Total current assets                                                                                                                                    |  |                           | 65,868   |   |                             |   | 59,833   |  
|                                                                                                                                                        |  |                          
|Property and equipment, net                                                                                                                             |  |                           | 5,058    |   |                             |   | 5,004    |  
|Goodwill                                                                                                                                                |  |                           | 40,066   |   |                             |   | 40,416   |  
|Other assets                                                                                                                                            |  |                           | 3,096    |   |                             |   | 3,222    |  
|                                                                                                                                                        |  |                           |          |   |                             |   |          |  
|Total assets                                                                                                                                            |  | $                         | 114,088  |   |                             | $ | 108,475  |  
|                                                                                                                                                        |  |                           |          |   |                             |   |          |  
|                                                                                                                                                        |  |                          
|Liabilities and Stockholders Equity                                                                                                                    |  |                           |          |   |                             |   |          |  
|Accounts payable                                                                                                                                        |  | $                         | 3,667    |   |                             | $ | 2,861    |  
|Accrued payroll                                                                                                                                         |  |                           | 3,163    |   |                             |   | 3,539    |  
|Acquisition reserve                                                                                                                                     |  |                           | 1,572    |   |                             |   | 1,757    |  
|Other accrued expenses                                                                                                                                  |  |                           | 715      |   |                             |   | 1,024    |  
|Deferred revenue                                                                                                                                        |  |                           | 20,109   |   |                             |   | 21,663   |  
|                                                                                                                                                        |  |                           |          |   |                             |   |          |  
|Total current liabilities                                                                                                                               |  |                           | 29,226   |   |                             |   | 30,844   |  
|                                                                                                                                                        |  |                          
|Acquisition reserve, net of current portion                                                                                                             |  |                           | 1,309    |   |                             |   | 1,839    |  
|Deferred revenue, net of current portion                                                                                                                |  |                           | 4,330    |   |                             |   | 3,778    |  
|                                                                                                                                                        |  |                           |          |   |                             |   |          |  
|Total liabilities                                                                                                                                       |  |                           | 34,865   |   |                             |   | 36,461   |  
|                                                                                                                                                        |  |                          
|Stockholders equity                                                                                                                                    |  |                           |          |   |                             |   |          |  
|Preferred stock, par value $.01 per share; authorized  2,000,000; issued and outstanding  none at March 31, 2004 and December 31, 2003                |  |                           |         |   |                             |   |         |  
|Common stock, par value $.01 per share; authorized  50,000,000; issued and outstanding  March 31, 2004  35,508,644 and December 31, 2003
34,953,772 |  |                           | 355      |   |                             |   | 350      |  
|Additional paid-in capital                                                                                                                              |  |                           | 195,115  |   |                             |   | 190,090  |  
|Accumulated other comprehensive loss                                                                                                                    |  |                           | (545     | ) |                             |   | (519     | )
|Accumulated deficit                                                                                                                                     |  |                           | (115,702 | ) |                             |   | (117,907 | )
|                                                                                                                                                        |  |                           |          |   |                             |   |          |  
|Total stockholders equity                                                                                                                              |  |                           | 79,223   |   |                             |   | 72,014   |  
|Total liabilities and stockholders equity                                                                                                              |  | $                         | 114,088  |   |                             | $ | 108,475  |  
|                                                                                                                                                        |  |                           |          |   |                             |   |          |  



NOTE: The balance sheet at December
31, 2003 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.



See accompanying notes to condensed consolidated financial statements.



3



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SECURE COMPUTING CORPORATION

CONSOLIDATED CONDENSED STATEMENT OF OPERATIONS

(Unaudited, in thousands,
except per share amounts)



|                                                 |  |                    |        |      |   |        |  
|------------------------------------------------ |  | ------------------ | ------ | ---- | - | ------ | -
|                                                 |  | Three Months Ended |       
|                                                 |  | March 31,          |       
|                                                 |  | 2004               |        | 2003 |  
|Revenue                                          |  | $                  | 21,216 |      | $ | 16,179 |  
|Cost of revenue                                  |  |                    | 2,513  |      |   | 1,335  |  
|                                                 |  |                    |        |      |   |        |  
|Gross profit                                     |  |                    | 18,703 |      |   | 14,844 |  
|                                                 |  |                   
|Operating expenses:                              |  |                    |        |      |   |        |  
|Selling and marketing                            |  |                    | 10,989 |      |   | 8,818  |  
|Research and development                         |  |                    | 4,103  |      |   | 3,888  |  
|General and administrative                       |  |                    | 1,533  |      |   | 1,229  |  
|                                                 |  |                    |        |      |   |        |  
|                                                 |  |                    | 16,625 |      |   | 13,935 |  
|                                                 |  |                    |        |      |   |        |  
|                                                 |  |                   
|Operating income                                 |  |                    | 2,078  |      |   | 909    |  
|                                                 |  |                   
|Other income                                     |  |                    | 127    |      |   | 53     |  
|                                                 |  |                    |        |      |   |        |  
|Net income from continuing operations            |  |                    | 2,205  |      |   | 962    |  
|                                                 |  |                   
|Loss from operations of discontinued AT division |  |                    |       |      |   | (391   | )
|                                                 |  |                    |        |      |   |        |  
|Net income                                       |  | $                  | 2,205  |      | $ | 571    |  
|                                                 |  |                    |        |      |   |        |  
|                                                 |  |                   
|Basic earnings/(loss) per share:                 |  |                    |        |      |   |        |  
|Continuing operations                            |  | $                  | 0.06   |      | $ | 0.03   |  
|Discontinued operations                          |  |                    |       |      |   | (0.01  | )
|                                                 |  |                    |        |      |   |        |  
|Basic earnings per share                         |  | $                  | 0.06   |      | $ | 0.02   |  
|                                                 |  |                    |        |      |   |        |  
|                                                 |  |                   
|Weighted average shares outstandingbasic        |  |                    | 35,352 |      |   | 29,723 |  
|                                                 |  |                    |        |      |   |        |  
|                                                 |  |                   
|Diluted earnings/(loss) per share:               |  |                    |        |      |   |        |  
|Continuing operations                            |  | $                  | 0.06   |      | $ | 0.03   |  
|Discontinued operations                          |  |                    |       |      |   | (0.01  | )
|                                                 |  |                    |        |      |   |        |  
|Diluted earnings per share                       |  | $                  | 0.06   |      | $ | 0.02   |  
|                                                 |  |                    |        |      |   |        |  
|                                                 |  |                   
|Weighted average shares outstandingdiluted      |  |                    | 38,085 |      |   | 30,293 |  
|                                                 |  |                    |        |      |   |        |  



See accompanying notes
to condensed consolidated financial statements.



4



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SECURE COMPUTING CORPORATION

CONSOLIDATED CONDENSED STATEMENT OF CASHFLOWS

(Unaudited, in thousands)



|                                                                                                             |  |                              |        |   |      |   |        |  
|------------------------------------------------------------------------------------------------------------ |  | ---------------------------- | ------ | - | ---- | - | ------ | -
|                                                                                                             |  | Three Months Ended March 31, |       
|                                                                                                             |  | 2004                         |        |   | 2003 |  
|Operating activities                                                                                         |  |                              |        |   |      |   |        |  
|Net income                                                                                                   |  | $                            | 2,205  |   |      | $ | 571    |  
|Loss from discontinued operations                                                                            |  |                              |       |   |      |   | 391    |  
|                                                                                                             |  |                              |        |   |      |   |        |  
|Net income from continuing operations                                                                        |  |                              | 2,205  |   |      |   | 962    |  
|                                                                                                             |  |                             
|Adjustments to reconcile net income from continuing operations to net cash provided by operating activities: |  |                              |        |   |      |   |        |  
|Depreciation                                                                                                 |  |                              | 603    |   |      |   | 711    |  
|Amortization                                                                                                 |  |                              | 200    |   |      |   | 56     |  
|Loss on disposals of property and equipment                                                                  |  |                              | 65     |   |      |   | 6      |  
|Deferred income taxes, net                                                                                   |  |                              | (64    | ) |      |   | (151   | )
|Changes in operating assets and liabilities:                                                                 |  |                              |        |   |      |   |        |  
|Accounts receivable                                                                                          |  |                              | 2,714  |   |      |   | 1,246  |  
|Inventories                                                                                                  |  |                              | (645   | ) |      |   | (179   | )
|Other current assets                                                                                         |  |                              | (794   | ) |      |   | (239   | )
|Accounts payable                                                                                             |  |                              | 806    |   |      |   | 370    |  
|Payroll related accruals                                                                                     |  |                              | (376   | ) |      |   | (674   | )
|Accrued liabilities and reserves                                                                             |  |                              | (984   | ) |      |   | (148   | )
|Deferred revenue                                                                                             |  |                              | (1,003 | ) |      |   | (823   | )
|                                                                                                             |  |                              |        |   |      |   |        |  
|Net cash provided by operating activities                                                                    |  |                              | 2,727  |   |      |   | 1,137  |  
|                                                                                                             |  |                             
|Investing activities                                                                                         |  |                              |        |   |      |   |        |  
|Net proceeds from sales/maturities of investments                                                            |  |                              | 5,529  |   |      |   | 976    |  
|Purchase of property and equipment, net                                                                      |  |                              | (722   | ) |      |   | (530   | )
|Increase in intangibles and other assets                                                                     |  |                              | (74    | ) |      |   | (59    | )
|                                                                                                             |  |                              |        |   |      |   |        |  
|Net cash provided by investing activities                                                                    |  |                              | 4,733  |   |      |   | 387    |  
|                                                                                                             |  |                             
|Financing activities                                                                                         |  |                              |        |   |      |   |        |  
|Proceeds from issuance of common stock                                                                       |  |                              | 5,031  |   |      |   | 535    |  
|                                                                                                             |  |                             
|Effect of exchange rate changes                                                                              |  |                              | 5      |   |      |   | (42    | )
|Net cash provided /(used) by discontinued operations                                                         |  |                              | 260    |   |      |   | (834   | )
|                                                                                                             |  |                              |        |   |      |   |        |  
|Net increase in cash and cash equivalents                                                                    |  |                              | 12,756 |   |      |   | 1,183  |  
|Cash and cash equivalents, beginning of period                                                               |  |                              | 17,101 |   |      |   | 18,050 |  
|                                                                                                             |  |                              |        |   |      |   |        |  
|Cash and cash equivalents, end of period                                                                     |  | $                            | 29,857 |   |      | $ | 19,233 |  
|                                                                                                             |  |                              |        |   |      |   |        |  



See accompanying notes
to condensed consolidated financial statements.



5



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SECURE COMPUTING CORPORATION

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(In thousands,
except share and per share amounts)

(Unaudited)



|1. | Organization
|-- | ------------



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



|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 accounting principles generally accepted in the United States. 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, 2003 Condensed Balance Sheet is derived from our audited Condensed Balance
Sheet as of December 31, 2003. 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, 2003, as
filed with the Securities and Exchange Commission.



|3. | Significant Accounting Policies
|-- | -------------------------------



Stock Options



We account for our stock option based plans under the recognition and measurement provisions of Accounting Principles Bulletin (APB) Opinion No. 25,
Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in the consolidated statements of operations, as all options granted under those plans had an exercise price
equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and net income per share if we had applied the fair value recognition provisions of Statement of Financial
Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation:



|                                                                                                                                            |  |                              |        |   |      |   |        |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------- | ------ | - | ---- | - | ------ | -
|                                                                                                                                            |  | Three Months Ended March 31, |       
|                                                                                                                                            |  | 2004                         |        |   | 2003 |  
|Net income, as reported                                                                                                                     |  | $                            | 2,205  |   |      | $ | 571    |  
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax
effects |  |                              | (4,251 | ) |      |   | (4,671 | )
|                                                                                                                                            |  |                              |        |   |      |   |        |  
|Pro forma net income (loss)                                                                                                                 |  | $                            | (2,046 | ) |      | $ | (4,100 | )
|                                                                                                                                            |  |                              |        |   |      |   |        |  
|Net income (loss) per share:                                                                                                                |  |                              |        |   |      |   |        |  
|Basic and Diluted  as reported                                                                                                             |  | $                            | 0.06   |   |      | $ | 0.02   |  
|                                                                                                                                            |  |                              |        |   |      |   |        |  
|Basic  pro forma                                                                                                                           |  | $                            | (0.06  | ) |      | $ | (0.14  | )
|                                                                                                                                            |  |                              |        |   |      |   |        |  
|Diluted  pro forma                                                                                                                         |  | $                            | (0.05  | ) |      | $ | (0.14  | )
|                                                                                                                                            |  |                              |        |   |      |   |        |  



6



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SECURE COMPUTING CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except
share and per share amounts)

(Unaudited)



|3. | Significant Accounting Policies (continued)
|-- | -------------------------------------------



Comprehensive Income



During the first quarter of 2004, total comprehensive income amounted to $2,179 compared to $529 for the first quarter of 2003. The components of our
comprehensive income are net income, foreign currency translation adjustments, and unrealized loss on available for sale investments. Results of operations are translated using the average exchange rates throughout the period. Translation gains or
losses, net of applicable deferred taxes, are accumulated as a separate component of stockholders equity and included in comprehensive income.



|4. | Acquisition of N2H2, Inc.
|-- | -------------------------



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



The aggregate purchase price was $20,525 million consisting primarily of 1,868,514 shares of common stock valued at $17,160, 422,000 options with a value
of $2,858 million and direct costs of the acquisition of $505. 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.



The following
unaudited pro forma financial information was prepared in accordance with SFAS No. 141 and assumes the acquisition had occurred at the beginning of the periods presented. The unaudited pro forma financial information is provided for informational
purposes only. These pro forma results are based upon the respective historical financial statements of the respective companies, and do not incorporate, nor do they assume, any benefits from cost savings or synergies of operations of the combined
company. The unaudited combined results of continuing operations are as follows:



|                               |  |                                  |       
|------------------------------ |  | -------------------------------- | ------
|                               |  | Three MonthsEnded March 31, 2003
|Revenue                        |  | $                                | 19,276
|Net income                     |  | $                                | 642   
|Net income per share  basic   |  | $                                | 0.02  
|Net income per share  diluted |  | $                                | 0.02  



The pro forma results
include the estimated amortization of acquired intangibles, which consist of a customer list, control list, and capitalized developed technology. We do not record amortization expense related to the goodwill. The pro forma results are not
necessarily indicative of what would have occurred if the acquisition had actually been completed as of the beginning of the periods presented, nor are they necessarily indicative of future consolidated results.



7



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SECURE COMPUTING CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except
share and per share amounts)

(Unaudited)



|5. | Net Income Per Share
|-- | --------------------



In accordance with SFAS No. 128, Earnings Per Share, basic net income per share is computed using the weighted average number of common shares
outstanding during the period. Diluted net income per share is computed using the combination of dilutive common share equivalents and the weighted average number of common shares outstanding. Potential common shares of 783,000, and 5,732,000
related to our outstanding stock options were excluded from the computation of diluted earnings per share as of March 31, 2004 and 2003, respectively, as inclusion of these shares would have been anti-dilutive.



The following table represents the calculation of basic and diluted net
income per share applicable to common stockholders:



|                                                                                        |  |                    |        |      |   |       
|--------------------------------------------------------------------------------------- |  | ------------------ | ------ | ---- | - | ------
|                                                                                        |  | Three months ended
|                                                                                        |  | March 31,         
|                                                                                        |  | 2004               |        | 2003
|Net income applicable to common stockholders                                            |  | $                  | 2,205  |      | $ | 571   
|                                                                                        |  |                    |        |      |   |       
|Shares used in computing basic net income per share applicable to common stockholders   |  |                    | 35,352 |      |   | 29,723
|Effect of outstanding dilutive stock options                                            |  |                    | 2,733  |      |   | 570   
|                                                                                        |  |                    |        |      |   |       
|Shares used in computing diluted net income per share applicable to common stockholders |  |                    | 38,085 |      |   | 30,293
|Basic net income per share applicable to common stockholders                            |  | $                  | 0.06   |      | $ | 0.02  
|                                                                                        |  |                    |        |      |   |       
|Diluted net income per share applicable to common stockholders                          |  | $                  | 0.06   |      | $ | 0.02  
|                                                                                        |  |                    |        |      |   |       



|6. | Segment Information
|-- | -------------------



We view our operations and manage our business as one segment, 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 35% of total revenue for both of the three months ended March 31, 2004 and 2003. The following table summarizes information about our international and domestic sales and operations:



|                    |  |                              |        |      |   |       
|------------------- |  | ---------------------------- | ------ | ---- | - | ------
|                    |  | Three months ended March 31,
|                    |  | 2004                         |        | 2003
|Revenues:           |  |                              |        |      |   |       
|United States sales |  | $                            | 13,790 |      | $ | 10,516
|International sales |  |                              | 7,426  |      |   | 5,663 
|                    |  |                              |        |      |   |       
|                    |  | $                            | 21,216 |      | $ | 16,179
|                    |  |                              |        |      |   |       



8



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



CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS



With the exception of historical facts, the statements
contained in this discussion are forward-looking statements, which are subject to the Safe Harbor provisions created by the Private Securities Litigation Reform Act of 1995. Such forward-looking statements include, but are not limited to, statements
that relate to the realization of net deferred tax assets and the sufficiency of financial resources to support future operations and capital expenditures. Such statements are based on current expectations and are subject to risks, uncertainties,
and changes in condition, significance, value and effect, including those discussed below under the heading Risk Factors within the section of this report entitled Managements Discussion and Analysis of Financial Condition
and Results of Operations and other documents we file from time to time with the Securities and Exchange Commission, such as our last filed Annual Report on Form 10-K for the fiscal year ended December 31, 2003. Such risks, uncertainties and
changes in condition, significance, value and effect could cause our actual results to differ materially from those expressed herein and in ways not readily foreseeable. Readers are cautioned not to place undue reliance on these forward-looking
statements, which speak only as of the date hereof and are based on information currently and reasonably known to us. We undertake no obligation to release the results of any revisions to these forward-looking statements, which may be made to
reflect events or circumstances, which occur after the date hereof or to reflect the occurrence or effect of anticipated or unanticipated events.



EXECUTIVE OVERVIEW



Our products provide complete solutions separately and they also work well together for a more comprehensive, unified, and centrally managed solution to
meet the goals and needs of our customers. Our solutions are easy to use, administer, and manage across different systems as they grow. 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 architecture allows security functions to be easily embedded into other platforms. Our solutions run on a variety of platforms and integrate well with other enterprise solutions, making our products a safe and
economical choice for organizations worldwide. The three product lines that represent the majority of our revenue are the Sidewinder® G2Firewall , our SafeWord® products and our Web filtering products. However, we view our operations and manage our
business as one segment, enterprise security solutions.



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. Our most prominent
vertical markets consist of 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 35% of total
revenue during first quarter 2004. Major foreign markets for our products include Europe, Japan, China, the Pacific Rim and Latin America. In each country, we have independent channel partners that are responsible for marketing, selling and
supporting our products to resellers and end users.



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



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



In general, the quarter ended March 31, 2004 was a solid quarter for us. Our significant year over year improvement in net income from continuing
operations was driven by strong revenue growth, sustained strong gross margin rates and our ability to control our operating expenses on an overall basis.



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RESULTS OF OPERATIONS



Comparison of Three Months Ended March 31, 2004 and 2003.



Revenue.    Our revenue increased 31% to $21.2 million for the first quarter of 2004 up from $16.2 million in the same period
of 2003. The year over year revenue growth was driven primarily by an increase in our Sidewinder G2security
appliance sales, continued increasing traction with our Smartfilter OEM relationships and growth in our web filtering subscription revenue as a result of our N2H2 acquisition.



Gross Profit.    Gross profit as a percentage of revenue was 88% in the first quarter of 2004
compared to 92% in 2003. The decrease in gross margins was primarily driven by increased sales volume of products containing a hardware component, primarily Sidewinder appliance sales, which have a lower gross profit margin than our software only
products.



Operating
Expenses.    Operating expenses consist of selling and marketing, research and development, and general and administrative expenses. Total operating expenses increased 19% to $16.6 million for the first quarter of 2004 up
from $13.9 million in the same period of 2003. The increase resulted primarily from normal inflationary increase in payroll and related costs and an increase in commission expense due to expanding revenues. As a percentage of revenue, total
operating expenses were 78% for the quarter compared to 86% in the same period of 2003.



Selling and Marketing.    Selling and marketing expenses consist primarily of salaries, commissions, and benefits related to personnel engaged in selling, marketing and customer support
functions, along with costs related to advertising, promotions, public relations, travel and allocations of information technology, facilities and human resources expenses. Selling and marketing expenses increased 25% to $11.0 million in the first
quarter of 2004 up from $8.8 million in the same period of 2003. The increase resulted primarily from normal inflationary increases in payroll and related costs and an increase in commission expense due to expanding revenues. As a percentage of
revenue, selling and marketing expense was 52% for the quarter compared to 55% in the same period of 2003.



Research and Development.    Research and development expenses consist primarily of salaries and benefits for our product
development personnel and allocations of information technology, facilities and human resources expenses. Research and development expenses increased 5% to $4.1 million in first quarter of 2004 up from $3.9 million in the same period of 2003. The
increase resulted primarily from normal inflationary increases in payroll and related costs. As a percentage of revenue, research and development expenses were 19% for the quarter compared to 24% in the same period of 2003.



General and Administrative.    General and
administrative expenses consist primarily of salaries, benefits, and related expenses for our executive, finance, and legal personnel along with allocated information technology, facilities and human resources expenses. General and administrative
expenses increased 25% to $1.5 million in the first quarter of 2004 up from $1.2 million in the same period of 2003. The increase resulted primarily from normal inflationary increases in payroll and related costs. As a percentage of revenue, general
and administrative expenses were 7% for the quarter compared to 8% in the same period of 2003.



Interest and Other Income.    Net interest and other income was $127,000 in the first quarter of 2004, an increase from $53,000 in the same period of 2003. The increase reflects higher
average cash and short-term investment balances for interest income and an increase in other income related to a state capital use tax refund.



Income Taxes.    We recognized tax benefits of $64,000 and $151,000 for the first quarters of 2004 and 2003, respectively. Tax
expenses incurred for various foreign income and domestic minimum income taxes in the first quarters of 2004 and 2003 were offset by the reversal of a like amount of the previously established valuation allowance against our deferred tax asset. The
computations of our deferred tax assets and valuation allowance are based on taxable income we expect to earn on sales of existing products, and projected interest and other income over the next three years. We believe it is more likely than not
that our net deferred tax assets, which total $3.3 million at March 31, 2004, will be realized. Realization of the $3.3 million of net deferred tax assets is dependent upon our ability to generate sufficient future taxable income and the
implementation of tax planning strategies. We believe it is more likely than not that the net deferred tax assets will be realized based on historical earnings, expected levels of future taxable income in the U.S. and certain foreign jurisdictions,
and the implementation of tax planning strategies.



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LIQUIDITY AND CAPITAL RESOURCES



Our cash, cash equivalents and short term investments increased by $7.2 million from $33.7 million at December 31, 2003 to
$40.9 million at March 31, 2004. This increase is due to cash provided by operating activities, the exercise of stock options and sales of common stock through our employee stock purchase plan.



Net cash provided by operating activities for the three months ended March
31, 2004 of $2.7 million consisted of net income for the quarter, a decrease in accounts receivable and an increase in accounts payable, offset by decreases in accrued liabilities and reserves and deferred revenue. Net cash provided by operations
was driven by sustained strong gross margin rate and our ability to control our operating expenses. Accounts receivable decreased from $17.1 million at December 31, 2003 to $14.8 million at March 31, 2004. Days sales outstanding decreased to 63 days
at March 31, 2004 compared to 67 days at December 31, 2003 primarily due to the decrease in deferred revenue during the quarter. Accounts payable increased from $2.9 million at December 31, 2003 to $3.7 million at March 31, 2004 primarily due to an
increase in inventory received with payment terms that extended beyond the end of the quarter. Accrued liabilities and reserves decreased from $4.6 million at December 31, 2003 to $3.6 million at March 31, 2004 primarily due to payment of N2H2
acquisition related items. Deferred revenue decreased from $25.4 million at December 31, 2003 to $24.4 million at March 31, 2004.



Net cash used for capital additions of $0.7 million during the three months ended March 31, 2004, was for computer equipment and technology upgrades. We
expect to use another $1.8 million during the remainder of 2004 mainly for computer equipment, technology upgrades and leasehold improvements.



Net cash provided by financing activities of $5.0 million for the three months ended March 31, 2004 consisted primarily of proceeds received from the
exercise of stock options and sales of common stock through our employee stock purchase plan.



As of March 31, 2004, we had working capital of $36.6 million. We anticipate using available cash to fund growth in operations, invest in capital equipment, acquire businesses, and to license technology or products
related to our line of business.



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



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 believe it is more likely than not that our net deferred tax assets, which total $3.3 million at March 31, 2004, will be realized.  This expectation depends upon
our ability to generate sufficient future taxable income and the implementation of tax planning strategies. 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;
| | - | ---------------------------------------------------------------------------



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



| |  | and currently unplanned acquisitions.
| | - | -------------------------------------



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Item 3.    Quantitative and Qualitative Disclosures About Market Risk



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



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



Item 4.    Controls and Procedures



Our Chief Executive Officer, Chief Operating Officer and Chief Financial
Officer have concluded, based on their evaluation as of the end of the period covered by this report, that our disclosure controls and procedures are effective for gathering, analyzing and disclosing the information we are required to disclose in
our reports filed under the Securities Exchange Act of 1934. There has been no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect,
our internal control over financial reporting.



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PART IIOTHER INFORMATION



Item 1.    Legal Proceedings



None



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



None



Item 5.    Other Information



None



Item
6.    Exhibits and Reports on Form 8-K



|(a) | Exhibits
|--- | --------



|        |  |                                                                                                                          
|------- |  | -------------------------------------------------------------------------------------------------------------------------
|Exhibit |  | Description                                                                                                              
|31.1    |  | Certification by Chairman and Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.             
|31.2    |  | Certification by President and Chief Operating Officer Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.            
|31.3    |  | Certification by Senior Vice President and Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.
|32.1    |  | Certification by Chairman and Chief Executive Officer Pursuant to Section 906 of Sarbanes-Oxley Act of 2002.             
|32.2    |  | Certification by President and Chief Operating Officer Pursuant to Section 906 of Sarbanes-Oxley Act of 2002.            
|32.3    |  | 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:
|--- | --------------------



A Form 8-K was not filed during the quarter ended March 31, 2004.



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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: April 30, 2004 |  |  |  | By: |  | /s/ Timothy J. Steinkopf
|                     |  |  |  |     |  |                          | 
|                     |  |  |  |     |  |                          |  | Timothy J. Steinkopf Senior Vice President and Chief Financial Officer (Duly authorized officer and Principal Financial Officer)





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