##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 
 Form 10-K/A
 (Amendment #1)
 þ
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the Fiscal Year Ended December 31, 2004
 or o
    
    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: 001-31216 McAfee, Inc.
 (Exact name of registrant as specified in its charter)
 Delaware
    
    77-0316593(State or other jurisdiction of incorporation or organization)
    
    (I.R.S. EmployerIdentification Number)3965 Freedom CircleSanta Clara, California
    
    95054(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code:
(408) 988-3832 Securities registered pursuant to Section 12(b) of the Act:
None Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.01 Par Value,
together with associated Rights 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 þ No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation
S-K is not contained herein, and will not be contained, to the best of the registrants knowledge,
in definitive proxy or information statements incorporated by reference in Part III of this Form
10-K/A or any amendment to this Form 10-K/A. o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Act). Yes þ No o The aggregate market value of the voting stock held by non-affiliates of the issuer as of the
last business day of the Registrants most recently completed second fiscal quarter (June 30, 2004)
was approximately $2.8 billion. The number of shares outstanding of the issuers common stock as of
February 28, 2005 was 163,500,000. EXPLANATORY NOTE This Amendment to Form 10-K is being filed for the purpose of amending and restating
contractual and lease obligation disclosures within Item 7 Managements Discussion and Analysis
of Financial Condition and Results of Operations, and Item 15, Exhibits and Financial Statement
Schedules, of our Annual Report on Form 10-K filed on March 31, 2005. Specifically, the
obligation disclosures within (1) the Contractual Obligations portion of the Liquidity and
Capital Resources section of Managements Discussion and Analysis of Financial Condition and
Results of Operations under Item 7, and (2) Note 11 to the Consolidated Financial Statements under
Item 15 of our Annual Report on Form 10-K filed on March 31, 2005, have been amended to reflect a
restatement of both our contractual obligation disclosure and our future minimum lease obligation
disclosure, and we have provided enhanced disclosures related to leases in Note 11. These
obligation disclosures in the Form 10-K as originally filed included both overstatements and
understatements for individual obligations, which resulted in the aggregate obligation disclosures
for the years 2005 through 2009 and thereafter being overstated by approximately $50.0 million in
Item 7 and $52.9 million in Item 15. Other than as described above, no other changes or amendments
have been made to Item 7 or Item 15. This Amendment to Form 10-K does not otherwise change or
update the disclosures set forth in the Form 10-K as originally filed and does not otherwise
reflect events occurring after the filing of the Form 10-K. For a description of our business and
the risks related to our business, see our Annual Report on Form 10-K for the year ended December
31, 2004.




---



MCAFEE INC.
FORM 10-K/A
For the fiscal year ended December 31, 2004 TABLE OF CONTENTS PagePART IIItem 7.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    3Item 9a.
    
    Controls and
Procedures
    
    
    27PART IVItem 15.
    
    Exhibits and Financial Statement Schedules
    
    
    31Signatures
    
    
    752005 Independent Director Cash Compensation PlanSubsidiariesConsent of Deloitte & Touche LLPConsent of PricewaterhouseCoopers LLPCertification of CEO and CFO Pursuant to Section 302Certification of CEO and CFO Pursuant to Section 906
  2




---



##### Table of Contents



PART II 
 Item 7.Managements Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements and Factors That May Affect Future Results This Managements Discussion and Analysis of Financial Condition and Results of Operations
contains forward-looking statements that involve known and unknown risks, uncertainties and other
factors that may cause our actual results, levels of activity, performance or achievements to be
materially different from any future results, levels of activity, performance or achievements
expressed or implied by such forward-looking statements. Such factors include, among others things,
those risk factors set forth in this section and elsewhere in this report. We identify
forward-looking statements by words such as may, will, should, could, expects, plans,
anticipates, believes, estimates, predicts, potential or continue or similar terms that
refer to the future. We cannot guarantee future results, levels of activity, performance or
achievements. Therefore, actual results may differ materially and adversely from those expressed in
any forward-looking statements. We undertake no obligation to revise or update publicly any
forward-looking statements for any reason. Overview and Executive Summary We are a leading supplier of computer security solutions designed to prevent intrusions on
networks and protect computer systems from the next generation of blended attacks and threats. We
offer two families of products, McAfee System Protection Solutions and McAfee Network Protection
Solutions. Our computer security solutions are offered primarily to large enterprises, governments,
small and medium sized business and consumer users. We derive our revenue and generate cash from customers from primarily two sources (i) product
revenue, which includes software license, hardware and royalty revenue, and (ii) services and
support revenue, which includes software license maintenance, training, consulting and on-line
subscription arrangements revenue. For 2004 and 2003, our net revenue was $910.5 million and $936.3
million, and our net income was $225.1 million and $70.2 million, respectively. Our net revenue was
impacted by a gradual recovery in the global economy which resulted in increased corporate IT
spending in 2004. Additionally, the sales of our Sniffer and Magic businesses in 2004 resulted in a
$179.6 million reduction in revenues from 2003 to 2004. In addition to total net revenue and net
income, in evaluating our business, management considers, among many other factors, the following:  
    Sales by geography.We operate our business in five geographic regions: North America
(U.S. and Canada); Europe, Middle East and Africa, or EMEA; Japan; Asia-Pacific (excluding
Japan) and Latin America. In 2004, 39% of our net revenue was generated outside of North
America, with North America and EMEA collectively accounting for 87% of our total net
revenue. North America and EMEA have benefited from increased corporate IT spending. Our
2004 sales in EMEA totaling $241.7 million were favorably impacted by the strengthening of
the Euro during the year.The following table illustrates the strengthening of foreign currencies in geographic
regions outside of North America from which we derive a significant portion of our
revenues: JapaneseEuro
    
    
    Yen2003 Average Exchange Rate to $1 US
    
    
    .8854
    
    
    
    115.982004 Average Exchange Rate to $1 US
    
    
    .8051
    
    
    
    108.17% Change
    
    
    9
    %
    
    
    7
    %
  
    McAfee.Our McAfee products include enterprise, small and medium sized businesses
(SMB) and consumer products, with enterprise including our Entercept host-based intrusion
protection products which were acquired in connection with the Entercept acquisition in
April 2003. SMB sales remained relatively consistent from $232.6 million for 2003 to $228.9
million for 2004. Enterprise sales, excluding IntruShield, for 2004 were $238.9 million, a
$13.0 million, or 6%, increase from $225.9 million for 2003. The year over year increase
reflects an increase in corporate IT spending in 2004, partially offset by the impact of our
perpetual plus license model, which recognizes less revenue upfront and defers more revenue
to future periods.We continue to experience significant growth in the consumer market. Our consumer market is
comprised of our McAfee consumer on-line subscription service and retail boxed product sales.
In 2004, we added 4.7 million net new subscribers.Revenue from our consumer security market increased $122.6 million, or 70% from $176.3 million
in 2003 to $298.9 million in 2004. At December 31, 2004, we had a total subscriber base of
approximately 8.5 million consumer customers, compared to 3.7 million at December 31, 2003.
Drivers of this subscriber growth include (i) numerous virus outbreaks during the second half
of 2003 and through 2004, including variations of Sasser, MyDoom, Bagle and NetSky, and (ii)
continued strategic relationships with channel partners, such as AOL and Dell. In October
2004, we announced a renewed relationship with AOL 3




---



##### Table of Contents



under which, among other things, AOL will offer our on-line PC anti virus services to AOL
members as part of their AOL subscription and membership experience for both broadband and
dial up members.
    IntruShield.Our IntruShield network protection products, acquired by us in the second
quarter of 2003, are sold primarily to enterprises and small and medium sized businesses.
During 2004, we had revenues of approximately $43.7 million, compared to $15.5 million in
2003. The $28.2 million increase is due to the full year impact on revenues in 2004, as well
as sequential quarter growth in 2004.
    Foundstone.Our Foundstone network protection products, acquired by us in October 2004,
are sold primarily to enterprises and small and medium sized businesses. We are in the
process of integrating Foundstones operations with ours and its products with our intrusion
prevention technologies and systems management capabilities. Revenues from Foundstone were
not significant in 2004.
    Sniffer Technologies.We sold Sniffer in July 2004 for net cash proceeds of $213.8
million. As there were only approximately six months of Sniffer revenue in 2004, there was a
significant decline in revenue from $210.2 million in 2003 to $90.9 million in 2004.
Additionally, there was a declining trend in Sniffer revenues in 2004 prior to the sale.We have agreed to provide certain post-closing transitional services to Network General. We
are reimbursed for our cost plus a profit margin and present these reimbursements as a
reduction of operating expenses on a separate line in our income statement. For the year ended
December 31, 2004, we have recorded approximately $6.0 million for these transition services.
    Magic.We sold the assets of our Magic Solutions service desk business to BMC Software,
Inc. in January 2004 for cash proceeds of $47.1 million, net of direct expenses. During 2004
and 2003, net revenue from Magic Solutions products totaled approximately $2.9 million and
$63.2 million, respectively.
    McAfee Labs.We entered into an agreement to sell the assets of McAfee Labs on December
21, 2004 for cash proceeds of $1.5 million. During 2004 and 2003, net revenue from McAfee
Labs totaled approximately $6.4 million and $11.0 million, respectively.
    Deferred revenue balances.Our deferred revenue balance at December 31, 2004 was $601.4
million, and at December 31, 2003 it was $459.6 million, excluding approximately $22.0
million relating to our Magic product line which was classified as liabilities related to
assets held for sale. The increase from December 31, 2003 to December 31, 2004 was 31%. We
believe that the deferred revenue balance improves predictability of future revenues. In the
middle of 2003, we introduced our perpetual plus licensing program in EMEA and introduced
this program in the United States in the first quarter of 2004. Under the perpetual plus
licensing program more revenue is allocated to service and support due to a change in
pricing structure, which was the primary reason for the increase in deferred revenue. The
strengthening of foreign currencies against the U.S. dollar resulted in approximately $18
million of the increase. These increases were partially offset by the sale of our Sniffer
business in 2004, which had a deferred revenue balance at December 31, 2003 of approximately
$60.2 million.
    Cash, cash equivalents and investment balances.Cash, cash equivalents and investment
balances at December 31, 2004 and 2003 totaled $924.7 million and $766.3 million. During
2004, we generated approximately $358.9 million in cash from operations. We used
approximately $39.4 million of cash for investing activities and $369.9 million for
financing activities. We received $260.9 million for the sale of Sniffer and Magic, and paid
$84.7 million, net of cash assumed, for the acquisition of Foundstone, which is reflected in
investing activities. Our primary utilizations of cash in 2004 were for the net purchases of
marketable securities of approximately $210.6 million, the repurchase shares of common stock
for $221.8 million and the redemption of convertible debt for $265.6 million. In 2005, our management is focused, on among other things, (i) continuing to build on the
current momentum in the consumer market and to grow faster than the competition in the consumer
space; (ii) increasing revenue from the small to medium sized business customers by improving our
channel distribution relationships; (iii) implementing cost controls and business streamlining
measures required to improve operating margins; and (iv) continuing to grow our intrusion
prevention business. Critical Accounting Policies and Estimates In preparing our consolidated financial statements, we make estimates, assumptions and
judgments that can have a significant impact on our net revenue, operating income and net income,
as well as the value of certain assets and liabilities on our consolidated balance sheet. The
application of our critical accounting policies requires an evaluation of a number of complex
criteria and significant accounting judgments by us. Management bases its estimates on historical
experience and on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about the carrying values
of assets and liabilities. Senior management has discussed the development, selection and
disclosure of these estimates with the audit 4




---



##### Table of Contents



committee of our board of directors. Actual results may differ, and could be material, from
these estimates under different assumptions or conditions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made
based on assumptions about matters that are highly uncertain at the time the estimate is made, and
if different estimates that reasonably could have been used, or changes in the accounting estimates
that are reasonably likely to occur periodically, could materially impact the consolidated
financial statements. Management believes the following critical accounting policies reflect our
more significant estimates and assumptions used in the preparation of the consolidated financial
statements. We have not materially changed our methodology for calculating the estimates below in
the past three years. Our critical accounting policies are as follows:  
    revenue recognition;
    estimating valuation allowances and accrued liabilities, specifically sales returns and
other allowances, the allowance for doubtful accounts, our facility restructuring accrual;
and the assessment of the probability of the outcome of litigation against us;
    accounting for income taxes; and
    valuation of goodwill, intangibles and long-lived assets. 5




---



##### Table of Contents



Revenue Recognition As described below, significant management judgments and estimates must be made and used in

connection with the revenue recognized in any accounting period. Material differences may result in
the amount and timing of our revenue for any period if our management made different judgments or
utilized different estimates. These estimates affect the deferred revenue line item on our
consolidated balance sheet and the net revenue line item on our consolidated statement of income.
Estimates regarding revenue affect all of our operating geographies. We apply the provisions of Statement of Position 97-2, Software Revenue Recognition,(SOP
97-2) as amended by Statement of Position 98-9 Modification of SOP 97-2, Software Revenue
Recognition, With Respect to Certain Transactionsto all transactions involving the sale of
software products and hardware transactions where the software is not incidental. For hardware
transactions where software is not incidental, we do not bifurcate the fee and we do not apply
separate accounting guidance to the hardware and software elements. For hardware transactions where
no software is involved, we apply the provisions of Staff Accounting Bulletin 104 Revenue
Recognition(SAB 104). In addition, we apply the provisions of Emerging Issues Task Force Issue
No. 00-03 Application of AICPA Statement of Position 97-2 to Arrangements that Include the Right
to Use Software Stored on Another Entitys Hardwareto our on-line software subscription services. We license our software products on a one and two-year subscription basis or on a perpetual
basis. Our two-year subscription licenses include the first year of maintenance and support. Our
on-line subscription arrangements require customers to pay a fixed fee and receive service over a
period of time, generally one or two years. Customers do not pay set-up fees. We recognize revenue
from the sale of software licenses when persuasive evidence of an arrangement exists, the product
has been delivered, the fee is fixed or determinable and collection of the resulting receivable is
reasonably assured. For all sales, except those completed over the Internet, we use either a
binding purchase order or signed license agreement as evidence of an arrangement. For sales over
the Internet, we use a credit card authorization as evidence of an arrangement. Sales through our
distributors are evidenced by a master agreement governing the relationship together with binding
purchase orders on a transaction by transaction basis. Delivery generally occurs when product is delivered to a common carrier or upon delivery of
the license key which is delivered primarily through email. At the time of the transaction, we
assess whether the fee associated with our revenue transactions is fixed or determinable and
whether or not collection is reasonably assured. We assess whether the fee is fixed or determinable
based on the payment terms associated with the transaction. If a significant portion of a fee is
due after our normal payment terms, which are 30 to 90 days from invoice date, we account for the
fee as not being fixed or determinable. In these cases, we recognize revenue as the fees become
due. With respect to rebate programs, we make estimates of amounts for promotional and rebate
programs based on our historical experience, and reduce revenue by the amount of the estimates. We
assess collection based on a number of factors, including past transaction history and
credit-worthiness of direct customers. We do not request collateral from our customers. If we
determine that collection of a fee is not reasonably assured, we defer the fee and recognize
revenue at the time collection becomes reasonably assured, which is generally upon receipt of cash.
For indirect customers, we monitor the financial condition and ability to pay for goods sold. If we
do not identify potential collection problems with our indirect customers on a timely basis, we
could incur a charge for bad debt that could be material to our consolidated financial statements. For arrangements with multiple obligations (for example, undelivered maintenance and support),
we allocate revenue to each component of the arrangement using the residual value method based on
the fair value of the undelivered elements, which is specific to our company. This means that we
defer revenue from the arrangement fee equivalent to the fair value of the undelivered elements.
Fair values for the ongoing maintenance and support obligations for both our two-year time based
licenses and perpetual licenses are based upon separate sales of renewals to other customers or
upon renewal rates quoted in the contracts. This assessment generally includes analyses of the
variability of renewal rates by product and region and determination of whether a majority of
renewals supports our estimated fair value of the maintenance and support obligations. In cases
where renewal rates are not quoted in the initial sales contracts, our assessment is critical
because if an estimated fair value cannot be established through separate sales then the fee for
the entire arrangement (e.g. delivered software and undelivered maintenance and support
obligations) is deferred until delivery occurs which for maintenance would be ratably over the
service period. Fair value of services, such as training or consulting, is based upon separate
sales by us of these services to other customers. Our arrangements do not generally include
acceptance clauses. However, if an arrangement includes a specified acceptance provision,
recognition occurs upon the earlier of receipt of a written customer acceptance or expiration of
the acceptance period. We recognize revenue for maintenance services ratably over the contract term. Our training and
consulting services are billed based on hourly rates, and we generally recognize revenue as these
services are performed. However, at the time of entering into a transaction, we assess whether or
not any services included within the arrangement require us to perform significant work either to
alter the underlying software or to build additional complex interfaces so that the software
performs as the customer requests. If these services are included as part of an arrangement, we
recognize the entire fee using the percentage of completion method. We estimate the percentage of
completion based on our estimate of the total costs estimated to complete the project as a
percentage of the costs incurred to date and the estimated costs to complete. 6




---



##### Table of Contents



Estimation of Sales Returns and Other Allowances, Allowance for Doubtful Accounts,
Restructuring Accrual and Litigation Sales Returns and Other Allowances.In each accounting period, our management must make
judgments and estimates of potential future product returns related to current period product
revenue. We analyze and monitor current and historical return rates, current economic trends, and
changes in customer demand and acceptance of our products when evaluating the adequacy of the sales
returns and other allowances. We also budget for our sales incentives each quarter and determine
amounts to be spent and we monitor amounts spent against our budgets. These estimates affect our
net revenue line item on our statement of income and affect our net accounts receivable line item
on our consolidated balance sheet. These estimates affect all of our operating geographies. If our sales returns experience were to increase by an additional 1% of license revenues, our
allowance for sales returns at December 31, 2004 would increase and net revenue and operating
income for 2004 would decrease by approximately $1.6 million. Allowance for Doubtful Accounts.We also make estimates of the uncollectibility of our
accounts receivables. Management specifically analyzes accounts receivable balances, current and
historical bad debt trends, customer concentrations, customer credit-worthiness, current economic
trends and changes in our customer payment terms when evaluating the adequacy of the allowance for
doubtful accounts. We specifically reserve for any account receivable for which there are
identified collection issues. Bad debts have historically been approximately 2% of our average
accounts receivable. These estimates affect the provision for doubtful accounts line item on our
statement of income and the net accounts receivable line item on the consolidated balance sheet.
The estimation of uncollectible accounts affects all of our operating geographies. December 31,
    
    
    December 31,2004
    
    
    2003(In millions)Allowance for sales return and incentives
    
    $
    29.2
    
    
    $
    39.6Allowance for doubtful accounts
    
    
    2.5
    
    
    
    3.1Total allowance
    
    $
    31.7
    
    
    $
    42.7
 At December 31, 2004, our accounts receivable balance was $137.5 million, net of allowance for
doubtful accounts of $2.5 million, and our allowance for sales return and incentives amounts to
$29.2 million. At December 31, 2003, our accounts receivable balance was $170.2 million, net of
allowance for doubtful accounts of $2.9 million (excluding the allowance related to Magic accounts
receivable) and provision for sales returns and other allowances of $39.6 million as of December
31, 2003. If an additional 1% of our gross accounts receivable were deemed to be uncollectible at
December 31, 2004, our allowance for doubtful accounts and provision for bad debt expense would
increase by approximately $1.7 million. Restructuring Accrual.During 2004, we permanently vacated several leased facilities,
including an additional two floors in our Santa Clara headquarters building. As a result of these
vacancies, we recorded $8.7 million in restructuring accruals. In 2003, as part of a consolidation
of activities into our Plano, Texas facility from our headquarters in Santa Clara, California, we
recorded a restructuring charge of $15.8 million. In 2004, we recorded adjustments to the 2004 and
2003 lease termination restructuring accruals of $0.2 million and $0.6 million, respectively. We
recorded these facility restructuring charges in accordance with Statement of Financial Accounting
Standard No. 146, Accounting for Exit Costs Associated With Exit or Disposal Activities(SFAS
146). In order to determine our restructuring charges and the corresponding liabilities, SFAS 146
required us to make a number of assumptions. These assumptions included estimated sublease income
over the remaining lease period, estimated term of subleases, estimated utility and real estate
broker fees, as well as estimated discount rates for use in calculating the present value of our
liability. We developed these assumptions based on our understanding of the current real estate
market in the respective locations as well as current market interest rates. The assumptions used
are our managements best estimate at the time of the accrual, and adjustments are made on a
periodic basis if better information is obtained. If, at December 31, 2004, our estimated sublease
income were to decrease 10%, the restructuring reserve and related expense would have increased by
approximately $0.2 million. The estimates regarding our restructuring accruals affect our current liabilities and other
long term liabilities line items in our consolidated balance sheet, since these liabilities will be
settled each year through 2013. These estimates affect our statement of income in the restructuring
line item. At December 31, 2004, our North American operating segment was affected by these
estimates. Litigation.Managements current estimated range of liability related to litigation that is
brought against us from time to time is based on claims for which our management can estimate the
amount and range of loss. We recorded the minimum estimated liability related to those claims,
where there is a range of loss as there is no better point of estimate. Because of the
uncertainties related to an unfavorable outcome of litigation, and the amount and range of loss on
pending litigation, management is often unable to make a reasonable estimate of the liability that
could result from an unfavorable outcome. As litigation progresses, we continue to assess our
potential liability and revise our estimates. Such revisions in our estimates could materially
impact our results of operations and financial position. Estimates of litigation liability affect
our accrued liability line item on our consolidated balance sheet and our general and
administrative expense line item on our statement of income. 7




---



##### Table of Contents



Accounting for Income Taxes As part of the process of preparing our consolidated financial statements we are required to
estimate our income taxes in each of the jurisdictions in which we operate. This process involves
estimating our actual current tax exposure together with assessing temporary differences resulting
from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These
differences result in deferred tax assets and liabilities, which are included within our
consolidated balance sheet. We must then assess and make significant estimates regarding the
likelihood that our deferred tax assets will be recovered from future taxable income and to the
extent we believe that recovery is not likely, we must establish a valuation allowance. To the
extent we establish a valuation allowance or increase this allowance in a period, we must include
an expense within the tax provision in the statement of income. Estimates related to income taxes
affect the deferred tax asset and liability line items and accrued liabilities in our consolidated
balance sheet and our income tax (benefit) expense line item in our statement of income. Income tax
estimates affect all of our operating geographies. The net deferred tax asset as of December 31, 2004 is $421.1 million, net of a valuation
allowance of $65.8 million due to uncertainties related to our ability to utilize some of our
deferred tax assets related to acquired companies, primarily consisting of certain net operating
losses carried forward and foreign tax credits, before they expire. The valuation allowance is
based on our historical experience and estimates of taxable income by jurisdiction in which we
operate and the period over which our deferred tax assets will be recoverable. In the event that
actual results differ from these estimates or we adjust these estimates in future periods we may
need to establish an additional valuation allowance which could materially impact our financial
position and results of operations. Tax returns are subject to audit by various taxing authorities. Although we believe that
adequate accruals have been made for unsettled issues, additional benefits or expenses could occur
in future years from resolution of outstanding matters. We continue to assess our potential tax
liability included in accrued taxes in the consolidated financial statements, and revise our
estimates. Such revisions in our estimates could materially impact our results of operations and
financial position. We have classified a portion of our tax liability as noncurrent in the
consolidated balance sheet based on the expected timing of cash payments to settle contingencies
with taxing authorities.  Valuation of Goodwill, Intangibles, and Long-lived Assets We account for goodwill and other indefinite-lived intangible assets in accordance with SFAS
142, Goodwill and Other Intangible Assets(SFAS 142). SFAS 142 requires, among other things,
the discontinuance of amortization for goodwill and indefinite-lived intangibles and at least an
annual test for impairment. An impairment review may be performed more frequently in the event
circumstances indicate that the carrying value may not be recoverable. The goodwill impairment
review involves a two-step process as described in Note 2 to the consolidated financial statements. We are required to make estimates regarding the fair value of our reporting units when testing
for potential impairment. We estimate the fair value of our reporting units using a combination of
the income approach and the market approach. Under the income approach, we calculate the fair value
of a reporting unit based on the present value of estimated future cash flows. Under the market
approach, we estimate the fair value based on market multiples of revenues or earnings for
comparable companies. We estimate cash flows for these purposes using internal budgets based on
recent and historical trends. We base these estimates on assumptions we believe to be reasonable,
but which are unpredictable and inherently uncertain. We also make certain judgments about the
selection of comparable companies used in the market approach in valuing our reporting units, as
well as certain assumptions to allocate shared assets and liabilities to calculate the carrying
value for each of our reporting units. If an impairment were present, these estimates would affect
an impairment line item on our consolidated statement of income and would affect the goodwill in
our consolidated balance sheet. As goodwill is allocated to all of our reporting units, any
impairment could potentially affect each operating geography. Based on our current impairment test, there would have to be a significant change in
assumptions used in such calculation in order for an impairment to occur as of December 31, 2004. We account for finite-lived intangibles and long-lived assets in accordance with SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets.Under this standard we will
record an impairment charge on finite-lived intangibles or long-lived assets to be held and used
when we determine that the carrying value of intangibles and long-lived assets may not be
recoverable. Based upon the existence of one or more indicators of impairment, we measure any impairment of
intangibles or long-lived assets based on a projected discounted cash flow method using a discount
rate determined by our management to be commensurate with the risk inherent in our current business
model. Our estimates of cash flows require significant judgment based on our historical results and
anticipated results and are subject to many of the factors, noted below as triggering factors,
which may change in the near term. Factors considered important, which could trigger an impairment review include, but are not
limited to:  
    significant under performance relative to expected historical or projected future operating results; 8




---



##### Table of Contents




    significant changes in the manner of our use of the acquired assets or the strategy for our overall business;
    significant negative industry or economic trends;
    significant declines in our stock price for a sustained period; and
    our market capitalization relative to net book value. Goodwill amounted to $439.2 million and $443.6 million as of December 31, 2004 and 2003,
respectively. We did not hold any other indefinite-lived intangibles as of December 31, 2004 or
2003. Net finite-lived intangible assets and long-lived assets amounted to $198.8 million and
$217.6 million as of December 31, 2004 and 2003, respectively. Results of Operations  Years Ended December 31, 2004, 2003, and 2002  Net Revenue The following table sets forth for the periods indicated our product revenue and services and
support revenue as a percent of net revenue (in thousands, except percentages): Percentage ofFor the Year Ended December 31,
    
    
    Net Revenue2004
    
    
    2003
    
    
    2002
    
    
    2004
    
    
    2003
    
    
    2002(In thousands)Net revenue:Product
    
    $
    294,163
    
    
    $
    513,610
    
    
    $
    631,550
    
    
    
    32
    %
    
    
    55
    %
    
    
    61
    %Services and support
    
    
    616,379
    
    
    
    422,726
    
    
    
    411,494
    
    
    
    68
    
    
    
    45
    
    
    
    39Total net revenue
    
    $
    910,542
    
    
    $
    936,336
    
    
    $
    1,043,044
    
    

    
    100
    %
    
    
    100
    %
    
    
    100
    %
 Net revenue decreased 3%, or $25.8 million from 2003 to 2004. The decrease reflects (i) a
$119.3 million decrease in our Sniffer product line related to declining Sniffer revenues
throughout 2004 and its sale in July 2004, and (ii) a $60.3 million decrease due to the January
2004 sale of Magic, (iii) a decrease due to the introduction of our perpetual plus licensing
model in 2003, offset by (iv) a $28.2 million increase in our IntruShield product sales from our
May 2003 IntruVert acquisition, (v) a $103.9 million increase in our McAfee.com consumer business
due to on-line subscriber growth, (vi) an increase in revenues in EMEA and Japan of approximately
$26.0 million due to a weakening U.S. Dollar, and (vii) increased corporate IT spending in 2004,
which had a positive impact on our revenues. Net revenue decreased 10% or $106.7 million from 2002
to 2003. The decline was due primarily to weaknesses in the United States and other economies and
continued reductions in corporate spending. Many of our customers and potential customers: (i)
delayed initiating the purchase process; (ii) increased the evaluation time to complete a purchase
or postponed, sometimes indefinitely, full IT deployments; and/or (iii) reduced their capital
expenditure budgets, thereby restricting their software/services purchases to those believed by
them to be necessary to satisfy an immediate need. In 2003, we began introducing our perpetual plus licensing arrangements outside of North
America. In the first quarter of 2004, we expanded our perpetual plus licensing arrangements to
North America. Under these arrangements, we provide a perpetual license coupled with additional
support, with a higher percentage of the contract value allocated to support revenues. As a result
of these arrangements, there has been an increase in services and support revenue relative to
product revenue due to higher renewal rates for support bundled in these arrangements and an
increase of revenue being deferred to future periods as support revenues are deferred and
recognized over the life of the arrangement. The perpetual plus licensing model is designed to make
our products more competitive in the channel and increase channel volumes, while having the added
effect of improving the visibility and predictability of our business through increased deferred
revenue balances. The balance of deferred revenue has increased 31% from $459.6 million at December
31, 2003 to $601.4 million at December 31, 2004. 9




---



##### Table of Contents



Net Revenue by Geography The following table sets forth for the periods indicated net revenue, in each of the five
geographic regions in which we operate: Percentage ofFor the Year Ended December 31,
    
    
    Net Revenue2004
    
    
    2003
    
    
    2002
    
    
    2004
    
    
    2003
    
    
    2002(In thousands)Net revenue:North America
    
    $
    554,641
    
    
    $
    606,685
    
    
    $
    653,532
    
    
    
    61
    %
    
    
    65
    %
    
    
    63
    %EMEA
    
    
    241,724
    
    
    
    240,616
    
    
    
    298,659
    
    
    
    27
    
    
    
    26
    
    
    
    28Japan
    
    
    54,609
    
    
    
    40,519
    
    
    
    39,369
    
    
    
    6
    
    
    
    4
    
    
    
    4Asia-Pacific (excluding Japan)
    
    
    38,494
    
    
    
    29,014
    
    
    
    33,595
    
    
    
    4
    
    
    
    3
    
    
    
    3Latin America
    
    
    21,074
    
    
    
    19,502
    
    
    
    17,889
    
    
    
    2
    
    
    
    2
    
    
    
    2Total net revenue
    
    $
    910,542
    
    
    $
    936,336
    
    
    $
    1,043,044
    
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
 Net revenue outside of North America (United States and Canada) accounted for
approximately 39%, 35% and 37% of net revenue for 2004, 2003 and 2002. Historically and for 2004,
North America and EMEA has comprised between 87% and 91% of our business. In 2004, we saw a
weakening of the U.S. dollar against many currencies, but most dramatically against the Euro. As a
result of the weakening U.S. dollar, we experienced positive impacts on our net revenue in EMEA
region. In 2004, total net revenue in North America decreased 9% or $52.0 million as compared to 2003
and decreased 7% or $46.8 million from 2002 to 2003. The revenue decline from 2003 to 2004 was due
to (i) a decline of $92.4 million due to the July 2004 sale of Sniffer as well as declining Sniffer
revenues in 2004, (ii) a decline of $40.9 million due to the January 2004 sale of Magic, and (iii)
a decrease in our enterprise revenues, excluding IntruShield, of approximately $26.3 million,
partially offset by (iv) an increase of $99.9 million related to the increase in McAfee.com on-line
subscriptions and (v) a $15.9 million increase due to our IntruShield product. The economic growth
and increased corporate IT spending had a positive impact on our revenues, while the introduction
of the perpetual plus model in North America in 2004 resulted in an increase in the amount of
revenue deferred to future periods. The revenue decline from 2002 to 2003 was due to the impact of
an economic downturn as well as softness in corporate IT spending. In EMEA, total net revenue remained consistent from 2003 to 2004, and decreased 19% or $58.0
million from 2002 to 2003. For 2004, the Sniffer sale and declining revenues in 2004 resulted in an
$18.0 million decrease, the sale of Magic resulted in an $18.4 million decrease and IntruShield
resulted in a $4.4 million increase. The strengthening of foreign currencies against the U.S.
dollar resulted in an approximate $22.0 million increase in revenues from 2003 to 2004, and we also
benefited from increased corporate IT spending in 2004. The decline in revenue from 2002 to 2003
was due to the effects of the economic downturn and reduced corporate IT spending, as well as the
introduction of the perpetual plus pricing model in the middle of 2003. Our Japan, Latin America and Asia-Pacific operations combined have historically been less than
15% of our total business, and we expect this trend to continue. Revenues increased in each of
these geographic regions primarily due to the strengthening of foreign currencies against the U.S.
Dollar and increased corporate IT spending. Risks inherent in international revenue include the impact of longer payment cycles, greater
difficulty in accounts receivable collection, unexpected changes in regulatory requirements,
seasonality due to the slowdown in European business activity during the third quarter, tariffs and
other trade barriers, currency fluctuations, product localization and difficulties staffing and
managing foreign operations. These factors may have a material adverse effect on our future
international revenue. 10




---



##### Table of Contents



Product Revenue The following table sets forth for the periods indicated each major category of our product
revenue: Percentage ofFor the Year Ended December 31,
    
    
    Product Revenue2004
    
    
    2003
    
    
    2002
    
    
    2004
    
    
    2003
    
    
    2002(In thousands)Term subscription licenses
    
    $
    39,682
    
    
    $
    113,696
    
    
    $
    181,825
    
    
    
    14
    %
    
    
    23
    %
    
    
    29Perpetual licenses
    
    
    118,301
    
    
    
    227,492
    
    
    
    277,882
    
    
    
    40
    
    
    
    44
    
    
    
    44Hardware
    
    
    79,828
    
    
    
    99,502
    
    
    
    93,359
    
    
    
    27
    
    
    
    19
    
    
    
    15Retail
    
    
    27,787
    
    
    
    45,993
    
    
    
    63,236
    
    
    
    9
    
    
    
    9
    
    
    
    10Other
    
    
    28,565
    
    
    
    26,927
    
    
    
    15,248
    
    
    
    10
    
    
    
    5
    
    
    
    2Total product revenue
    
    $
    294,163
    
    
    $
    513,610
    
    
    $
    631,550
    
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
 Product revenue includes revenue from software licenses, hardware, our retail product and
royalties. The $219.4 million, or 43% decrease from 2003 to 2004 is due to (i) the introduction of
our perpetual plus licensing arrangements in the United States in the first quarter of 2004, and in
EMEA and Asia-Pacific (excluding Japan) in the middle of 2003, resulting in reduced product
revenues and increased services and support revenues, (ii) our continued shift in focus from retail
boxed products to our on-line subscription model for consumers and SMBs, and (iii) the Sniffer
sale in July 2004 and declining 2004 revenues, partially offset by the effects of the strengthening
foreign currencies against the U.S. Dollar and increased corporate IT spending. The introduction of
the perpetual plus licensing arrangement has resulted in revenue declines in the term subscription
license and perpetual license revenues. Our hardware revenue decreased $19.7 million, or 20%, due
to the Sniffer sale in July 2004, which was partially offset by an increase in revenue from our
IntruShield product due to our purchase of IntruVert in the second quarter of 2003. The $18.2
million, or 40%, decrease in retail revenues is due to our shift to the on-line subscription model
for consumers and SMB. The $117.9 million, or 19%, decrease in product revenue from 2002 to 2003 was due to (i) the
introduction of our perpetual plus licensing arrangements in EMEA and Asia-Pacific (excluding
Japan) in 2003, (ii) our continued shift in focus from retail boxed products to our on-line
subscription model for consumers and SMBs, and (iii) the continued softness in corporate IT
spending in 2003. Our customers license our software on a perpetual or term subscription basis depending on
their preference. We are continuing to see perpetual licenses become a larger percentage of our
license revenue in any quarter following the implementation of our perpetual plus licensing model
worldwide. Furthermore, support pricing under the perpetual plus model is significantly higher than
the subscription model. Thus, revenue is shifting out of the product revenue and into services and
support revenue. We expect the remaining mix of product revenue to fluctuate as a percentage of
revenue.  Services and Support Revenue The following table sets forth for the periods indicated each major category of our services
and support revenue: Percentage of ServicesFor the Year Ended December 31,
    
    
    and Support Revenue2004
    
    
    2003
    
    
    2002
    
    
    2004
    
    
    2003
    
    
    2002(In thousands)Support and maintenance
    
    $
    436,299
    
    
    $
    313,731
    
    
    $
    310,473
    
    
    
    71
    %
    
    
    74
    %
    
    
    75
    %Consulting
    
    
    19,157
    
    
    
    27,421
    
    
    
    36,740
    
    
    
    3
    
    
    
    7
    
    
    
    9Training
    
    
    8,394
    
    
    
    9,486
    
    
    
    12,527
    
    
    
    1
    
    
    
    2
    
    
    
    3On-line subscription arrangements
    
    
    152,529
    
    
    
    72,088
    
    
    
    51,754
    
    
    
    25
    
    
    
    17
    
    
    
    13Total services and support revenue
    
    $
    616,379
    
    
    $
    422,726
    
    
    $
    411,494
    
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
 Services and support revenues include revenues from software support and maintenance
contracts, consulting, training and on-line subscription arrangements. The $193.7 million, or 46%,
increase from 2003 to 2004 is due to (i) an increase in support and maintenance due to our
perpetual plus licensing model and (ii) a $80.4 million increase in our on-line subscription
arrangements, (iii) the positive impact of foreign currencies strengthening against the U.S.
Dollar, partially offset by (iv) a $9.4 million combined decrease in consulting and training
revenues. The increase in our on-line subscription arrangements is due to an increase in our
customer base to approximately 8.5 million subscribers at December 31, 2004, from 3.7 million
subscribers at December 31, 2003. The increase in customers was due to our continued channel
relationships with Dell, AOL and others, as well as an outbreak of computer viruses in the second
half of 2003 continuing through 2004. The $11.2 million, or 3%, increase in service and support revenue from 2002 to 2003 was due to
a $20.3 million increase in our on-line subscription arrangements, partially offset by decreases in
consulting and training revenues totaling $12.4 million. The increase in our on-line subscription
arrangements was due to an increase in our customer base to approximately 3.7 million subscribers
at the end of 2003, as well as an increase in our McAfee ASaP on-line service for small-to-medium
sized businesses. We saw decreases in our consulting and training revenues in each year because our
customers typically first reduce consulting and training budgets when reducing overall corporate IT
costs and projects. 11




---



##### Table of Contents



Our future profitability and rate of growth, if any, will be directly affected by increased
price competition and the size of our revenue base. Our growth rate and net revenue depend
significantly on renewals of existing licenses as well as our ability to respond successfully to
the pace of technological change and expand our customer base. If our renewal rate or our pace of
new customer acquisition slows, our net revenues and operating results would be adversely affected.
Additionally, support pricing under the perpetual plus model is significantly higher than the
previous subscription model. In the event customers choose not to renew their support arrangements
or renew such arrangements at other than the contractual rates, revenue recognition under the
perpetual plus model could be impacted.  Cost of Net Revenue; Gross Margin Percentage of Cost ofFor the Year Ended December 31,
    
    
    Net Revenue2004
    
    
    2003
    
    
    2002
    
    
    2004
    
    
    2003
    
    
    2002(In thousands)Cost of net revenue:Product
    
    $
    73,058
    
    
    $
    80,895
    
    
    $
    101,019
    
    
    
    49
    %
    
    
    54
    %
    
    
    61
    %Services and support
    
    
    62,520
    
    
    
    57,362
    
    
    
    60,539
    
    
    
    42
    
    
    
    38
    
    
    
    37Amortization of purchased technology
    
    
    13,331
    
    
    
    11,369
    
    
    
    3,153
    
    
    
    9
    
    
    
    8
    
    
    
    2Total cost of net revenue
    
    $
    148,909
    
    
    $
    149,626
    
    
    $
    164,711
    
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Gross margin
    
    $
    761,633
    
    
    $
    786,710
    
    
    $
    878,333Gross margin percentage
    
    
    84
    %
    
    
    84
    %
    
    
    84
    %
 Our total cost of revenue remained consistent at $148.9 million for 2004 and $149.6
million for 2003 as revenues remained relatively consistent, with a slight decline of 3%. Our total
cost of net revenue decreased $15.1 million, or 9% due primarily to our 10% decrease in net revenue
from 2002 to 2003. Cost of Product Revenue.Our cost of product revenue consists primarily of the cost of media,
manuals and packaging for products distributed through traditional channels, and, with respect to
hardware-based anti-virus and security products and network fault and performance products,
computer platforms and other hardware components. Our cost of product revenue decreased $7.8
million from 2003 to 2004 and $20.1 million from 2002 to 2003. The decrease from 2003 to 2004 is
primarily due to the sale of Sniffer in July 2004, partially offset by IntruShield hardware due to
a full year of activity in 2004. The decrease from 2002 to 2003 was due to lower costs of computer
platforms and other hardware components as at the end of 2002 we began using a more competitive
contract manufacturer which also utilized a greater number of standardized computer platforms and
hardware components. We also benefited from the favorable impact of cost control measures. These
costs have decreased as a percentage of total cost of net revenue from 2002 to 2004 due to the
change in the mix of our revenues, with a shift from product revenues to service and support
revenues over this period. We anticipate that cost of product revenue will continue to fluctuate as a percent of cost of
net revenue, due to various factors including product mix, material and labor costs and warranty
costs. Cost of Services and Support.Cost of services and support revenue consists principally of
salaries and benefits related to employees providing customer support and consulting services, and
costs related to the sale of on-line subscription arrangements, including revenue sharing
arrangements and royalties paid to our on-line strategic partners. Cost of services and support
revenue increased $5.2 million from 2003 to 2004, and decreased $3.2 million from 2002 to 2003. The
increase from 2003 to 2004 is due to an increase in revenue sharing arrangements and royalties paid
to our on-line strategic partners, which was partially offset by reduced support and consulting
headcount as a result of the sale of Magic in January 2004, as well as on-going cost reduction
efforts. Cost of services and support have increased as a percentage of total cost of net revenue
from 2002 through 2004 primarily as a result of the increase in revenue sharing arrangements and
royalty payments to our on-line strategic partners. We anticipate that cost of service revenue will
continue to fluctuate as a percentage of cost of net revenue. Amortization of Purchased Technology.Amortization of purchased technology increased $2.0
million, or 17%, from 2003 to 2004 and increased $8.2 million, or 261%, from 2002 to 2003. The
increases are due to our acquisitions of Entercept and IntruVert in 2003, for which we recorded
purchased technology of $21.7 million and $18.2 million, respectively, and our acquisition of
Foundstone in October 2004, for which we recorded purchased technology of $27.0 million.
Amortization for these items was $9.0 million and $5.2 million in 2004 and 2003, respectively. The
increase in amortization related to the 2003 and 2004 acquisitions was partially offset by certain
purchased technology assets becoming fully amortized in 2003. The purchased technology is being
amortized over its estimated useful lives of four to seven years. Amortization of purchased
technology is expected to be $15.3 million in 2005. Gross Margins.Our gross margins were stable at 84% from 2002 to 2004. The increase in cost
of service and support revenue was offset by the decrease in cost of product revenue in 2004. The
increase of amortization of purchased technology as a percentage of cost of net revenue in 2003 to
8% offset the improvement we experienced in our cost of product revenues from 2002 to 2003. Gross
margins may fluctuate in the future due to various factors, including the mix of products sold,
sales discounts, revenue sharing agreements, material and labor costs and warranty costs. 12




---



##### Table of Contents



Operating Costs The following table sets forth for the periods indicated each major category of our operating
expenses: Percentage ofFor the Year Ended December 31,
    
    
    Net Revenue2004
    
    
    2003
    
    
    2002
    
    
    2004
    
    
    2003
    
    
    2002(In thousands)Research and development(1)
    
    $
    172,717
    
    
    $
    184,606
    
    
    $
    148,801
    
    
    
    19
    %
    
    
    20
    %
    
    
    14
    %Marketing and sales(2)
    
    
    354,380
    
    
    
    363,306
    
    
    
    397,747
    
    
    
    39
    
    
    
    39
    
    
    
    38General and administrative(3)
    
    
    139,845
    
    
    
    129,920
    
    
    
    119,393
    
    
    
    15
    
    
    
    14
    
    
    
    11(Gain)loss on sale of assets and technology(4)
    
    
    (240,336
    )
    
    
    788
    
    
    
    (9,301
    )
    
    
    (26
    )
    
    
    
    
    
    
    (1
    )Litigation (reimbursement) settlement
    
    
    (24,991
    )
    
    
    
    
    
    
    70,000
    
    
    
    (3
    )
    
    
    
    
    
    
    7Restructuring charges
    
    
    17,493
    
    
    
    22,667
    
    
    
    1,116
    
    
    
    2
    
    
    
    2
    
    
    
    Amortization of intangibles
    
    
    14,065
    
    
    
    15,637
    
    
    
    10,742
    
    
    
    2
    
    
    
    2
    
    
    
    1Severance/bonus costs related to Sniffer and Magic dispositions(5)
    
    
    10,070
    
    
    
    
    
    
    
    
    
    
    
    1
    
    
    
    
    
    
    
    Reimbursement from transition services agreement
    
    
    (5,997
    )
    
    
    
    
    
    
    
    
    
    
    (1
    )
    
    
    
    
    
    
    Provision for (recovery from) doubtful accounts
    
    
    1,716
    
    
    
    (1,216
    )
    
    
    (219
    )
    
    
    
    
    
    
    
    
    
    
    Acquisition related costs not subject to capitalization
    
    
    
    
    
    
    
    
    
    
    16,026
    
    
    
    
    
    
    
    
    
    
    
    2In-process research and development
    
    
    
    
    
    
    6,600
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total operating costs, including the effects of stock-based compensation
    
    $
    438,962
    
    
    $
    722,308
    
    
    $
    754,305
    
    
    
    48
    %
    
    
    77
    %
    
    
    72
    %
   (1)
    
    Includes stock-based compensation charge of $6,518, $5,157 and $3,963 in 2004, 2003 and 2002,
respectively.(2)
    
    Includes stock-based compensation charge of $2,642, $5,065 and $1,980 in 2004, 2003 and 2002,
respectively.(3)
    
    Includes stock-based compensation charge of $4,085, $2,285 and $16,461 in 2004, 2003 and
2002, respectively.(4)
    
    Net of stock-based compensation charge of $84 in 2004(5)
    
    Includes stock-based compensation charge of $991 in 2004 Research and Development.Research and development expenses consist primarily of salary,
benefits, and contractors fees for our development and technical support staff, and other costs
associated with the enhancements of existing products and services and development of new products
and services. Research and development expenses decreased $11.9 million, or 6%, from 2003 to 2004,
and increased $35.8 million, or 24%, from 2002 to 2003. The decrease from 2003 to 2004 reflects (i)
a $16.5 million decrease due to the Sniffer sale in July 2004, (ii) a $6.7 million decrease related
to the Magic sale in January 2004, and (iii) a decrease in expenses due to headcount reductions and
the movement of research and development headcount to the Bangalore research facility, which has
lower salary costs, partially offset by (iv) a $9.2 million increase due to a full year impact of
the IntruVert acquisition in 2003, (v) a $2.1 million increase due to strengthening foreign
currencies against the US Dollar in EMEA and Japan in 2004, (vi) a $1.4 million increase in
stock-based compensation, and (vii) a $1.1 million increase due to the acquisition of Foundstone in
October 2004. The $35.8 million increase from 2002 to 2003 was due to $9.7 million and $3.2 million,
respectively, related to our acquisitions IntruVert and Entercept, and our acquisitions Deersoft,
Inc. and Traxess, Inc.; $4.6 million related to the 2003 opening of our research and development
facility in Bangalore, India and $9.0 million related to increased McAfee research and development
expenditures; and $8.0 million related to higher headcount. Research and development expenses include stock-based compensation charges of $6.5 million,
$5.2 million and $4.0 million in 2004, 2003 and 2002, respectively. See Stock Based Compensation
below for further discussion. We believe that continued investment in product development is critical to attaining our
strategic objectives and, as a result, expect product development expenses to remain relatively
flat in future periods and continue to fluctuate as a percentage of net revenue. Marketing and Sales.Marketing and sales expenses consist primarily of salary, commissions
and benefits for marketing and sales personnel and costs associated with advertising and
promotions. Marketing and sales expenses decreased $8.9 million, or 2%, from 2003 to 2004, and
decreased $34.4 million, or 9% from 2002 to 2003. The decrease from 2003 to 2004 reflects (i) a
$14.6 million decrease due to the Sniffer sale in July 2004, the Magic sale in January 2004 and the
impact of headcount reductions in 2004, and (ii) a $2.4 million decrease in stock-based
compensation, partially offset by (iii) a $6.4 million increase in expenses due to strengthening
foreign currencies against the U.S. Dollar in EMEA and Japan in 2004, and (iv) a $1.7 million
increase due to the Foundstone acquisition in October 2004. The decrease of $34.4 million from 2002 to 2003 was primarily due to a corresponding 10%
decrease in net revenue from 2002 to 2003. We also experienced lower sales and marketing expense in
2003 of approximately (i) $10.6 million due to a reduction of salary, 13




---



##### Table of Contents



benefit and commission expenses following a decrease in headcount of approximately 100 sales
personnel, (ii) $5.7 million from our reduced use of outside services and other cost saving
measures, and (iii) $2.1 million related to travel expense cost savings measures, which were
partially offset by (iv) an increase in stock-based compensation expense of $3.1 million. As a
result of the change in the way we account for sales commissions, we had lower sales and marketing
expense of approximately $5.0 million. Marketing and sales expenses include stock-based compensation charges of $2.6 million, $5.1
million and $2.0 million for 2004, 2003 and 2002, respectively. See Stock Based Compensation
below for further discussion. We anticipate that marketing and sales expenses will decrease in absolute dollars, and will
continue to fluctuate as a percentage of net revenue. General and Administrative.General and administrative expenses consist principally of salary
and benefit costs for executive and administrative personnel, professional services and other
general corporate activities. General and administrative expenses increased $9.9 million, or 8%,
from 2003 to 2004, and increased $10.5 million, or 9%, from 2002 to 2003. The increase from 2003 to
2004 reflects (i) a $11.1 million increase in costs incurred to comply with Section 404 of the
Sarbanes-Oxley Act (SOX 404), (ii) $2.9 million in consulting fees paid in connection with
strategic planning, (iii) a $4.3 million increase in depreciation expense due to a full year impact
of significant hardware additions for back-office functions in 2003, (iv) a $2.7 million increase
due to strengthening foreign currencies against the US Dollar in EMEA and Japan in 2004, (v) a $1.8
million increase in stock-based compensation expense, and (vi) a $0.8 million increase due to the
Foundstone acquisition in October 2004, partially offset by (vi) $8.8 million in expenses incurred
in 2003 related to financial statement restatements which did not occur in 2004, and a reduction in
headcount and facilities costs related to restructurings in 2004 and 2003. The increase from 2002 to 2003 is due to costs incurred in connection with our restatement of
$8.8 million and acquisition related bonuses of $4.0 million. In 2003, our legal expenses increased
approximately $4.6 million in 2003 from 2002 due to an increase in outside legal services due to
our on-going SEC and DOJ investigations. Our information technology department expenses increased
approximately $6.2 million due to increases in headcount and depreciation and equipment expense. We
also had a full year of internal audit and four months of SOX 404 related expenses in 2003,
resulting in an increase of approximately $0.8 million and $1.4 million, respectively, as compared
to 2002. These increases were partially offset by a decrease in stock-based compensation charges of
$14.2 million from 2002 to 2003. In 2004 and 2003, we recognized acquisition-related compensation of $3.6 million and $4.0
million, respectively, which represents amounts paid to Entercept, IntruVert and Foundstone
employees currently providing services to us. We expect to recognize an additional $4.4 million in
expense related to these services in 2005, and an additional $3.3 million through 2007. General and administrative expenses include stock-based compensation charges of $4.1 million,
$2.3 million and $16.5 million in 2004, 2003 and 2002, respectively. See Stock Based Compensation
below for further discussion. We expect our general and administrative expenses to decrease as we continue to implement cost
control measures and decrease as a percentage of net revenue. (Gain) loss on Sale of Assets and Technology.In January 2004, we completed the sale of our
Magic product line to BMC Software and, as a result, recognized a gain of approximately $46.1
million. In July 2004, we completed the sale of our Sniffer product line to Network General and, as
a result, recognized a gain of approximately $197.4 million. These gains were partially offset by
write-offs of property and equipment. The loss on sale of assets and technology of $0.8 million in 2003 consists of the write-off of
property and equipment. We recognized a $6.7 million and $2.6 million gain on the sale of the PGP Gauntlet businesses
in February 2002, and the PGP Desktop/Encryption assets and technology in August 2002,
respectively. Litigation Reimbursement/Settlement.We agreed to settle a securities class action litigation
in September 2003. The $70.0 million litigation charge was recorded in 2002 because our agreement
to settle, which established the liability to be probable and estimable, occurred prior to the
publication of our 2002 consolidated financial statements in October 2003. We paid the $70.0
million settlement in October 2003. During 2004, we received insurance reimbursements of
approximately $25.0 million from our insurance carriers for insurance coverage related to the class
action lawsuit settled in October 2003. 14




---



##### Table of Contents



Restructuring Charges  2004 Restructuring During 2004, we recorded several restructuring charges related to the reduction of employee
headcount. In the first quarter of 2004, we recorded a restructuring charge of approximately $2.2
million related to the severance of approximately 160 employees, of which $0.7 million and $1.5
million was related to our North America and EMEA operating segments, respectively. The workforce
was reduced primarily due to our sale of Magic in January 2004. In the second quarter of 2004, we
recorded a restructuring charge of approximately $1.6 million related to the severance of
approximately 80 employees in our sales, technical support and general and administrative
functions. Approximately $0.6 million of the restructuring charge was related to our EMEA operating
segment and the remaining $1.0 million was related to our North America operating segment. In the
third quarter of 2004, we recorded a restructuring charge related to ten employees which totaled
approximately $0.9 million, all of which related to our North America operating segment. In the
fourth quarter of 2004, we recorded a restructuring charge of $1.3 million related to 111
employees, of which $0.7 million, $0.2 million, $0.2 million and $0.2 million related to our Latin
America, North America, EMEA and Asia-Pacific (excluding Japan) operating segments, respectively.
All employees have been terminated at December 31, 2004. The reductions in the second, third and
fourth quarters are part of the previously announced cost-savings measures being implemented by us. In September 2004, we announced the move of our European headquarters to Ireland, which is
expected to be substantially completed by the first quarter of 2005. As a result of this
relocation, approximately 80 employees in EMEA research and development, operations and finance
were notified that their jobs would be moving to Ireland. We recorded restructuring charges of $0.2
million and $2.2 million in the third and fourth quarters of 2004, respectively. The costs will be
substantially paid in the first half of 2005. Also in September 2004, we permanently vacated an additional two floors in our Santa Clara
headquarters building. We recorded a $7.8 million accrual for the estimated lease related costs
associated with the permanently vacated facility, offset by a $1.3 million write off of deferred
rent liability. The remaining costs associated with vacating the facility are primarily comprised
of the present value of remaining lease obligations, net of estimated sublease income, along with
estimated costs associated with subleasing the vacated facility. The remaining costs will generally
be paid over the remaining lease term ending in 2013. We also recorded a non-cash charge of
approximately $0.8 million related to disposals of certain leasehold improvements. The
restructuring charge of $6.5 million and related cash outlay are based on managements current
estimates. In the fourth quarter of 2004, we permanently vacated several leased facilities and recorded a
$2.2 million accrual for estimated lease related costs associated with the permanently vacated
facilities. The remaining costs associated with vacating the facilities are primarily comprised of
the present value of remaining lease obligations, net of estimated sublease income, along with
estimated costs associated with subleasing the vacated facility. We adjusted the restructuring accruals related to severance costs and lease termination costs
recorded in 2004. We recorded a $0.3 million adjustment to reduce the EMEA severance accrual for
amounts that were no longer necessary after paying out substantially all accrued amounts to the
former employees. We also recorded a $0.2 million reduction in lease termination costs due to
changes in estimates related to the sublease income to be received over the remaining lease term of
its Santa Clara headquarters building. The following table summarizes our restructuring accrual established from January 1, 2004
through December 31, 2004 (in thousands): Lease
    
    
    SeveranceTermination
    
    
    and OtherCosts
    
    
    Benefits
    
    
    Other Costs
    
    
    TotalBalance, January 1, 2004
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Restructuring accrual
    
    
    8,685
    
    
    
    7,932
    
    
    
    480
    
    
    
    17,097Cash payments
    
    
    (579
    )
    
    
    (4,175
    )
    
    
    (63
    )
    
    
    (4,817
    )Adjustment to liability
    
    
    (222
    )
    
    
    (275
    )
    
    
    
    
    
    
    (497
    )Accretion
    
    
    74
    
    
    
    
    
    
    
    
    
    
    
    74Balance, December 31, 2004
    
    $
    7,958
    
    
    $
    3,482
    
    
    $
    417
    
    
    $
    11,857
  2003
    Restructuring In January 2003, as part of a restructuring effort to gain operational efficiencies, we
consolidated operations formerly housed in three leased facilities in the Dallas, Texas area into
our newly constructed regional headquarters facility in Plano, Texas. The facility houses employees
working in finance, information technology, and the customer support and telesales groups servicing
the McAfee System Protection Solutions and McAfee Network Protection Solutions businesses. As part of the consolidation of activities into the Plano facility, we relocated employees
from our Santa Clara, California headquarters site. As a result of this consolidation, in March
2003, we recorded a $15.6 million accrual for estimated lease related 15




---



##### Table of Contents



costs associated with the
permanently vacated facilities, offset by a $1.9 million write-off of deferred rent liability. The
remaining costs associated with vacating the facility are primarily comprised of the present value
of remaining lease obligations, net of estimated sublease income, along with estimated costs
associated with subleasing the vacated facility. The remaining costs will generally be paid over
the remaining lease term ending in 2013. We also recorded a non-cash charge of approximately $2.1
million related to asset
disposals and discontinued use of certain leasehold improvements and furniture and equipment.
The restructuring charge of $15.8 million and related cash outlay are based on managements current
estimates. During the second and third quarters of 2003, we recorded restructuring charges of $6.8
million and $0.6 million, respectively, which consisted of $6.7 million related to a headcount
reduction of 210 employees and $0.7 million related to other expenses such as legal expenses
incurred in international locations in conjunction with the headcount reduction. The restructuring
charge related to headcount reductions was $0.9 million and $5.8 million in our North American and
EMEA operating segments, respectively. The employees were located in our domestic and international
locations and were primarily in the sales, product development and customer support areas. In the
third and fourth quarters of 2003, we reversed a total of $0.7 million of restructuring accrual in
Europe that was no longer necessary after paying out substantially all accrued amounts to the
former employees. In 2004 and 2003, we adjusted the restructuring accrual related to lease termination costs
previously recorded in 2003. The adjustments decreased the liability by approximately $0.6 million
and $0.3 million due to changes in estimates related to the sublease income to be received over the
remaining lease term. Also in 2004, we recorded a $0.1 million adjustment to reduce the
restructuring accrual for severance and benefits from our EMEA operating segment that would not be
utilized. The following table summarizes the Companys restructuring accrual established in 2003 and
activity through December 31, 2004 (in thousands): Lease
    
    
    SeveranceTermination
    
    
    and OtherCosts
    
    
    Benefits
    
    
    Other Costs
    
    
    TotalBalance, January 1, 2003
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Restructuring accrual
    
    
    15,734
    
    
    
    6,692
    
    
    
    739
    
    
    
    23,165Cash payments
    
    
    (1,707
    )
    
    
    (6,259
    )
    
    
    (167
    )
    
    
    (8,133
    )Adjustment to liability
    
    
    (273
    )
    
    
    (116
    )
    
    
    (572
    )
    
    
    (961
    )Accretion
    
    
    463
    
    
    
    
    
    
    
    
    
    
    
    463Balance, December 31, 2003
    
    
    14,217
    
    
    
    317
    
    
    
    
    
    
    
    14,534Cash payments
    
    
    (1,841
    )
    
    
    (194
    )
    
    
    
    
    
    
    (2,035
    )Adjustment to liability
    
    
    (623
    )
    
    
    (123
    )
    
    
    
    
    
    
    (746
    )Accretion
    
    
    548
    
    
    
    
    
    
    
    
    
    
    
    548Balance, December 31, 2004
    
    $
    12,301
    
    
    $
    
    
    
    $
    
    
    
    $
    12,301
 Our estimates of the excess facilities charge recorded during 2003 and 2004 may vary
significantly depending, in part, on factors which may be beyond our control, such as our success
in negotiating with our lessor, the time periods required to locate and contract suitable subleases
and the market rates at the time of such subleases. Adjustments to the facilities accrual will be
made if further consolidations are required or if actual lease exit costs or sublease income differ
from amounts currently expected. The facility restructuring charges in 2003 and 2004 were allocated
to the North American operating segment. Restructuring Costs  2002.As part of the plan to integrate certain activities of our PGP
product group into our other product groups and to dispose of other product lines, we sold our
Gauntlet business during the first quarter of 2002. In connection with this process, a
restructuring charge of approximately $1.1 million was recorded. The restructuring charge consists
of costs of severance packages for 44 employees as well as related legal and outplacement services.
All amounts were paid as of December 31, 2002. Amortization of Intangibles.We expensed $14.1 million, $15.6 million and $10.7 million of
amortization related to intangibles in 2004, 2003, and 2002, respectively. Intangibles consist of
identifiable intangible assets. The decrease in amortization of $1.6 million in 2004 is the result
of certain intangible assets becoming fully amortized in 2003 and 2004, partially offset by a $0.5
million increase related to the acquisitions of IntruVert and Entercept in 2003 and Foundstone in
2004. The increase in amortization of $4.9 million from 2002 to 2003 was primarily due to the full
year impact in 2003 of amortization of intangible assets resulting from the acquisition of the
McAfee.com minority interest in September 2002. Severance/Bonus Costs Related to Sniffer and Magic Dispositions.In conjunction with the sale
of the Sniffer product line, we incurred severance and bonuses to the former executives of Sniffer
for their assistance in the transaction. The total bonuses and severance expensed was $7.7 million
in 2004, of which $5.3 million has been paid, and the remaining $2.4 million will be paid in the
first quarter of 2006. Furthermore, we accelerated the vesting of these executives stock options,
which resulted in a stock-based compensation charge of approximately $1.0 million. 16




---



##### Table of Contents



In conjunction with the Magic sale, we incurred bonus expense of approximately $1.4 million
for amounts paid to an executive. Reimbursement from Transition Services Agreement.In conjunction with the Sniffer sale, we
entered into a transition services agreement with Network General. Under this agreement, we provide
certain back office services to Network General for a period of time, generally expected to be
through June 2005. The reimbursements we have recognized under this agreement totaled approximately
$6.0 million in 2004. Provision for (Recovery from) Doubtful Accounts, Net.Provision for doubtful accounts
consists of our estimates for the uncollectibility of receivables, net of recoveries of amounts
previously written off. The provision for doubtful accounts was $1.7 million in 2004. The recovery
of doubtful accounts was $1.2 million and $0.2 million in 2003 and 2002, respectively. Acquisition Related Costs not Subject to Capitalization.Acquisition costs not subject to
capitalization consist primarily of expenses incurred by McAfee.com related to our exchange offer
for all outstanding publicly held shares of McAfee.com class A common stock. As of December 31,
2002, these charges totaled $16.0 million, or 2%, of net revenue. No additional costs were incurred
after 2002. In-Process Research and Development.In 2003, we expensed $5.7 million of in-process research
and development related to IntruVert. The ongoing project at IntruVert at the time of the purchase
included the development of the Infinity model of IntruShield sensor. Infinity is a lower end model
of the IntruShield sensor product family that is targeted towards remote offices and branch offices
of large enterprises as well as small/medium businesses. At the date we acquired IntruVert, we
estimated that, on average, 86% of the development effort had been completed and that the remaining
14% of the development effort would take approximately 2 1/2 months to complete and would cost $0.3
million. The efforts required to complete the development of these projects principally related to
finalization of coding, and completion of prototyping, verification, and testing activities
required to establish that products associated with the technologies can be successfully
introduced. The product was completed in the third quarter of 2003 and is being shipped to
customers. The value of the in-process technologies was determined by estimating the projected net
cash flows related to products, including costs to complete the development of the technologies or
products, and the future net revenues that may be earned from the products, excluding the value
attributed to integration with our products or that may have been achieved due to efficiencies
resulting from the combined sales force or the use of our more effective distribution channel.
These cash flows were discounted back to their net present value using a discount rate of 20%
(which represents a premium of approximately 4% over our weighted average cost of capital) and
excluding the value attributable to the use of the in-process technologies in future products. In 2003, we expensed $0.9 million of in-process research and development related to Entercept.
The ongoing projects at Entercept at the time of the purchase consisted of a Linux version of their
current product. At the date we acquired Entercept, we estimated that, on average, 31% of the
development effort had been completed and that the remaining 69% of the development effort would
take approximately eight months to complete and would cost $0.3 million. The efforts required to
complete the development of these projects principally related to additional design efforts,
finalization of coding, and completion of prototyping, verification, and testing activities
required to establish that products associated with the technologies can be successfully
introduced. The product was released in the fourth quarter of 2004. The value of the in-process
technologies was determined by estimating the projected net cash flows related to products,
including costs to complete the development of the technologies or products, and the future net
revenues that may be earned from the products, excluding the value attributed to integration with
our products or that may have been achieved due to efficiencies resulting from the combined sales
force or the use of the our more effective distribution channel. These cash flows were discounted
back to their net present value using a discount rate of 35% (which represents a premium of
approximately 19% over our weighted average cost of capital) and excluding the value attributable
to the use of the in-process technologies in future products. Interest and Other Income.Interest and other income was $15.9 million in 2004, $15.9 million
in 2003 and $27.3 million in 2002. Interest and other income remained consistent from 2003 to 2004
primarily due to an increase in cash and marketable securities of $158.4 million from 2003 to 2004,
partially offset by a $1.3 million loss in 2004 on the interest rate swap we entered into in 2002.
Interest and other income decreased from 2002 to 2003 due to a decrease of cash and marketable
securities of $247.5 million from 2002 to 2003 and an overall decrease in average yields on our
marketable securities. In 2003, we used cash of approximately $217.1 million to purchase Entercept
and IntruVert and $177.3 million to redeem the remaining portion of our outstanding zero coupon
debentures. Interest and Other Expenses.Interest and other expense was $5.3 million in 2004, $7.5
million in 2003 and $25.1 million in 2002. Interest and other expense decreased from 2003 to 2004
due to the redemption and conversion of the convertible debt in August 2004. The $17.6 million
decrease in interest and other expenses from 2002 to 2003 was due to an $8.8 million reduction
related to the repurchase in 2003 of the remaining zero coupon debentures and a $9.2 million
reduction related to the realization of a full year of effect of the interest rate swap we entered
into in July 2002. (Loss) gain on repurchase of convertible debt.In 2004 and 2003, we recognized losses of
$15.1 million and $2.7 million, respectively, on the redemption of all our remaining convertible
debt. In 2003, we redeemed debt which had an aggregate face amount at maturity of $358.0 million
for approximately $177.1 million resulting in a loss on redemption of $2.7 million. In August 2004,
we 17




---



##### Table of Contents



redeemed all of our outstanding $345.0 million 5.25% convertible notes for approximately $265.6
million in cash and the issuance of approximately 4.6 million of our common shares. The $15.1
million loss was the result of the write-off of unamortized debt issuance costs, fair value
adjustment of the debt and a 1.3125% premium paid for redemption. (Loss) gain on Investments, Net.In 2004, we recognized a loss on the sale marketable
securities of $1.7 million. In 2003 and 2002, we recognized gains of $3.1 million and $3.8 million,
respectively. Our investments are classified as available for sale and we may
sell securities from time to time to move funds into investments with more lucrative
investment yields, thus resulting in gains and losses on sale. Impairment of Strategic and Other Investments.In 2002, we recorded impairment charges of
$0.2 million related to an other than temporary decline in the value of our venture and strategic
investments. No such impairment charges were incurred in 2004 and 2003 as all of our investments
had no carrying value. Provision for (benefit from) Income Taxes.The provision for (benefit from) income taxes was
$91.4 million, $16.8 million (including $3.6 million included in the cumulative effect of change in
accounting principle) and $(0.3) million in 2004, 2003 and 2002, respectively. Tax expense was
28.9%, 18.1% (excluding $3.6 million included in the cumulative effect of change in accounting
principle) and 0% of income before income taxes and minority interest for 2004, 2003 and 2002,
respectively. The effective tax rate differs from the statutory rate primarily due to the impact of
research and development tax credits, utilization of foreign tax credits, and lower effective rates
in some overseas jurisdictions. Our future effective tax rates could be adversely affected if
earnings are lower than anticipated in countries where we have lower statutory rates or by
unfavorable changes in tax laws and regulations. Cumulative Effect of Change in Accounting Principle.In 2003, we changed our method of
accounting for recognizing commission expenses to sales personnel, and recorded a one-time credit
of $13.9 million, $10.3 million net of tax. Prior to January 1, 2003, we expensed sales commissions
as incurred. Commissions are now directly related to sales transactions and are deferred and
recognized ratably over the same period as the revenue is recognized and recorded. Stock-Based Compensation We recognized stock-based compensation expense of $14.3 million, $12.5 million and $22.4
million in 2004, 2003 and 2002, respectively, which is included in research and development,
marketing and sales, general and administrative expenses and severance costs related to Sniffer
disposition in the consolidated statements of income. Our stock-based compensation charges are
comprised of the following for the years presented (in thousands): Years Ended December 31,2004
    
    
    2003
    
    
    2002Exchange of McAfee.com options
    
    $
    6,669
    
    
    $
    3,369
    
    
    $
    16,101Former employees
    
    
    1,216
    
    
    
    1,125
    
    
    
    10,118New and existing executives and employees
    
    
    1,928
    
    
    
    424
    
    
    
    1,478Extended life of vested options of terminated employees
    
    
    1,164
    
    
    
    3,720
    
    
    
    Extended vesting term of options
    
    
    
    
    
    
    
    
    
    
    193Extended period of Employee Stock Purchase Plan
    
    
    
    
    
    
    3,869
    
    
    
    Shares purchased outside Employee Stock Purchase Plan and other
    
    
    
    
    
    
    
    
    
    
    62Repriced options
    
    
    3,343
    
    
    
    
    
    
    
    (5,548
    )Total stock-based compensation
    
    $
    14,320
    
    
    $
    12,507
    
    
    $
    22,404
 Described below are the events giving rise to the stock-based compensation charges in 2004.
These stock-based compensation charges are described in greater detail in Note 16 to our
consolidated financial statements. We expect significant future stock-based compensation charges
related to the exchange of McAfee.com options and repriced employee stock options, with the amount
of these charges being impacted by fluctuations in our stock price. Exchange of McAfee.com options.For 2004, 2003 and 2002, we recorded stock-based compensation
of approximately $6.7 million, $3.4 million and $16.1 million, respectively, related to exchanged
options subject to variable accounting. Our stock-based compensation charge related to exchanged
options subject to variable accounting was based on our closing share price of $28.93, $15.04 and
$16.09, respectively. As of December 31, 2004, we had outstanding exchanged options to acquire
approximately 0.4 million shares subject to this variable accounting. Further increases in our
stock price may result in significant additional stock-based compensation expense related to these
options. Former employees.As a result of the Sniffer sale in July 2004, we modified the stock option
agreements of several Sniffer executives by accelerating the vesting of their unvested options. We
recorded a stock-based compensation charge of approximately $1.0 million in 2004. 18




---



##### Table of Contents



In November and December 2003, we extended the vesting period of two employees and also
extended the period after which vesting ends to exercise their options. As these employees
continued to vest after termination and their exercise period was extended an additional 90 days,
we recorded a one-time stock-based compensation charge of approximately $0.1 million in 2004. In October 2002, we terminated the employment of four former McAfee.com executives. These
executives held McAfee.com exchanged options, which are subject to variable accounting. Upon
termination, the options were modified in accordance with a
change in control provision, which resulted in stock-based compensation charges of $1.1
million and $9.9 million in 2003 and 2002, respectively. New and existing executives and employees.In September 2004, our chief financial officer and
chief operating officer announced that he was retiring effective December 31, 2004. Under the terms
of his transition agreement, all of his options vested on December 31, 2004. We recorded
stock-based compensation expense due to the acceleration of vesting of $1.3 million in 2004. In connection with the acquisition of Foundstone in October 2004, we granted stock options to
Foundstone employees which are subject to vesting provisions as the employees provide service to
us. The total stock-based compensation charge was $2.3 million, of which approximately $0.2 million
was recognized in 2004, and an additional $0.5 million was reversed due to terminated employees. An
additional $1.4 million will be recognized through 2008, which is subject to a reduction based on
employees terminating prior to full vesting of their options. In January 2002, our board of directors granted 50,000 shares of restricted stock to our chief
executive officer. The fair value of the restricted stock grant was $1.4 million and is being
recognized as stock-based compensation expense over the vesting period through January 2005. We
recorded stock-based compensation expense of $0.4 million, $0.4 million and $0.5 million in 2004,
2003 and 2002, respectively. In January 2001, we entered into an employment agreement with our chief executive officer
which provided for the grant of 400,000 shares of restricted stock that vested over a two year
period from the date of grant. The fair value of the restricted stock was $2.0 million, of which
the remaining $1.0 million was recognized as stock-based compensation expense in 2002. Extended life of vested options held by terminated employees.As part of the purchase of
Foundstone in October 2004, we granted stock options to Foundstone employees, certain of which
terminated their employment after the acquisition. The terminated employees had 90 days to exercise
their stock options from the date of termination, otherwise the options would expire. We determined
in December 2004 that we would not be able to file the required public company reports with the SEC
that would allow the option holders to exercise their options within the 90 day period. In December
2004, we extended the expiration date of the options approximately one month, resulting in a new
measurement date for the options. We recorded a one-time stock-based compensation charge of $1.0
million in 2004 due to the extension of the expiration date. During a significant portion of 2003, we suspended exercises of stock options until our
required public company reports were filed with the SEC. The period during which stock option
exercises were suspended is known as the black-out period. Due to the blackout period, we have
extended the exercisability of any options that would otherwise terminate during the blackout
period for a period of time equal to a specified period after termination of the blackout period.
Accordingly, we have recorded stock-based compensation charges on the dates the options should have
terminated based on the intrinsic value of the option on the modification date and the option
price. In 2004 and 2003, we recorded stock-based compensation charges of approximately $0.1 million
and $3.7 million, respectively. Extended period of Employee Stock Purchase Plan.During the blackout period in 2003, we
suspended all stock purchases under our 2002 Employee Stock Purchase Plan (2002 Purchase Plan).
Due to the blackout period, we extended the purchase period for shares in the 2002 Purchase Plan
that would otherwise have been purchased on July 31, 2003. Accordingly, in 2003 we recorded a
one-time stock-based compensation charge of approximately $3.9 million. Repriced Options.In April 1999, we offered to substantially all of our employees, excluding
executive officers, the right to cancel certain outstanding stock options and receive new options
with an exercise price equivalent to the fair market value of our stock at the time of grant.
Options to purchase a total of 9.5 million shares were cancelled and the same number of new options
were granted. These new options vest at the same rate that they would have vested under previous
option plans and are subject to variable accounting. Stock-based compensation expense will be
recorded in the event our stock price closes above $20.375 at the end of period. We have and will
continue to remeasure compensation cost for these repriced options until these options are
exercised, cancelled or forfeited without replacement. Depending upon movements in the market value
of our common stock, this accounting treatment may result in additional stock-based compensation
charges or reversals in future periods. During 2004 and 2002, we incurred charges (credits) to earnings of approximately $3.3 million
and ($6.5) million, respectively, based on closing stock prices of $28.93 and $16.09, respectively.
We did not record any stock-based compensation for the repriced 19




---



##### Table of Contents



options in 2003 as our stock price
was below $20.375 as of December 31, 2002 and throughout 2003. As of December 31, 2004, 0.3 million
options were outstanding and subject to variable accounting. We also incurred an initial stock-based compensation charge in connection with the initial
issuance of the repriced options. Approximately $1.0 million was recorded in 2002. Impact of Recent Accounting Pronouncement on Stock-Based Compensation.In December 2004, the
Financial Accounting Standards Board (FASB) issued SFAS 123R, Share Based Payment(SFAS 123R)
which requires the measurement of all employee share-based payments to employees, including grants
of employee stock options, using a fair-value-based method and the recording of such expense in the
consolidated statements of income. The accounting provisions of SFAS 123R are effective for
reporting periods beginning after June 15, 2005. We are required to adopt SFAS 123R in the third
quarter of 2005. The pro forma disclosures previously permitted under SFAS 123 no longer will be an
alternative to financial statement recognition. See Note 2 for the pro forma net income and net
income per share amounts, for fiscal 2002 through fiscal 2004, as if we had used a fair-value-based
method similar to the methods required under SFAS 123R to measure compensation expense for employee
stock incentive awards. Although we have not yet determined whether the adoption of SFAS 123R will
result in amounts that are similar to the current pro forma disclosures under SFAS 123, we are
evaluating the requirements under SFAS 123R and expect the adoption to have a significant adverse
impact on the consolidated results of operations. Acquisition  Foundstone, Inc. On October 1, 2004, we acquired 100% of the outstanding capital shares of Foundstone, Inc., a
provider of risk assessment and vulnerability services and products for $82.5 million in cash and
$3.1 million of direct expenses, totaling $85.6 million. Total consideration paid for the
acquisition was $90.4 million including $4.8 million for the fair value of vested stock options
assumed in the acquisition. We acquired Foundstone to enhance our network protection product line.
The results of operations of Foundstone have been included in our consolidated financial statements
since the date of acquisition. Under the transaction, we recorded approximately $27.0 million for developed technology, $1.0
million for acquired product rights, including revenue related order backlog and contracts, $0.6
million for trade names/trademarks and non-compete arrangements, $59.2 million for goodwill (none
of which is deductible for tax purposes), $2.6 million for net deferred tax liabilities and $5.1
million of tangible assets, net of liabilities. The intangible assets acquired in the acquisition,
excluding goodwill, are being amortized over their estimated useful lives of two to 6.5 years or a
weighted average period of 6.4 years. We accrued $0.3 million in severance costs for employees
terminated at the time of the acquisition, of which less than $0.1 million remains as an accrual as
of December 31, 2004. Liquidity and Capital Resources 2004
    
    
    2003
    
    
    2002(In thousands)Cash, cash equivalents and investments
    
    $
    924,681
    
    
    $
    766,257
    
    
    $
    1,013,709Net cash provided by operating activities
    
    $
    358,913
    
    
    $
    156,304
    
    
    $
    195,093Net cash used in investing activities
    
    $
    (39,373
    )
    
    $
    (374,480
    )
    
    $
    (183,646
    )Net cash (used in)provided by financing activities
    
    $
    (369,867
    )
    
    $
    (146,579
    )
    
    $
    43,736
  Overview We ended 2004 with cash, cash equivalents and investments totaling $924.7 million, as compared
to $766.3 million at the end of 2003. The increase was due primarily to our sale of Sniffer in July
2004 for cash proceeds of $213.8 million, net of direct expenses; our sale of Magic Solutions in
January 2004 for cash proceeds of $47.1 million, net of direct expenses; the receipt of $113.8
million in proceeds from stock issued under options and employee stock purchase plans; the receipt
of $25.0 million in reimbursements from our insurance carriers related to the securities class
action lawsuit; and an increase in deferred revenue, net of dispositions of businesses, of $161.9
million. The receipts of cash were partially offset by our use of $265.6 million to repurchase the
remaining balance of convertible debt; our use of $221.8 million to repurchase shares of our common
stock; our use of $210.6 million for the net purchase of marketable securities; and our use of
$84.7 million to purchase Foundstone. A more detailed discussion of changes in our liquidity
follows.  Operating Activities Net cash provided by operating activities in 2004, 2003 and 2002 was primarily the result of
our net income of $225.1 million, $70.2 million and $128.3 million, respectively, which is adjusted
for non-cash items such as depreciation and amortization, non-cash restructuring charges, acquired
in-process research and development, stock-based compensation, tax benefits from the exercise of 20




---



##### Table of Contents



employee stock options and changes in various assets and liabilities such as accounts payable,
deferred revenue, accounts receivable and other current assets. Our historical and primary source of operating cash flow is the collection of accounts
receivable from our customers and the timing of payments to our vendors and service providers. One
measure of the effectiveness of our collection efforts is average accounts receivable days sales
outstanding (DSO). DSOs were 71 days, 92 days and 69 days at December 31, 2004, 2003 and 2002,
respectively. We calculate accounts receivable DSO on a gross basis by dividing the gross
accounts receivable balance at the end of the quarter by the amount of revenue recognized for the
quarter multiplied by 90 days. We expect DSO to vary from period to period because of changes in
quarterly revenue and the effectiveness of our collection efforts. In 2004, 2003 and 2002, we have
not made any significant changes to our payment terms for our customers, which are generally net
30. Our balances in accounts payable, accrued liabilities and accrued taxes and other liabilities
increased from $402.1 million at December 31, 2003 to $435.1 million at December 31, 2004, causing
a $6.1 million increase in cash from operating activities, net of acquisitions, dispositions and
non-cash items. The increase is primarily due to an increase in accrued taxes payable. Our
operating cash flows will be impacted in the future based on the timing of payments to our vendors
for accounts payable and to taxing authorities. We typically pay our vendors and service providers
in accordance with invoice terms and conditions, and take advantage of invoice discounts when
available. The timing of future cash payments in future periods will be impacted by the nature of
accounts payable arrangements and managements assessment of our cash inflows. In 2004, 2003 and
2002, we have not made any significant changes to our payment timing to our vendors. Our cash balances are held in numerous locations throughout the world, including substantial

amounts held outside the United States. As of December 31, 2004, approximately $327.8 million of
our cash and cash equivalents were held outside the United States. We utilize a variety of tax
planning and financing strategies in an effort to ensure that our worldwide cash is available in
the locations in which it is needed. We have provided for U.S. federal income taxes on these
amounts for consolidated financial statement purposes, except for foreign earnings that are
considered indefinitely reinvested outside the United States. The American Jobs Creations Act of
2004 (AJCA) introduced a limited time 85% dividends received reduction on the repatriation of
certain foreign earnings to a U.S. taxpayer, provided certain criteria are met. We are analyzing
the impact of the AJCA and may repatriate to the United States some or all of our offshore earnings
currently characterized as indefinitely reinvested outside the United States. The range of possible
amounts we are considering for repatriation under this provision is between $0 and $500 million,
and the range of potential additional income taxes is between $0 and $30 million. Our working capital, defined as current assets minus current liabilities, was $259.9 million
and $415.8 million at December 31, 2004 and December 31, 2003, respectively. The cause of the
decrease in working capital of approximately $155.9 million is primarily due to the $132.8 million
increase in the current portion of deferred revenue. Our new perpetual plus licensing model results
in less revenue recognition up-front, therefore causing increases in our deferred revenue.
Additionally, the strengthening of foreign currencies against the U.S. dollar resulted in an
increase in deferred revenue of approximately $18 million. The remainder of the decrease in working
capital is primarily due to an increase in the current portion of accrued taxes payable from 2003
to 2004. We are currently under an SEC and DOJ investigation. As a result of these investigations, we
may be exposed to penalties that may be material to our consolidated financial statements. We expect to meet our obligations as they become due through available cash and internally
generated funds. We expect to continue generating positive working capital through our operations.
However, we cannot predict whether current trends and conditions will continue or what the effect
on our business might be from the competitive environment in which we operate. We believe the
working capital available to us will be sufficient to meet our cash requirements for at least the
next 12 months.  Investing Activities A summary of our investing activities at December 31, 2004, 2003 and 2002 is as follows (in
thousands). The detail of these line items can be seen in our consolidated statement of cash flows: Activity
    
    2004
    
    
    2003
    
    
    2002Cash payments for acquisitions, net
    
    $
    (84,650
    )
    
    $
    (217,256
    )
    
    $
    (118,308
    )Cash payments for property and equipment
    
    
    (25,374
    )
    
    
    (60,027
    )
    
    
    (59,427
    )Net (purchases) proceeds of investments in marketable securities
    
    
    (210,588
    )
    
    
    (97,861
    )
    
    
    8,668Decrease(increase) in restricted cash
    
    
    19,930
    
    
    
    664
    
    
    
    (21,734
    )Proceeds from sale of assets and technology
    
    
    261,309
    
    
    
    
    
    
    
    7,155Net cash used in investing activities
    
    $
    (39,373
    )
    
    $
    (374,480
    )
    
    $
    (183,646
    )
 21




---



##### Table of Contents



Acquisitions In 2004, we paid cash for our acquisition of Foundstone in the amount of $84.7 million, net of
cash assumed. In 2003, we paid cash for our acquisitions of Entercept and IntruVert in the amount
of $124.8 million and $92.3 million, respectively. We purchased IntruVert and Entercept to enhance
our network intrusion prevention products. In September 2002, to, among other things, reduce
customer and brand confusion, we acquired the outstanding minority interest in McAfee.com for a
combination of shares our common stock and $98.4 million total cash payments. In 2002, we also
purchased several smaller entities for cash in the amount of $19.1 million in order to enhance our
products and improve distribution in Latin America. We may buy or make investments in complementary companies, products and technologies. Our
available cash and equity and debt securities may be used to acquire or invest in companies or
products, possibly resulting in significant acquisition-related charges to earnings and dilution to
our stockholders. We have also made divestitures previously. In July and January 2004, we completed the sales of
our Sniffer and Magic businesses, respectively, as part of our continued focus on security and
security related products. In 2004, we received cash proceeds of approximately $213.8 million for
the Sniffer sale and approximately $47.1 million for the Magic sale.  Property and Equipment We added $25.4 million of equipment during 2004 to update hardware for our employees and
enhance various back office systems and purchases of equipment for our Bangalore research and
development facility. We added $60.0 million of equipment during 2003 to update hardware for our
employees and enhance various back office systems, including our new customer relationship
management system which we deployed in early 2004. In 2002, we added $59.4 million of property and
equipment, including approximately $17.0 million related to the construction of our regional office
in Plano, Texas. Our property and equipment additions have been funded from operations. We anticipate that we will continue to purchase property and equipment necessary in the normal
course of our business. The amount and timing of these purchases and the related cash outflows in
future periods is difficult to predict and is dependent on a number of factors including our hiring
of employees, the rate of change in computer hardware/software used in our business and our
business outlook.  Investments We (made net purchases of) and received net proceeds from sales/maturities of our marketable
securities of $(210.6) million, $(97.9 million), and $8.7 million in 2004, 2003 and 2002,
respectively. We have classified our investment portfolio as available for sale, and our
investments are made with a policy of capital preservation and liquidity as the primary objectives.
We generally hold investments in corporate bonds and U.S. government agency securities to maturity;
however, we may sell an investment at any time if the quality rating of the investment declines,
the yield on the investment is no longer attractive or we are in need of cash. Because we invest
only in investment securities that are highly liquid with a ready market, we believe that the
purchase, maturity or sale of our investments has no material impact on our overall liquidity.  Restricted Cash At December 31, 2003, we had on deposit approximately $20.2 million as collateral for our
interest rate swap arrangements we entered into related to our $345.0 million of 5.25% subordinated
convertible debt. The arrangements required us to keep a minimum amount of $20.0 million on deposit
with the swap counterparties, subject to increase based on the fair value of the swap. The swap
agreement terminated in October 2004. The December 31, 2004 restricted cash balance of $0.6 million
consists primarily of cash collateral related to our workers compensation insurance coverage.  Financing Activities The primary uses of cash for financing activities in 2004 were the use of $265.6 million of
cash to repurchase our convertible debt, and the use of $221.8 million for the repurchase common
stock. In 2003 and 2002, we also repurchased debt using $177.3 million and $66.2 million of cash,
respectively. Historically, our recurring cash flows provided by financing activities have been from the
receipt of cash from the issuance of common stock under stock option and employee stock purchase
plans. We received cash proceeds from these plans in the amount of $113.8 million, $35.4 million
and $109.9 million in 2004, 2003 and 2002, respectively. While we expect to continue to receive
these proceeds in future periods, the timing and amount of such proceeds are difficult to predict
and are contingent on a number of factors including the price of our common stock, the number of
employees participating in the plans and general market conditions. 22




---



##### Table of Contents



As our stock price rises, more participants are in the money in their options, and, thus,
more likely to exercise their options, which results in cash to us. As our stock price decreases,
more of our employees are out of the money or under water in regards to their options, and,
therefore, are not able to exercise options, resulting in no cash received by us. The decrease in
cash proceeds from the exercise of stock options and employee stock purchase plans from 2002 to
2003 was primarily the result of the blackout period in most of 2003 due to our restatement. From
March 2003 through November 2003, all purchases under our stock option plans and employee stock
purchase plan were suspended pending the filing with the SEC of our public company reports,
including our restated financial results. Following the October 31, 2003 filing of these reports,
activity under our plans was resumed and increased in 2004. We have a $17.0 million credit facility with a bank. The credit facility is available on an
offering basis, meaning that transactions under the credit facility will be on such terms and
conditions, including interest rate, maturity, representations, covenants and events of default, as
mutually agreed between us and the bank at the time of each specific transaction. The credit
facility is intended to be used for short term credit requirements, with terms of one year or less.
The credit facility can be cancelled at any time. No balances are outstanding as of December 31,
2004. Contractual Obligations Subsequent to the issuance of our Form 10-K, we determined that our contractual obligations as
of December 31, 2004 had been improperly calculated. As a
result, the amounts in the table below have been restated from amounts
previously reported. The restated summary of our contractual obligations at
December 31, 2004 is as follows (in thousands): Payments Due by PeriodLess Than
    
    
    1-3
    
    
    3-5
    
    
    More ThanContractual Obligations
    
    Total
    
    
    1 Year
    
    
    Years
    
    
    Years
    
    
    5 YearsOperating leases(1)
    
    $
    100,578
    
    
    $
    20,025
    
    
    $
    25,424
    
    
    $
    17,680
    
    
    $
    37,449Other commitments(2)
    
    
    23,720
    
    
    
    10,464
    
    
    
    10,741
    
    
    
    2,515
    
    
    
    Purchase obligations(3)
    
    
    3,277
    
    
    
    3,277
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    127,575
    
    
    $
    33,766
    
    
    $
    36,165
    
    
    $
    20,195
    
    
    $
    37,449
   (1)
    
    Operating leases are for office space and office equipment. The operating lease commitments
above reflect contractual and reasonably assured rent escalations under the lease
arrangements. The majority of our lease contractual obligations relate to the following three
leases: $51.2 million for the Santa Clara, California facility lease, $20.5 million for the
Slough, United Kingdom facility lease and $5.2 million for the Cork, Ireland facility lease.(2)
    
    Other commitments are minimum commitments on telecom contracts and contractual commitments
for naming rights and advertising services.(3)
    
    We generally issue purchase orders to our contract manufacturers with delivery dates from
four to six weeks from the purchase order date. In addition, we regularly provide such
contract manufacturers with rolling six-month forecasts of product requirements for planning
and long-lead time parts procurement purposes only. We are committed to accept delivery of
materials pursuant to our purchase orders subject to various contract provisions which allow
us to delay receipt of such order or allow us to cancel orders beyond certain agreed lead
times. Such cancellations may or may not include cancellation costs payable by us. If we are
unable to adequately manage our contract manufacturers and adjust such commitments for changes
in demand, we may incur additional inventory expenses related to excess and obsolete
inventory. Off-Balance Sheet Arrangements As part of our ongoing business, we do not participate in transactions that generate
relationships with unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, often established for the purpose of
facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. All
of our subsidiaries are 100% owned by us and are fully consolidated into our consolidated financial
statements. Convertible Debt On August 17, 2001, we issued 5.25% convertible subordinated notes (Notes) with an aggregate
principal amount of $345.0 million. The issuance generated net proceeds to us of approximately
$335.1 million (after deducting fees and expenses). The Notes had a maturity date of August 15,
2006, unless earlier redeemed by us at our option or converted at the holders option. Interest was
payable semi-annually in cash in arrears on February 15 and August 15 of each year, commencing
February 15, 2002. At the option of the holder, the Notes could be converted into our common stock
at any time, unless previously redeemed, at a conversion price of $18.07 per share. We had the
option to redeem all or a portion of the Notes for cash at a repurchase price of 101.3125% of the
principal amount at any time between August 20, 2004 and August 14, 2005. On August 20, 2004, we
redeemed the outstanding balance for approximately $265.6 million in cash. Prior to the redemption
date, approximately $83.4 million in aggregate principal was converted into approximately 4.6
million shares of our common stock. We recorded a loss on redemption of the Notes of 23




---



##### Table of Contents



approximately
$15.1 million due to the write-off of unamortized debt issuance costs, fair value adjustment of the
debt and the premium paid for redemption. We had interest rate swap agreements with two banks to hedge the interest rate risk on the
Notes. The Swap agreements had a maturity date of August 15, 2006, subject to early termination
provisions if on or after August 20, 2004 and prior to August 15, 2006 the average closing price of
our common stock equals or exceeds $22.59 per share for a five-day period. We left the swap
agreements intact after the Notes were redeemed in August 2004. On October 27, 2004, the swap
agreements automatically terminated under the terms of the agreements as our five-day average stock
price equaled the $22.59 threshold. In February 1998, we issued zero coupon convertible subordinated debentures due 2018 with an
aggregate face amount at maturity of $885.5 million and generating net proceeds to us of
approximately $337.6 million. Prior to December 31, 2002, we repurchased zero coupon debentures
with an aggregate face amount of approximately $527.0 million, at a total price of $239.9 million.
On February 13, 2003, we paid approximately $177.1 million in cash to redeem approximately $358.0
million in face amount of the zero coupon debentures. On June 9, 2003, we redeemed the remaining
zero coupon debentures with an aggregate face amount at maturity of $0.5 million for a net price of
$0.2 million. Stock Repurchases In 2004 and 2003, we repurchased 12.6 million and 0.4 million shares or our common stock in
the open market for $221.8 million and $4.7 million, respectively. As of December 31, 2004, we were
authorized to repurchase an additional $123.6 million of our common stock from time to time through
August 2006, depending upon market conditions, share price and other factors. We repurchased approximately 2.0 million shares of our common stock in the open market for
$47.4 million in March 2005. Financial Risk Management The following discussion about our risk management activities includes forward-looking
statements that involve risks and uncertainties. Actual results could differ materially from those
projected in the forward-looking statements.  Foreign Currency Risk As a global concern, we face exposure to movements in foreign currency exchange rates. These
exposures may change over time as business practices evolve and could have a material adverse
impact on our financial results. Our primary exposures are related to non U.S. dollar-denominated
sales and operating expenses in Japan, Canada, Australia, Europe, Latin America, and Asia. At the
present time, we hedge only those currency exposures associated with certain assets and liabilities
denominated in nonfunctional currencies and do not generally hedge anticipated foreign currency
cash flows. Our hedging activity is intended to offset the impact of currency fluctuations on
certain nonfunctional currency assets and liabilities. The success of this activity depends upon
estimates of transaction activity denominated in various currencies, primarily the Japanese Yen,
Canadian dollar, Australian dollar, the Euro, and the British Pound. To the extent that these
estimates are overstated or understated during periods of currency volatility, we could experience
unanticipated currency gains or losses. To reduce exposures associated with nonfunctional net monetary asset positions in various
currencies, we enter into spot, forward and swap foreign exchange contracts. Our foreign exchange
contracts typically range from one to three months in original maturity. In general, we have not
hedged anticipated foreign currency cash flows nor do we enter into forward contracts for trading
purposes. We do not use any derivatives for speculative purposes. Our existing forward contracts do
not qualify for hedge accounting and accordingly are marked to market at the end of each reporting
period with any unrealized gain or loss being recognized in the consolidated statements of income.
Net realized gains and losses arising from settlement of our forward foreign exchange contracts
were not significant in 2004, 2003, and 2002. The forward contracts outstanding and their fair values are presented below as of December 31
(in thousands): 2004
    
    
    2003Carrying
    
    
    Fair
    
    
    Carrying
    
    
    FairValue
    
    
    Value
    
    
    Value
    
    
    ValueEuro
    
    $
    116
    
    
    $
    116
    
    
    $
    490
    
    
    $
    490British Pound Sterling
    
    
    288
    
    
    
    288
    
    
    
    54
    
    
    
    54Brazilian Real
    
    
    420
    
    
    
    420
    
    
    
    
    
    
    
    Singapore Dollar
    
    
    
    
    
    
    
    
    
    
    (16
    )
    
    
    (16
    )Japanese Yen
    
    
    1
    
    
    
    1
    
    
    
    
    
    
    
    Australian Dollar
    
    
    4
    
    
    
    4
    
    
    
    75
    
    
    
    75Canadian Dollar
    
    
    39
    
    
    
    39
    
    
    
    255
    
    
    
    255$
    868
    
    
    $
    868
    
    
    $
    858
    
    
    $
    858
 24




---



##### Table of Contents



Interest Rate Risk In July 2002, we entered into interest rate swap transactions (the Transactions) with two
investment banks (the Banks), to hedge the interest rate risk of its outstanding 5.25%
Convertible Subordinated Note due 2006 (Notes) (See Note 7 to the consolidated financial
statements). The notional amount of the Transactions was $345.0 million to match the entire principal
amount of the Notes. We received from the Banks fixed payments equal to 5.25% percent of the
notional amount, payable on February 15 and August 15 which started on
August 15, 2002. In exchange, we paid to the Banks floating rate payments based upon the
London Interbank Offered Rate (LIBOR) plus 1.66% multiplied by the notional amount of the
Transactions with the LIBOR resetting every three months which began on August 15, 2002. The Transactions were to terminate on August 15, 2006 (Termination Date), subject to certain
early termination provisions if on or after August 20, 2004 and prior to August 15, 2006 the
five-day average closing price of our common stock were to equal or exceed $22.59. On October 27,
2004, the Transactions automatically terminated as our five-day average common stock price equaled
$22.59. The Transactions qualified and were designated as a fair value hedge under SFAS 133,
Accounting for Derivative Instruments and Hedging Activitiesto hedge against movements in the
fair value of the Notes due to changes in the benchmark interest rate. Under the fair value hedge
model, the derivative was recognized at fair value on the consolidated balance sheet with an
offsetting entry to the consolidated income statement. In addition, changes in fair value of the
Notes due to changes in the benchmark interest rate were recognized as a basis adjustment to the
carrying amount of the Notes with an offsetting entry to the consolidated income statement. The
gain or loss from the change in fair value of the Transaction and the offsetting change in the fair
value of the Notes were recognized as interest and other expense. The net gain recorded as of
December 31, 2003 was approximately $5.6 million. There was no net gain or loss as of December 31,
2004 as the Transactions terminated in October 2004. To test effectiveness of the hedges, regression analysis was performed at least quarterly
comparing the change in fair value of the Transactions and the Notes. The fair values of the
Transactions and the Notes were calculated at least quarterly as the present value of the
contractual cash flows to the expected maturity date, where the expected maturity date is based on
probability-weighted analysis of interest rates relating to the five-year LIBOR curve and our stock
prices. For the year ended December 31, 2003, the hedge was highly effective and therefore, the
ineffective portion did not have a material impact on earnings. In support of our obligation under the Transactions, we were required to maintain with the
Banks a minimum level of cash and investment collateral of $20.0 million and periodically adjust
the overall level of collateral depending on the fair market value of the Transactions. This
minimum amount of collateral was presented as restricted cash in our consolidated financial
statements at December 31, 2003.  Cash Management Risk We maintain balances in cash, cash equivalents and investment securities. We maintain our
investment securities in portfolio holdings of various issuers, types and maturities including
money market, government, agency and corporate bonds. These securities are classified as
available-for-sale, and consequently are recorded on the consolidated balance sheet at fair value
with unrealized gains and losses reported as a separate component of accumulated other
comprehensive income. These securities are not leveraged and are held for purposes other than
trading. The following tables present the hypothetical changes in fair values in the securities held at
December 31, 2004 that are sensitive to the changes in interest rates. The modeling technique used
measures the change in fair values arising from hypothetical parallel shifts in the yield curve of
plus or minus 50 basis points (BPS), 100 BPS and 150 BPS over six and twelve-month time horizons.
Beginning fair values represent the market principal plus accrued interest and dividends at
December 31, 2004. Ending fair values are the market principal plus accrued interest, dividends and
reinvestment income at six and twelve month time horizons. The following table estimates the fair value of the portfolio at a six-month time horizon (in
millions): Valuation ofSecurities Givenan Interest Rate
    
    
    
    
    
    
    Valuation of Securities GivenDecrease of
    
    
    No
    
    
    an Interest Rate Increase ofX Basis Points
    
    
    Change in
    
    
    X Basis PointsIssuer
    
    100 BPS
    
    
    50 BPS
    
    
    Interest Rate
    
    
    50 BPS
    
    
    100 BPS
    
    
    150 BPSU.S. Government notes and bonds
    
    $
    288.8
    
    
    $
    287.3
    
    
    $
    285.8
    
    
    $
    285.4
    
    
    $
    283.9
    
    
    $
    282.4Municipal bonds
    
    
    4.9
    
    
    
    4.9
    
    
    
    4.9
    
    
    
    4.9
    
    
    
    4.9
    
    
    
    4.9Corporate notes, bonds and preferreds
    
    
    422.1
    
    
    
    421.1
    
    
    
    420.1
    
    
    
    419.1
    
    
    
    418.1
    
    
    
    417.1Total
    
    $
    715.8
    
    
    $
    713.3
    
    
    $
    710.8
    
    
    $
    709.4
    
    
    $
    706.9
    
    
    $
    704.4
 25




---



##### Table of Contents



The following table estimates the fair value of the portfolio at a twelve-month time
horizon (in millions): Valuation ofSecurities Givenan Interest Rate
    
    
    
    
    
    
    Valuation of Securities GivenDecrease of
    
    
    No
    
    
    an Interest Rate Increase ofX Basis Points
    
    
    Change in
    
    
    X Basis PointsIssuer
    
    100 BPS
    
    
    50 BPS
    
    
    Interest Rate
    
    
    50 BPS
    
    
    100 BPS
    
    
    150 BPSU.S. Government notes and bonds
    
    $
    292.9
    
    
    $
    291.6
    
    
    $
    290.3
    
    
    $
    289.1
    
    
    $
    287.8
    
    
    $
    286.5Municipal bonds
    
    
    5.0
    
    
    
    5.0
    
    
    
    5.0
    
    
    
    5.0
    
    
    
    5.0
    
    
    
    5.0Corporate notes, bonds and preferreds
    
    
    428.3
    
    
    
    427.5
    
    
    
    426.6
    
    
    
    425.8
    
    
    
    425.0
    
    
    
    424.2Total
    
    $
    726.2
    
    
    $
    724.1
    
    
    $
    721.9
    
    
    $
    719.9
    
    
    $
    717.8
    
    
    $
    715.7
 Recent Accounting Pronouncements Update See Note 2 of the consolidated financial statements for a full description of recent
accounting pronouncements, including the expected dates of adoption and effects on financial
condition, results of operations and cash flows. 26




---



##### Table of Contents



Item 9A.Controls and Procedures Evaluation of Disclosure Controls and Procedures Our management evaluated, with the participation of our Chief Executive Officer (CEO) and
Chief Financial Officer (CFO), the effectiveness of the design and operation of our disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange
Act of 1934, as amended (the Exchange Act)) as of the end of the period covered by this annual
report on Form 10-K/A. Based on this evaluation, and because of the material weaknesses in our
internal control over financial reporting described below, our management, including our CEO and
CFO, has concluded that, as of December 31, 2004, our disclosure controls and procedures were
ineffective to ensure that the information we are required to disclose in reports that we file or
submit under the Exchange Act is recorded, processed, summarized and reported within the time
periods specified in Securities and Exchange Commission rules and forms. Managements Report on Internal Control over Financial Reporting Our management, with the participation of our CEO and CFO, is responsible for establishing and
maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) of the
Exchange Act. Our internal controls are designed to provide reasonable assurance to our management
and members of our Board of Directors regarding the preparation and fair presentation of published
financial statements in accordance with generally accepted accounting principles of the United
States of America (GAAP). As part of our compliance efforts relative to Section 404 of the Sarbanes-Oxley Act of 2002,
our management assessed the effectiveness of our internal control over financial reporting as of
December 31, 2004. In making this assessment, management used the criteria set forth in the
Internal Control  Integrated Frameworkby the Committee of Sponsoring Organizations of the
Treadway Commission (COSO). In performing the assessment, our management has identified three material weaknesses in
internal control over financial reporting existing as of December 31, 2004. Accounting for Income Taxes While preparing the annual provision for 2004 income taxes, we identified certain unreconciled
differences in our tax reserve accounts dating back to calendar years 2002 and 2003. After further
analysis, we determined that no adjustments were required to prior or current year financial
statements. However, in reaching this conclusion, our management noted that there was a lack of
historic analysis and documentation, ineffective account reconciliation procedures, and
insufficient tax accounting personnel which did not allow the timely calculation of the year end
tax provisions. Given the significance of the tax account balances and the absence of sufficient
mitigating controls, these deficiencies which existed as of December 31, 2004 represent a material
weakness in internal control over financial reporting on the basis that there is more than a remote
likelihood that a material misstatement in our interim or annual financial statements due to errors
in accounting for income taxes could occur and would not be prevented or detected by our internal
control over financial reporting. Revenue Accounting In August 2004, we restated our results for the first quarter of 2004 as a result of revenue
accounting misstatements that resulted from the improper system set up of a limited number of
product stock keeping units. Subsequent to this event, we took action to remediate our revenue
accounting controls. During the fourth quarter 2004 review and audit process, we noted that certain
revenue accounting controls relating to (a) the analysis of transactions in certain geographies and
(b) the deferral and amortization of the appropriate amounts of post contract support had not
operated as designed and adjustments were recorded in the consolidated financial statements for the
year ended December 31, 2004 to correct the identified errors. Our management has concluded that
given the magnitude of the revenue adjustments recorded and the potential for misstatements to
occur as a result of internal control deficiencies in revenue accounting existing as of December
31, 2004, there is more than a remote likelihood that a material misstatement in our interim or
annual financial statements could occur and would not be prevented or detected by our internal
control over financial reporting. 27




---



##### Table of Contents



Financial Close and Reporting Process During the 2004 year end review and audit process, we identified a series of adjustments
relating to complex transactions and balance sheet reconciliations and were unable to complete the
financial close process in a timely manner due to a lack of sufficient accounting personnel. Given
the number of adjustments identified, the significance of the financial closing and reporting
process to the preparation of reliable financial statements, and the potential for errors to
significant account balances to occur as of December 31, 2004, our management has concluded that
there is more than a remote likelihood that a material misstatement in our interim or annual
financial statements could occur and would not be prevented or detected by our internal control
over financial reporting. As a result of the material weaknesses described above, managements conclusion is that, as of
December 31, 2004, the Company did not maintain effective internal control over financial reporting
based upon the criteria set forth in COSOs Internal Control  Integrated Framework. Deloitte & Touche LLP, an independent registered public accounting firm, has issued an
attestation report on managements assessment of our internal control over financial reporting.
That report appears below. On October 1, 2004, we completed the acquisition of all of Foundstone, Inc., as discussed
elsewhere in this report under Business  Overview, Managements Discussion and Analysis of
Financial Condition and Results of Operations and Note 4 to our consolidated financial statements.
Therefore, in making managements assessment of the effectiveness of our internal control over
financial reporting, we have excluded Foundstone, whose financial statements reflect total assets
and revenues constituting 0.6% and 0.3%, respectively, of the related consolidated financial
statement amounts as of and for the year ended December 31, 2004, from our report on internal
control over financial reporting as management did not have sufficient time to make an assessment
of Foundstones internal controls using the COSO criteria in accordance with Section 404 of the
Sarbanes-Oxley Act. Changes in Internal Control over Financial Reporting We undertook significant efforts in 2004 to establish a framework to improve internal controls
over financial reporting. We committed considerable resources to the design, implementation,
documentation and testing of our internal controls. Additional efforts were required to remediate
and re-test certain internal control deficiencies. Our management believes that these efforts have
improved our internal control over financial reporting. While these steps have helped address some of the internal control deficiencies noted above,
they have not been sufficient to remedy the control issues that existed as of December 31, 2004. We
are taking the following steps to remediate these material weaknesses:  
    Increasing the number of internal general ledger and tax accounting personnel trained in
reporting under accounting principles generally accepted in the United States (GAAP)
    Improving the documentation, communication and periodic review of our accounting policies
throughout our domestic and international locations for consistency and application with
GAAP at each of our operating locations
    Improving the interim and annual review and reconciliation process for certain key
account balances
    Enhancing the training and education for our international finance and accounting
personnel and new hire additions to the worldwide finance team
    Implementing more stringent policies and procedures regarding revenue accounting and
change management of our product catalogue
    Directing more internal audit time and attention to sales order processing and revenue accounting activities
    Increasing diligence regarding user access and change management to our network, databases and applications
    Automating certain controls that are currently performed manually
    Simplifying and integrating systems 28




---



##### Table of Contents



Inherent Limitation on the Effectiveness of Internal Controls The effectiveness of any system of internal control over financial reporting, including
McAfees, is subject to inherent limitations, including the exercise of judgment in designing,
implementing, operating, and evaluating the controls and procedures, and the inability to eliminate
misconduct completely. Accordingly, any system of internal control over financial reporting,
including McAfees, can only provide reasonable, not absolute assurances. In addition, projections
of any evaluation of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of compliance with the
policies or procedures may deteriorate. We intend to continue to monitor and upgrade our internal
controls as necessary or appropriate for our business, but cannot assure you that such improvements
will be sufficient to provide us with effective internal control over financial reporting. REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of McAfee, Inc. (formerly known as Network Associates, Inc.): We have audited managements assessment, included in the accompanying Managements Report on
Internal Control Over Financial Reporting (Managements Report), that McAfee, Inc. and
subsidiaries (the Company) did not maintain effective internal control over financial reporting
as of December 31, 2004, because of the effect of the material weaknesses identified in
managements assessment based on criteria established in Internal Control  Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission. As described in
Managements Report, management excluded from their assessment the internal control over financial
reporting at Foundstone, Inc. which was acquired on October 1, 2004 and whose financial statements
reflect total assets and revenues constituting 0.6% and 0.3%, respectively, of the related
consolidated financial statement amounts as of and for the year ended December 31, 2004.
Accordingly, our audit did not include the internal control over financial reporting at Foundstone,
Inc. The Companys management is responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express an opinion on managements assessment and an opinion on
the effectiveness of the Companys internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether effective internal control over financial reporting was
maintained in all material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating managements assessment, testing and evaluating the
design and operating effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audit provides a reasonable basis
for our opinions. A companys internal control over financial reporting is a process designed by, or under the
supervision of, the companys principal executive and principal financial officers, or persons
performing similar functions, and effected by the companys board of directors, management, and
other personnel to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance with generally
accepted accounting principles. A companys internal control over financial reporting includes
those policies and procedures that (1) pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and dispositions of the assets of the
company; (2) provide reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted accounting principles,
and that receipts and expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and (3) provide reasonable assurance
regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the
companys assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including
the possibility of collusion or improper management override of controls, material misstatements
due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any
evaluation of the effectiveness of the internal control over financial reporting to future periods
are subject to the risk that the controls may become inadequate because of changes in conditions,
or that the degree of compliance with the policies or procedures may deteriorate. A material weakness is a significant deficiency, or combination of significant deficiencies,
that results in more than a remote likelihood that a material misstatement of the annual or interim
financial statements will not be prevented or detected. The following material weaknesses have been
identified and included in managements assessment: 29




---



##### Table of Contents




    The Companys controls over the calculation of the income tax provision, taxes payable
and deferred income tax amounts did not operate effectively as of December 31, 2004. In
particular, (1) the Company did not have a sufficient number of personnel with adequate
expertise in income tax accounting matters, (2) historical analyses were not maintained in
sufficient detail and (3) account reconciliations, which are necessary to detect whether
income tax amounts are calculated properly and recorded in the proper period, were not
completed and reviewed in time to permit timely reporting of financial results. Due to the
potential that a material misstatement could occur related to the income tax amounts and the
absence of mitigating controls, there is a more than remote likelihood that a material
misstatement of the interim and annual financial statements would not have been prevented or
detected.
    The Companys controls over the recognition of revenue for software contracts did not
operate effectively as of December 31, 2004. In particular, controls to properly apply the
provisions of AICPA Statement of Position 97-2, Software Revenue Recognition(as amended) to
(1) analyze the terms of new contracts from a certain geographic region and (2) defer and
amortize the appropriate amount applicable to post contract support, did not operate
effectively and audit adjustments to defer revenue that had been improperly recognized were
recorded by the Company for the quarter ended December 31, 2004. Such adjustments in the
aggregate were material to the interim financial statements for that period and the
potential misstatement could have been material to the annual financial statements. In
addition, based on (1) the amount of the misstatements identified and the potential for
additional misstatements related to the revenue recognized, (2) the elevated risk of
misstatement associated with revenue recognition and (3) the absence of mitigating controls,
there is a more than remote likelihood that a material misstatement of the interim and
annual financial statements would not have been prevented or detected.
    The Companys controls over the period-end financial closing and reporting process are
inadequate and constitute a material weakness in the design of internal control over
financial reporting. Specifically, the Company lacks sufficient resources with the
appropriate level of technical accounting expertise within the accounting function and
therefore was unable to accurately perform certain of the designed controls over the
December 31, 2004 financial closing and reporting process on a timely basis, evidenced by a
significant number of adjustments which were necessary to present the financial statements
for the year ended December 31, 2004 in accordance with generally accepted accounting
principles. Based on (1) the misstatements identified and (2) the significance of the
financial closing and reporting process to the preparation of reliable financial statements,
there is a more than remote likelihood that a material misstatement of the interim and
annual financial statements would not have been prevented or detected. These material weaknesses were considered in determining the nature, timing, and extent of
audit tests applied in our audit of the consolidated financial statements and financial statement
schedule as of and for the year ended December 31, 2004 of the Company and this report does not
affect our report on such consolidated financial statements and financial statement schedule. In our opinion, managements assessment that the Company did not maintain effective internal
control over financial reporting as of December 31, 2004, is fairly stated, in all material
respects, based on the criteria established in Internal Control  Integrated Frameworkissued by
the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, because
of the effect of the material weakness described above on the achievement of the objectives of the
control criteria, the Company has not maintained effective internal control over financial
reporting as of December 31, 2004, based on the criteria established in Internal Control 
Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway
Commission. We have also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated financial statements and financial statement
schedule as of and for the year ended December 31, 2004, of the Company and our report dated March
30, 2005 (May 19, 2005 as to the effects of the restatement described
in Note 11) expressed an unqualified opinion on such consolidated financial statements and financial
statement schedule. DELOITTE & TOUCHE LLP San Jose, California
March 30, 2005 30




---



##### Table of Contents



Part IV 
 Item 15.Exhibits and Financial Statement Schedules (a)(1) Financial Statements: PageNumberReports of Independent Registered Public Accounting Firms
    
    
    32Consolidated Balance Sheets: December 31, 2004 and 2003
    
    
    34Consolidated Statements of Income and Comprehensive Income: Years ended December 31, 2004, 2003 and 2002
    
    
    35Consolidated Statements of Stockholders Equity: Years ended December 31, 2004, 2003 and 2002
    
    
    37Consolidated Statements of Cash Flows: Years ended December 31, 2004, 2003, and 2002
    
    
    38Notes to Consolidated Financial Statements
    
    
    39
 (a)(2) Financial Statement Schedule The following financial statement schedule of McAfee, Inc. for the years ended December 31,
2004, 2003, and 2002 is filed as part of this Form 10-K and should be read in conjunction with
McAfee, Inc.s Consolidated Financial Statements. Schedule II  Valuation and Qualifying Accounts on Page 126 Schedules not listed above have been omitted because they are not applicable or are not
required or because the required information is included in the Consolidated Financial Statements
or Notes thereto. (a)(3) Exhibits:See Index to Exhibits on Page 123. The Exhibits listed on the accompanying
Index of Exhibits are filed or incorporated by reference as part of this report. 31




---



##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of
McAfee, Inc. (formerly Network Associates, Inc.): We have audited the accompanying consolidated balance sheet of McAfee, Inc. and subsidiaries
(the Company) as of December 31, 2004, and the related consolidated statements of income and
comprehensive income, stockholders equity, and cash flows for the year then ended. Our audit also
included the financial statement schedule listed in the Index at Item 15(a)(2) for the year ended
December 31, 2004. These financial statements and financial statement schedule are the
responsibility of the Companys management. Our responsibility is to express an opinion on the
financial statements and financial statement schedule based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such 2004 consolidated financial statements present fairly, in all material
respects, the financial position of the Company as of December 31, 2004, and the results of its
operations and its cash flows for the year then ended in conformity with accounting principles
generally accepted in the United States of America. Also, in our opinion, such 2004 financial
statement schedule, when considered in relation to the basic consolidated financial statements
taken as a whole, presents fairly in all material respects the information set forth therein. We have also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the effectiveness of the Companys internal control over financial
reporting as of December 31, 2004, based on the criteria established in Internal Control -
Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission
and our report dated March 30, 2005 expressed an unqualified opinion on managements assessment of
the effectiveness of the Companys internal control over financial reporting and an adverse opinion
on the effectiveness of the Companys internal control over financial reporting. /s/ DELOITTE & TOUCHE LLP San Jose, California
March 30, 2005 (May 19, 2005 as to Note 11) 32




---



##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders
of McAfee, Inc. (formerly Networks Associates, Inc.): In our opinion, the consolidated balance sheet as of December 31, 2003 and the related
consolidated statements of income and comprehensive income, of shareholders equity and of cash
flows for each of the two years in the period ended December 31, 2003 present fairly, in all
material respects, the financial position, results of operations and cash flows of McAfee, Inc. and
its subsidiaries at December 31, 2003 and for each of the two years in the period ended December
31, 2003, in conformity with accounting principles generally accepted in the United States of
America. In addition, in our opinion, the financial statement schedule listed in the index
appearing under Item 15 (a) (2) for each of the two years in the period ended December 31, 2003
presents fairly, in all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements. These financial statements and
financial statement schedule are the responsibility of the Companys management; our responsibility
is to express an opinion on these financial statements and financial statement schedule based on
our audits. We conducted our audits of these statements in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 3 to the consolidated financial statements, the Company changed its
method of accounting for sales commissions effective January 1, 2003. /s/ PricewaterhouseCoopers LLP Dallas, Texas
February 26, 2004 33




---



##### Table of Contents



MCAFEE, INC. AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS
 December 31,2004
    
    
    2003(In thousands, exceptshare data)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    291,155
    
    
    $
    333,651Short-term marketable securities
    
    
    232,929
    
    
    
    174,499Accounts receivable, net of allowance for doubtful accounts of $2,536 and $2,863, respectively
    
    
    137,520
    
    
    
    170,218Prepaid expenses, income taxes and other current assets
    
    
    103,687
    
    
    
    97,616Deferred income taxes
    
    
    200,459
    
    
    
    160,550Assets held for sale
    
    
    
    
    
    
    24,719Total current assets
    
    
    965,750
    
    
    
    961,253Long-term marketable securities
    
    
    400,597
    
    
    
    258,107Restricted cash
    
    
    617
    
    
    
    20,547Property and equipment, net
    
    
    91,715
    
    
    
    111,672Deferred income taxes
    
    
    220,604
    
    
    
    199,196Intangible assets, net
    
    
    107,133
    
    
    
    105,952Goodwill
    
    
    439,180
    
    
    
    443,593Other assets
    
    
    12,080
    
    
    
    20,178Total assets
    
    $
    2,237,676
    
    
    $
    2,120,498LIABILITIESCurrent liabilities:Accounts payable
    
    $
    32,891
    
    
    $
    32,099Accrued liabilities
    
    
    197,368
    
    
    
    147,281Deferred revenue
    
    
    475,621
    
    
    
    342,795Liabilities related to assets held for sale
    
    
    
    
    
    
    23,310Total current liabilities
    
    
    705,880
    
    
    
    545,485Deferred revenue, less current portion
    
    
    125,752
    
    
    
    116,762Convertible debt
    
    
    
    
    
    
    347,397Accrued taxes and other long term liabilities
    
    
    204,796
    
    
    
    222,765Total liabilities
    
    
    1,036,428
    
    
    
    1,232,409Commitments and contingencies (Notes 11, 12 and 20)STOCKHOLDERS EQUITYPreferred stock, $0.01 par value:Authorized: 5,000,000 shares; Issued and outstanding: none in 2004 and 2003
    
    
    
    
    
    
    Common stock, $0.01 par value:Authorized: 300,000,000 shares; Issued:162,266,174 shares and 162,071,798 shares for 2004 and
2003, respectively;Outstanding: 162,266,174 shares and 161,721,798 for 2004 and 2003, respectively
    
    
    1,623
    
    
    
    1,621Treasury stock, at cost: no shares in 2004 and 350,000 shares in 2003
    
    
    
    
    
    
    (4,707
    )Additional paid-in capital
    
    
    1,178,855
    
    
    
    1,087,625Deferred stock-based compensation
    
    
    (1,777
    )
    
    
    (598
    )Accumulated other comprehensive income
    
    
    27,361
    
    
    
    34,027Accumulated deficit
    
    
    (4,814
    )
    
    
    (229,879
    )Total stockholders equity
    
    
    1,201,248
    
    
    
    888,089Total liabilities and stockholders equity
    
    $
    2,237,676
    
    
    $
    2,120,498
 The accompanying notes are an integral part of these consolidated financial statements. 34




---



##### Table of Contents



MCAFEE, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
 Years Ended December 31,2004
    
    
    2003
    
    
    2002(In thousands, except per share data)Net revenue:Product
    
    $
    294,163
    
    
    $
    513,610
    
    
    $
    631,550Services and support
    
    
    616,379
    
    
    
    422,726
    
    
    
    411,494Total net revenue
    
    
    910,542
    
    
    
    936,336
    
    
    
    1,043,044Cost of net revenue:Product
    
    
    73,058
    
    
    
    80,895
    
    
    
    101,019Services and support
    
    
    62,520
    
    
    
    57,362
    
    
    
    60,539Amortization of purchased technology
    
    
    13,331
    
    
    
    11,369
    
    
    
    3,153Total cost of net revenue
    
    
    148,909
    
    
    
    149,626
    
    
    
    164,711Operating costs:Research and development(1)
    
    
    172,717
    
    
    
    184,606
    
    
    
    148,801Marketing and sales(2)
    
    
    354,380
    
    
    
    363,306
    
    
    
    397,747General and administrative(3)
    
    
    139,845
    
    
    
    129,920
    
    
    
    119,393(Gain) loss on sale of assets and technology(4)
    
    
    (240,336
    )
    
    
    788
    
    
    
    (9,301
    )Litigation (reimbursement) settlement
    
    
    (24,991
    )
    
    
    
    
    
    
    70,000Restructuring charges
    
    
    17,493
    
    
    
    22,667
    
    
    
    1,116Amortization of intangibles
    
    
    14,065
    
    
    
    15,637
    
    
    
    10,742Severance/bonus costs related to Sniffer and Magic disposition(5)
    
    
    10,070
    
    
    
    
    
    
    
    Reimbursement from transition services agreement
    
    
    (5,997
    )
    
    
    
    
    
    
    Provision for (recovery of) doubtful accounts, net
    
    
    1,716
    
    
    
    (1,216
    )
    
    
    (219
    )Acquisition related costs not subject to capitalization
    
    
    
    
    
    
    
    
    
    
    16,026In-process research and development
    
    
    
    
    
    
    6,600
    
    
    
    Total operating costs
    
    
    438,962
    
    
    
    722,308
    
    
    
    754,305Income from operations
    
    
    322,671
    
    
    
    64,402
    
    
    
    124,028Interest and other income
    
    
    15,889
    
    
    
    15,917
    
    
    
    27,324Interest and other expenses
    
    
    (5,315
    )
    
    
    (7,543
    )
    
    
    (25,085
    )(Loss) gain on repurchase of convertible debt
    
    
    (15,070
    )
    
    
    (2,727
    )
    
    
    26(Loss) gain on investments, net
    
    
    (1,704
    )
    
    
    3,076
    
    
    
    3,838Impairment of strategic and other investments
    
    
    
    
    
    
    
    
    
    
    (198
    )Income before provision for (benefit from) income taxes, minority
interest and cumulative effect of change in accounting principle
    
    
    316,471
    
    
    
    73,125
    
    
    
    129,933Provision for (benefit from) income taxes
    
    
    91,406
    
    
    
    13,220
    
    
    
    (274
    )Income before minority interest and cumulative effect of change in
accounting principle
    
    
    225,065
    
    
    
    59,905
    
    
    
    130,207Minority interest in income of consolidated subsidiaries
    
    
    
    
    
    
    
    
    
    
    (1,895
    )Income before cumulative effect of change in accounting principle
    
    
    225,065
    
    
    
    59,905
    
    
    
    128,312Cumulative effect of change in accounting principle, net of taxes of $3,590
    
    
    
    
    
    
    10,337
    
    
    
    Net income
    
    $
    225,065
    
    
    $
    70,242
    
    
    $
    128,312Other comprehensive income:Unrealized losses on marketable securities, net of reclassification
adjustment for losses recognized on marketable securities during the
period and income tax
    
    $
    (2,129
    )
    
    $
    (709
    )
    
    $
    (2,667
    )Foreign currency translation (loss) gain
    
    
    (4,537
    )
    
    
    10,578
    
    
    
    10,744Comprehensive income
    
    $
    218,399
    
    
    $
    80,111
    
    
    $
    136,389Basic net income per share:Income before cumulative effect of change in accounting principle
    
    $
    1.40
    
    
    $
    0.37
    
    
    $
    0.86Cumulative effect of change in accounting principle, net of taxes
    
    
    
    
    
    
    0.07
    
    
    
    Net income per share  basic
    
    $
    1.40
    
    
    $
    0.44
    
    
    $
    0.86Shares used in per share calculation  basic
    
    
    160,714
    
    
    
    160,338
    
    
    
    149,441Diluted net income per share:Income before cumulative effect of change in accounting principle
    
    $
    1.31
    
    
    $
    0.36
    
    
    $
    0.80Cumulative effect of change in accounting principle, net of taxes
    
    
    
    
    
    
    0.07
    
    
    
    Net income per share  diluted
    
    $
    1.31
    
    
    $
    0.43
    
    
    $
    0.80Shares used in per share calculation  diluted
    
    
    177,099
    
    
    
    164,489
    
    
    
    176,249
   (1)
    
    Includes stock-based compensation charge of $6,518, $5,157 and $3,963 in 2004, 2003 and 2002,
respectively.(2)
    
    Includes stock-based compensation charge of $2,642, $5,065 and $1,980 in 2004, 2003 and 2002,
respectively. 35




---



##### Table of Contents



(3)
    
    Includes stock-based compensation charge of $4,085, $2,285 and $16,461 in 2004, 2003 and
2002, respectively.(4)
    
    Net of stock-based compensation charge of $84 in 2004.(5)
    
    Includes stock-based compensation charge of $991 in 2004. Year EndedDecember 31, 2002Pro forma amounts assuming the change in accounting principle is applied retroactively:Net income
    
    $
    121,513Basic income per share
    
    $
    0.81Diluted income per share
    
    $
    0.76
 The accompanying notes are an integral part of these consolidated financial statements. 36




---



##### Table of Contents



MCAFEE, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
 AccumulatedOtherAdditional
    
    
    Deferred
    
    
    Comprehensive
    
    
    
    
    
    
    TotalCommon Stock
    
    
    Treasury
    
    
    Paid-In
    
    
    Stock-Based
    
    
    Income
    
    
    Accumulated
    
    
    StockholdersShares
    
    
    Amount
    
    
    Stock
    
    
    Capital
    
    
    Compensation
    
    
    (Loss)
    
    
    Deficit
    
    
    Equity(In thousands)Balances, December 31, 2001
    
    
    140,681
    
    
    $
    1,406
    
    
    $
    
    
    
    $
    752,439
    
    
    $
    
    
    
    $
    16,081
    
    
    $
    (428,433
    )
    
    $
    341,493Issuance of common stock upon exercise of
stock options
    
    
    8,197
    
    
    
    82
    
    
    
    
    
    
    
    99,664
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    99,746Issuance of common stock upon exercise of
stock options by McAfee.com
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,633
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,633Issuance of common stock from Employee
Stock Purchase Plans
    
    
    743
    
    
    
    8
    
    
    
    
    
    
    
    6,524
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,532Issuance of common stock for acquisition
of minority interest in McAfee.com, net
of cost of $1,956
    
    
    8,307
    
    
    
    83
    
    
    
    
    
    
    
    119,397
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    119,480Deferred stock-based compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    31,955
    
    
    
    (31,955
    )
    
    
    
    
    
    
    
    
    
    
    Amortization of deferred stock-based
compensation and other compensation
charge
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,815
    )
    
    
    26,219
    
    
    
    
    
    
    
    
    
    
    
    22,404Reclassification of cash payable in
excess of exercise price related to
exchange of McAfee.com options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,190
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,190
    )Tax benefits from exercise of
non-qualified stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    45,962
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    45,962Stock options issued in connection with
acquisition
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    357
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    357Minority interest attributed to McAfee.com
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,638
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,638
    )Foreign currency translation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,744
    
    
    
    
    
    
    
    10,744Net decrease in unrealized gains on
investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,667
    )
    
    
    
    
    
    
    (2,667
    )Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    128,312
    
    
    
    128,312Balances, December 31, 2002
    
    
    157,928
    
    
    
    1,579
    
    
    
    
    
    
    
    1,050,288
    
    
    
    (5,736
    )
    
    
    24,158
    
    
    
    (300,121
    )
    
    
    770,168Issuance of common stock upon exercise of
stock options
    
    
    2,548
    
    
    
    26
    
    
    
    
    
    
    
    19,610
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19,636Issuance of common stock from Employee
Stock Purchase Plans
    
    
    1,596
    
    
    
    16
    
    
    
    
    
    
    
    15,765
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    15,781Repurchase of common stock
    
    
    (350
    )
    
    
    
    
    
    
    (4,707
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,707
    )Deferred stock-based compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (643
    )
    
    
    643
    
    
    
    
    
    
    
    
    
    
    
    Amortization of deferred stock-based
compensation and other stock-based
compensation charge
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,012
    
    
    
    4,495
    
    
    
    
    
    
    
    
    
    
    
    12,507Reclassification of cash payable in
excess of exercise price related to
exchange of McAfee.com options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,407
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,407
    )Foreign currency translation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,578
    
    
    
    
    
    
    
    10,578Net decrease in unrealized gains on
investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (709
    )
    
    
    
    
    
    
    (709
    )Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    70,242
    
    
    
    70,242Balances, December 31, 2003
    
    
    161,722
    
    
    
    1,621
    
    
    
    (4,707
    )
    
    
    1,087,625
    
    
    
    (598
    )
    
    
    34,027
    
    
    
    (229,879
    )
    
    
    888,089Issuance of common stock upon exercise of
stock options
    
    
    9,152
    
    
    
    92
    
    
    
    
    
    
    
    105,638
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    105,730Issuance of common stock from Employee
Stock Purchase Plans
    
    
    775
    
    
    
    8
    
    
    
    
    
    
    
    8,055
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,063Issuance of common stock upon exercise of
warrants
    
    
    184
    
    
    
    2
    
    
    
    
    
    
    
    (2
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Issuance of common stock upon conversion
of debt
    
    
    4,616
    
    

    
    46
    
    
    
    
    
    
    
    83,364
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    83,410Repurchase of common stock
    
    
    (12,623
    )
    
    
    
    
    
    
    (221,816
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (221,816
    )Retirement of treasury stock
    
    
    
    
    
    
    (130
    )
    
    
    226,523
    
    
    
    (226,393
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Deferred stock-based compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,443
    
    
    
    (6,443
    )
    
    
    
    
    
    
    
    
    
    
    Shares returned from trust
    
    
    (1,560
    )
    
    
    (16
    )
    
    
    
    
    
    
    16
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Amortization of deferred stock-based
compensation and other stock-based
compensation charge
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,804
    
    
    
    7,516
    
    
    
    
    
    
    
    
    
    
    
    14,320Reclassification of cash payable in
excess of exercise price related to
exchange of McAfee.com options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,154
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,154
    )Contribution of proceeds from sale of
common stock held in trust
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,779
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,779Tax benefits from exercise of
non-qualified stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    72,622
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    72,622Stock options issued in connection with
acquisition
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,039
    
    
    
    (2,252
    )
    
    
    
    
    
    
    
    
    
    
    4,787Release of deferred tax valuation
allowance related to acquisition
accounted for as a pooling of interests
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    27,019
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    27,019Foreign currency translation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,537
    )
    
    
    
    
    
    
    (4,537
    )Net decrease in unrealized gains on
investment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,129
    )
    
    
    
    
    
    
    (2,129
    )Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    225,065
    
    
    
    225,065Balances, December 31, 2004
    
    
    162,266
    
    
    $
    1,623
    
    
    $
    
    
    
    $
    1,178,855
    
    
    $
    (1,777
    )
    
    $
    27,361
    
    
    $
    (4,814
    )
    
    $
    1,201,248
 The accompanying notes are an integral part of these consolidated financial statements. 37




---



##### Table of Contents



MCAFEE, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 Years Ended December 31,2004
    
    
    2003
    
    
    2002(In thousands)Cash flows from operating activities:Net income
    
    $
    225,065
    
    
    $
    70,242
    
    
    $
    128,312Adjustments to reconcile net income to net cash provided by
operating activities:Cumulative effect of change in accounting principle, net
    
    
    
    
    
    
    (10,337
    )
    
    
    Depreciation and amortization
    
    
    66,699
    
    
    
    62,830
    
    
    
    53,684Non-cash restructuring charge
    
    
    9,624
    
    
    
    14,534
    
    
    
    Acquired in-process research and development
    
    
    
    
    
    
    6,600
    
    
    
    Premium amortization of marketable securities
    
    
    4,614
    
    
    
    7,114
    
    
    
    Provision for (recovery of) doubtful accounts
    
    
    1,716
    
    
    
    (1,216
    )
    
    
    (219
    )Non-cash interest and other expense on convertible debt
    
    
    1,224
    
    
    
    3,162
    
    
    
    12,025Stock-based compensation charges
    
    
    14,320
    
    
    
    12,507
    
    
    
    22,404Deferred income taxes
    
    
    (21,503
    )
    
    
    (25,368
    )
    
    
    (65,208
    )Loss (gain) on sale of investments
    
    
    1,704
    
    

    
    (3,076
    )
    
    
    (3,838
    )Impairment of strategic and other investments
    
    
    
    
    
    
    
    
    
    
    198Minority interest
    
    
    
    
    
    
    
    
    
    
    1,895Loss (gain) on repurchase of zero coupon convertible debenture
    
    
    15,070
    
    
    
    2,727
    
    
    
    (26
    )(Gain) loss on sale of assets and technology
    
    
    (238,923
    )
    
    
    788
    
    
    
    (9,301
    )Tax benefit from exercise of nonqualified stock options
    
    
    72,622
    
    
    
    
    
    
    
    45,962Change in fair value of interest rate swap, net of change in
the fair value of the debt
    
    
    382
    
    
    
    (5,646
    )
    
    
    (1,402
    )Changes in assets and liabilities, net of acquisitions:Accounts receivable
    
    
    44,524
    
    
    
    (6,676
    )
    
    
    (15,805
    )Prepaid expenses, income taxes and other assets
    
    
    (6,267
    )
    
    
    (17,624
    )
    
    
    9,699Accounts payable, accrued taxes and other liabilities
    
    
    6,109
    
    
    
    (78,452
    )
    
    
    77,993Deferred revenue
    
    
    161,933
    
    
    
    124,195
    
    
    
    (61,280
    )Net cash provided by operating activities
    
    
    358,913
    
    
    
    156,304
    
    
    
    195,093Cash flows from investing activities:Purchase of marketable securities
    
    
    (1,243,990
    )
    
    
    (1,120,561
    )
    
    
    (773,093
    )Proceeds from sale and maturity of marketable securities
    
    
    1,033,402
    
    
    
    1,022,700
    
    
    
    781,761Decrease (increase) in restricted cash
    
    
    19,930
    
    
    
    664
    
    
    
    (21,734
    )Purchase of minority interest in McAfee.com
    
    
    
    
    
    
    
    
    
    
    (98,447
    )Purchases of acquired technology
    
    
    
    
    
    
    (178
    )
    
    
    (807
    )Acquisitions, net of cash acquired
    
    
    (84,650
    )
    
    
    (217,078
    )
    
    
    (19,054
    )Purchase of property and equipment and leasehold improvements, net
    
    
    (25,374
    )
    
    
    (60,027
    )
    
    
    (59,427
    )Sale of Secure Computing shares and collar
    
    
    
    
    
    
    
    
    
    
    5,105Proceeds from sale of assets and technology
    
    
    261,309
    
    
    
    
    
    
    
    2,050Net cash used in investing activities
    
    
    (39,373
    )
    
    
    (374,480
    )
    
    
    (183,646
    )Cash flows from financing activities:Proceeds from issuance of common stock under stock option plan
and stock purchase plans
    
    
    113,793
    
    
    
    35,417
    
    
    
    109,911Contribution of proceeds from sale of common stock held in trust
    
    
    3,779
    
    
    
    
    
    
    
    Repurchase of common stock
    
    
    (221,816
    )
    
    
    (4,707
    )
    
    
    Repurchase of convertible debt
    
    
    (265,623
    )
    
    
    (177,289
    )
    
    
    (66,175
    )Net cash (used in) provided by financing activities
    
    
    (369,867
    )
    
    
    (146,579
    )
    
    
    43,736Effect of exchange rate fluctuations
    
    
    7,831
    
    
    
    24,180
    
    
    
    6,211Net (decrease) increase in cash and cash equivalents
    
    
    (42,496
    )
    
    
    (340,575
    )
    
    
    61,394Cash and cash equivalents at beginning of period
    
    
    333,651
    
    
    
    674,226
    
    
    
    612,832Cash and cash equivalents at end of period
    
    $
    291,155
    
    
    $
    333,651
    
    
    $
    674,226Non cash investing and financing activities:Unrealized losses on marketable investments, net
    
    $
    (2,129
    )
    
    $
    (709
    )
    
    $
    (2,667
    )Issuance of common stock for acquisition of minority interest in
McAfee.com, net of costs of $1,956
    
    $
    
    
    
    $
    
    
    
    $
    119,480Fair value of assets acquired in business combinations
    
    $
    110,394
    
    
    $
    247,958
    
    
    $
    Liabilities assumed in business combinations
    
    $
    20,037
    
    
    $
    25,465
    
    
    $
    Realization of deferred tax assets of acquired company
    
    $
    27,019
    
    
    $
    
    
    
    $
    Issuance of common stock upon conversion of debt
    
    $
    83,410
    
    
    $
    
    
    
    $
    Stock options issued in connection with acquisition
    
    $
    7,039
    
    
    $
    
    
    
    $
    357Supplemental disclosure of cash flow information:Cash paid during the year for interest
    
    $
    6,349
    
    
    $
    10,434
    
    
    $
    20,666Cash paid during the year for income taxes
    
    $
    31,393
    
    
    $
    20,864
    
    
    $
    18,547
 The accompanying notes are an integral part of these consolidated financial statements. 38




---



##### Table of Contents



MCAFEE, INC. AND SUBSIDIARIES 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 1. Organization and Business McAfee, Inc. (formerly Network Associates, Inc.) and its wholly owned subsidiaries (the
Company) are a leading supplier of computer security solutions designed to prevent intrusions on
networks and protect computer systems from the next generation of blended attacks and threats. The
Company offers two families of products, McAfee System Protection Solutions and McAfee Network
Protection Solutions. The Companys computer security solutions are offered primarily to large
enterprises, governments, small and medium sized businesses and consumers. The Company operates its
business in five geographic regions: North America; Europe, Middle East and Africa (EMEA); Japan;
Asia-Pacific (excluding Japan) and Latin America. In January 2004, the Company sold its Magic Solutions product line (Magic), and in July
2004, the Company sold its Sniffer product line (Sniffer). In October 2004, the Company purchased Foundstone, Inc. (Foundstone), a provider of risk
assessment and vulnerability services and products. In December 2004, the Company entered into an agreement to sell its McAfee Labs assets. The
sale is expected to close in the first half of 2005. 2. Summary of Significant Accounting Policies  Basis of Presentation The accompanying consolidated financial statements include the accounts of McAfee, Inc. and
its wholly owned subsidiaries. On September 13, 2002, the Company repurchased the 25% minority
interest in its McAfee.com subsidiary. Therefore, since the date of acquisition, no minority
interest exists in McAfee.com and accordingly the Companys consolidated net income beginning in
2002 includes the full amount of McAfee.com results from this date. All significant intercompany
accounts and transactions have been eliminated. Certain reclassifications have been made to the prior years consolidated financial statements
to conform to the current years presentation. These reclassifications had no effect on the prior
years stockholders equity or results of operations.  Minority Interest Minority interest in income of consolidated subsidiaries in the consolidated statement of
income for 2002 represents the minority stockholders share of the income of McAfee.com. As of
December 31, 2002 and for all subsequent periods, the Companys consolidated subsidiaries were all
wholly owned and there were no minority interests.  Use of Estimates The preparation of consolidated financial statements in conformity with accounting principals
generally accepted in the United States of America requires management to make estimates and
assumptions that affect the reported amount of assets and disclosure of contingent assets and
liabilities at the date of the consolidated financial statements and the reported amounts of
revenues and expenses during the reported period. Significant estimates include those required in
the valuation of intangible assets acquired in purchase combinations, impairment analysis of
goodwill and intangibles, property and equipment, allowances for doubtful accounts, sales returns
and allowances, vendor specific objective evidence of the fair value of the various elements of the
Companys multiple element software transactions, valuation allowances for deferred tax assets, tax
accruals, and warranty obligation accrual. Although the Company believes that adequate accruals
have been made for unsettled issues, additional gains or losses could occur in future years from
resolutions of outstanding matters. Actual results could differ materially from original estimates. 39




---



##### Table of Contents



Certain Risks and Concentrations The Company has historically derived a majority of its net revenue from its McAfee anti-virus
software products and its Sniffer network fault identification and application performance
management products. The Company sold its Sniffer business in July 2004, which accounted for $90.9
million and $210.2 million of revenues in 2004 and 2003, respectively, which represented 10% and
22% of total revenue for those periods, respectively. McAfee anti-virus software products and
support renewals are expected to continue to account for an even more significant portion of the
Companys net revenues after the sale of Sniffer. The markets in which the Company operates are
highly competitive and rapidly changing. Significant technological changes, changes in customer
requirements, or the emergence of competitive products with new capabilities or technologies could
adversely affect operating results. As a result of this revenue concentration, the Companys
business could be harmed by a decline in demand for, or in the prices of, these products as a
result of, among other factors, any change in pricing model, a maturation in the markets for these
products, increased price competition or a failure by the Company to keep up with technological
change. The Company sells a significant amount of its products through intermediaries such as
distributors, resellers and others. The Companys top ten distributors represented 49% to 63% of
net sales per quarter during 2004, 2003 and 2002. During 2004, 2003 and 2002, one customer
accounted for 22%, 24% and 25%, respectively, of the total net revenue for each year. During 2004
and 2002, another customer accounted for 11% and 10%, respectively, of the net revenue. At December
31, 2004 and 2003, one distributor had an accounts receivable balance which comprised 23% and 22%,
respectively, of the Companys total accounts receivable balance. The Companys distributor
agreements may be terminated by either party without cause. If one of the Companys significant
distributors terminates its distribution agreement, the Company could experience a significant
interruption in the sale and distribution of its products. The distributors may sell other vendors
products that are complementary to, or compete with, its products. While the Company encourages its
distributors to focus on the Companys products through market and support programs, these
distributors may give greater priority to products of other suppliers, including competitors. Some of the Companys distributors may experience financial difficulties, which could
adversely impact collection of accounts receivable. The Company regularly reviews the
collectibility and credit-worthiness of its distributors to determine an appropriate allowance for
doubtful accounts. The Companys bad debt allowance was $2.5 million at December 31, 2004 and $2.9
million at December 31, 2003. The Companys uncollectible accounts could exceed its current or
future allowances. The Company determines its allowance for doubtful accounts by assessing the
collectibility of individual accounts receivable over a specified aging and amount and provides an
amount equal to the historical percentage of write-off experience of the remaining accounts
receivable. Accounts receivable are written off on a case by case basis, considering the
probability that any amounts can be collected. Some of the Companys products incorporate licensed software and the Company must be able to
obtain reasonably priced licenses and successfully integrate this software with its hardware. In
addition, some of the Companys products may include open source software. The Companys ability
to commercialize products or technologies incorporating open source software may be restricted
because, among other reasons, open source license terms may be ambiguous and may result in
unanticipated obligations regarding its products. The Company maintains the majority of cash balances and all of its short-term investments with
seven financial institutions. The Company invests with financial institutions with high quality
credit and, by policy, limits the amount of deposit exposure to any one financial institution. The Company receives certain of its critical components from sole suppliers. Additionally, the
Company relies on a limited number of contract manufacturers and suppliers to provide manufacturing
services for its products. The inability of any contract manufacturer or supplier to fulfill supply
requirements of the Company could materially impact future operating results.  Foreign Currency Translation The Company considers the local currency to be the functional currency for its international
subsidiaries. Assets and liabilities denominated in foreign currencies are translated using the
exchange rate on the consolidated balance sheet date. Revenues and expenses are translated at
average exchange rates prevailing during the year. Translation adjustments resulting from this
process are charged or credited to accumulated other comprehensive income. Where the United States
Dollar is the functional currency of the subsidiary, all remeasurement adjustments are recorded in
the consolidated statement of income. Foreign currency transaction gains and losses, which to date have not been material, are
included in the consolidated statements of income.  Derivatives The Company follows the guidance in Statement of Financial Accounting Standard (SFAS) No.
133, Accounting for Derivative Instruments and Hedging Activities,as amended, in accounting for
derivatives. The standard requires the Company to recognize all 40




---



##### Table of Contents



derivatives on the consolidated balance sheet at fair value. Derivatives that are not hedges
must be adjusted to fair value through the consolidated statement of income. If the derivative is a
hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either
be offset against the change in fair value of the hedged assets, liabilities or firm commitments
through earnings, or recognized in other comprehensive income until the hedged item is recognized
in earnings. The ineffective portion of a derivatives change in fair value is immediately
recognized in earnings. The Companys use of derivative financial instruments is discussed in Note
7.  Cash and Cash Equivalents Cash equivalents are comprised of highly liquid debt instruments with original maturities or
remaining maturities at date of purchase of 90 days or less.  Restricted Cash Restricted cash balances were $0.6 million and $20.5 million at December 31, 2004 and 2003,
respectively. The restricted cash balance at December 31, 2004 consists of deposits restricted
related to the Companys workers compensation insurance coverage. The restricted cash balance at
December 31, 2003 consists primarily of collateral for an interest rate swap arrangement that
terminated in 2004.  Marketable Securities All marketable securities are classified as available-for-sale securities. Available-for-sale
securities are carried at fair value with resulting unrealized gains and losses, net of related
taxes, reported as a component of accumulated other comprehensive income. Premium and discount on
debt securities recorded at the date of purchase are amortized and accreted, respectively, to
interest income using the effective interest method. Short-term marketable securities are those
with remaining maturities at the consolidated balance sheet date of one year or less. Long-term
marketable securities have remaining maturities at the consolidated balance sheet date of greater
than one year. Realized gains and losses on sales of all such investments are reported in earnings
and computed using the specific identification cost method. The Company assesses the value of its available-for-sale marketable securities on a regular
basis to assess whether an other-than-temporary decline in the fair value has occurred. Factors
which the Company uses to assess whether an other than temporary decline has occurred include, but
are not limited to, the period of time which the fair value is below original cost, significant
changes in the operating performance, financial condition or business model, and changes in market
conditions. Any other than temporary decline in value is reported in earnings and a new cost
basis for the marketable security established. The Company did not record any other than temporary
declines in marketable securities for 2004, 2003 or 2002.  Inventory Inventory, which consists primarily of finished goods, is stated at lower of cost or market
and is included in other current assets. Cost is computed using standard cost, which approximates
cost on a first in, first out basis. Inventory of $5.1 million at December 31, 2004 and $15.9
million at December 31, 2003 is included in other current assets.  Property and Equipment Property and equipment are presented at cost less accumulated depreciation and amortization
(see Note 8). Depreciation and amortization of property and equipment are computed using the
straight-line method over the estimated useful lives as follows:  
    building  interior  seven years; exterior  twenty years;
    office furniture and equipment  three to seven years; and
    computer hardware and software  three to five years;
    leasehold improvements  the shorter of the lease term, including assumed lease renewal
periods that are reasonably assured or the estimated useful life of the asset. The costs associated with projects eligible for capitalization are accumulated on the
consolidated balance sheet until the project is substantially complete and is placed into service.
Capitalized interest is calculated on all eligible projects in progress. Interest capitalization
begins when three conditions have been met (1) expenditures have occurred, (2) activities necessary
to prepare the asset have begun, and (3) interest cost has been incurred. For 2004 and 2003, the
Company recorded $0.1 million and $0.3 million of capitalized interest, respectively. 41




---



##### Table of Contents



When assets are disposed, the Company removes the asset and accumulated depreciation from its
records and recognizes the related gain or loss in results of operations. Repairs and maintenance expenditures, which are not considered improvements and do not extend
the useful life of property and equipment, are expensed as incurred.  Internal Use Software The Company follows the guidance in Statement of Position 98-1, Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use.Software development costs, including
costs incurred to purchase third party software, are capitalized beginning when the Company has
determined factors are present, including among others, that technology exists to achieve the
performance requirements, buy versus internal development decisions have been made and the
Companys management has authorized the funding for the project. Capitalization of software costs
ceases when the software is substantially complete and is ready for its intended use and is
amortized over its estimated useful life of three years using the straight-line method. When events or circumstances indicate the carrying value of internal use software might not be
recoverable, the Company assesses the recoverability of these assets by determining whether the
amortization of the asset balance over its remaining life can be recovered through undiscounted
future operating cash flows. The amount of impairment, if any, is recognized to the extent that the
carrying value exceeds the projected discounted future operating cash flows and is recognized as a
write down of the asset. In addition, when it is no longer probable that computer software being
developed will be placed in service, the asset will be recorded at the lower of its carrying value
or fair value, if any, less direct selling costs.  Goodwill The Company follows the guidance of SFAS No. 142, Goodwill and Other Intangible Assets
(SFAS 142) in accounting for its goodwill and intangible assets. The Company adopted SFAS 142 as
of January 1, 2002, and as required, ceased amortizing goodwill. In lieu of amortization, an
impairment review of goodwill is performed on at least an annual basis and on an interim basis if
an event occurs or circumstances change that would more likely than not reduce the fair value of
the Companys reporting units below their carrying value. The Companys reporting units are
consistent with the operating geographies discussed in Note 19.  Finite-Lived Intangibles, Long-Lived Assets and Assets Held for Sale Purchased technology and other identifiable intangible assets are carried at cost less
accumulated amortization. The Company amortizes other identifiable intangibles on a straight-line
basis over their estimated useful lives. The range of estimated useful lives of the Companys
identifiable intangibles is one to seven years (see Note 10). The Company accounts for finite-lived intangibles and long-lived assets in accordance with
SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.Under this
standard, the Company reviews finite-lived intangibles or long-lived assets to be held and used for
impairment whenever events or changes in circumstances indicate that the carrying value such assets
may not be recoverable. Based upon the existence of one or more potential indicators of impairment, recoverability is
assessed based upon an estimate of undiscounted cash flows resulting from the use of the assets and
its eventual disposition. Measurement of an impairment loss is based on a projected discounted cash
flow method using a discount rate determined by management to be commensurate with the risk
inherent in the Companys current business model. Finite-lived intangibles and long-lived assets to
be disposed of are reported at the lower of carrying amount of fair value less the costs to sell. The Company announced plans to sell its McAfee Labs assets (McAfee Labs) in December 2004.
The assets and liabilities related to this disposal group are not significant as of December 31,
2004. The Company sold its Magic assets in January 2004. This disposal group met the criteria
stated in SFAS 144 to be held for sale in December 2003, and consequently, depreciation on the
equipment related to Magic ceased, and all assets and liabilities related to Magic were presented
as held for sale in the consolidated balance sheet at December 31, 2003.  Fair Value of Financial Instruments Carrying amounts of the Companys financial instruments including accounts receivable,
accounts payable and accrued liabilities approximate fair value due to their short maturities. The
fair values of the Companys investments in marketable securities are disclosed in Note 6. The fair
value of the Companys derivative instruments is disclosed in Note 7. The fair value of the
Companys convertible debt instruments is disclosed in Note 13. 42




---



##### Table of Contents



Revenue Recognition The Companys revenue is derived from primarily two sources (i) product revenue, which
includes software license, hardware, retail and royalty revenue and (ii) services and support
revenue which includes software license maintenance and support, training, consulting, and on-line
subscription revenue. The Company licenses its software products under one and two-year term or perpetual licenses.
The two-year licenses include the first year of maintenance and support. The Company sells its
products and services via its direct sales force, through domestic and foreign distributors and via
the Internet. Under the Companys on-line subscription arrangements, which do not include any
upfront setup fees, customers pay a fixed fee and receive service over a period of time, generally
one year. The Company applies the provisions of Statement of Position 97-2, Software Revenue
Recognition, (SOP 97-2) as amended by Statement of Position 98-9 Modification of SOP 97-2,
Software Revenue Recognition, With Respect to Certain Transactionsto all transactions involving
the sale of software products and hardware transactions where the software is not incidental. For
hardware transactions where software is not incidental, the Company does not bifurcate the fee and
apply separate accounting guidance to the hardware and software elements. For hardware transactions
where no software is involved, the Company applies the provisions of Staff Accounting Bulletin 104
Revenue Recognition. In addition, the Company applies the provisions of Emerging Issues Task
Force Issue No. 00-03 Application of AICPA Statement of Position 97-2 to Arrangements that Include
the Right to Use Software Stored on Another Entitys Hardwareto its on-line subscription software
transactions. Product revenue from the license of the Companys software products and sale of hardware
products where the software is and is not incidental is recognized when persuasive evidence of an
arrangement exists, the product has been delivered, the fee is fixed or determinable, and
collection of the resulting receivable is reasonably assured, and, if applicable, upon acceptance
when acceptance criteria are specified or upon expiration of the acceptance period. Maintenance and
support revenue for providing product updates and customer support is deferred and recognized
ratably over the service period. On-line subscription revenue is recognized ratably over the
service period, which is generally one year. Training and consulting revenue is recognized as
services are performed and billable according to the terms of the service arrangement. Revenue on
one-year time-based subscription licenses is recognized ratably over the contract term. Royalty
revenue is generally recognized upon receipt of periodic royalty reports received from customers,
which generally coincides with receipt of cash. For all sales except those completed via the Internet, the Company uses either a binding
purchase order or signed license agreement as evidence of an arrangement. For sales over the
Internet, the Company uses a credit card authorization as evidence of an arrangement. Sales through
distributors are evidenced by a master agreement governing the relationship together with binding
purchase orders on a transaction by transaction basis. Fees due under an arrangement are generally deemed not to be fixed or determinable if a
significant portion of the fee is due beyond the Companys normal payment terms that are 30 to 90
days from the date of invoice. Fees due under an arrangement with distributors and resellers are
generally deemed not to be fixed or determinable if a significant portion of the fee is due beyond
the date when the products have been sold by the distributor or reseller to the customers. In these
cases, revenue is not recognized until the fees become due. The Company assesses collection based
on a number of factors, including past transaction history with the customer and the
credit-worthiness of the customer. The Company does not request collateral from its customers. If
the Company determines that collection of a fee is not reasonably assured, the fee is deferred and
revenue recognized at the time collection becomes reasonably assured, which is generally upon
receipt of cash. The Companys distributors are permitted to purchase software licenses at the same time they
fill customer orders and to pay for hardware and retail products only when these products are
resold to the distributors customers. In addition, the distributors have an unlimited right of
return up until the point of sale. After sale, the Company must approve any returns from end-users.
As a result, the Company recognizes revenue from sales to distributors and resellers when products
have been sold by the distributors or resellers to their customers (sell-through or sell-out
method). In addition, the Company makes an estimate of returns from end users and amounts for
promotional and rebate programs based on its historical experience. The provisions are recorded as
a reduction of revenue. For arrangements with multiple obligations (e.g. undelivered maintenance and support bundled
with term and perpetual licenses), the Company allocates revenue to each component of the
arrangement using the residual value method based on evidence of the fair value of the undelivered
elements, which is specific to the Company. The vendor specific objective evidence of fair values
for the ongoing maintenance and support obligations for both term and perpetual licenses are based
upon the prices paid for the separate renewal of these services by the customer or upon substantive
renewal rates stated in the contractual arrangements. Vendor specific objective evidence of the
fair value of other services, primarily consulting and training services, is based upon separate
sales of these services. 43




---



##### Table of Contents



Government Contracts McAfee Labs performs a significant portion of the Companys research and development
activities with government agencies. The Company enters into research and development contracts
with government agencies under various pricing arrangements. Government contracting revenue is
classified as services and support revenue in the accompanying consolidated statements of income
and comprehensive income. Under government contracts, the Company is subject to audit by the
Defense Contract Audit Agency (DCAA) which could result in the renegotiation of amounts
previously billed. Revenue from cost-plus-fixed-fee contracts is recognized on the basis of reimbursable
contract costs incurred during the period, plus a percentage of the fixed fee. Revenue from time
and material contracts is recognized on the basis of hours utilized, plus other reimbursable
contract costs incurred during the period. Revenue from firm-fixed-price contracts is recognized
on the percentage of completion method. Under this method, individual contract revenues are
recorded based on the percentage relationship that contract costs incurred bear to costs incurred
plus managements estimate of costs to complete. Losses, if any, are accrued when their occurrence
becomes known and the amount of the loss is reasonably determinable. During 2004, 2003, and 2002,
the Company recognized revenue of approximately $6.4 million, $11.0 million, and $17.3 million,
respectively, associated with government contracts. The Company entered into an agreement for the
sale of its McAfee Labs assets in December 2004.  Research and Development Costs incurred in the research and development of new software products are expensed as
incurred until technological feasibility is established. Research and development costs include
salaries and benefits of researchers, supplies, and other expenses incurred with research and
development efforts. Development costs are capitalized beginning when a products technological
feasibility has been established and ending when the product is available for general release to
customers. Technological feasibility is reached when the product reaches the working model stage.
To date, products and enhancements have generally reached technological feasibility and have been
released for sale at substantially the same time and all research and development costs have been
expensed.  Advertising Costs Advertising production costs are expensed as incurred. Media (television and print) placement
costs are expensed in the period the advertising appears. Total advertising and promotional
expenses were $9.0 million, $7.9 million, and $13.6 million for 2004, 2003 and 2002, respectively.  Stock-based Compensation As permitted by SFAS No. 123, Accounting for Stock-Based Compensation(SFAS 123), the
Company accounts for employee stock-based compensation in accordance with Accounting Principles
Board Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees,and Financial
Accounting Standards Board (FASB) Interpretation No. 44 (FIN 44), Accounting for Certain
Transactions Involving Stock-Based Compensation, an interpretation of APB Opinion No. 25and
related interpretations in accounting for its stock-based compensation plans. Accordingly, with
respect to fixed-plan awards, the Company measures the excess, if any, of the market value of its
common stock on the date of the award over the exercise price of options granted as deferred
compensation expense (intrinsic method) and recognizes any such excess over the vesting period
using the straight-line method. With respect to variable-plan awards resulting from award
modifications or award terms where the amount of shares and the exercise price are not fixed at the
date of grant, the Company records stock-based deferred compensation for the excess, if any, of the
market value of its common stock at the end of each reporting period (or date of exercise,
forfeiture or cancellation without replacement, if earlier) over the fair value of its common stock
on the date of the award or modification. The resulting deferred compensation charge to earnings
will be recorded over the remaining vesting term using the accelerated method of amortization. When
variable plan options become fully vested, any remaining deferred compensation is recognized. The Company accounts for options awarded to non-employees (consultants) at fair value using
the Black-Scholes option pricing model. The resulting fair value is recognized in expense upon
performance. The following table illustrates the effect on net income and earnings per share if the Company
had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation.
The Company recognizes pro forma expense for FAS 123 purposes under the accelerated method of
amortization. 44




---



##### Table of Contents



For pro forma purposes, the compensation costs for the 1997 Plan, the Stock Option Plan for
Outside Directors, the 2000 Nonstatutory Stock Option Plan and the 2002 and 1994 Employee Stock
Purchase Plans (ESPPs) has been determined based on fair value at the grant date for awards from
1998 through 2004 consistent with the provisions of SFAS 123 using assumptions defined in Note 15,
the Companys net income and net income per share would have been as follows (in thousands): Year Ended December 31,2004
    
    
    2003
    
    
    2002Net income, as reported
    
    $
    225,065
    
    
    $
    70,242
    
    
    $
    128,312Deduct: Total stock-based
employee compensation
expense determined under
fair value based method
for all awards, net of tax
    
    
    (25,632
    )
    
    
    (55,848
    )
    
    
    (76,721
    )Add back: stock-based
compensation expense, net
of tax, included in
reported net income
    
    
    9,182
    
    
    
    7,504
    
    
    
    13,442Pro forma net income
    
    $
    208,615
    
    
    $
    21,898
    
    
    $
    65,033Net income per share:Basic  as reported
    
    $
    1.40
    
    
    $
    0.44
    
    
    $
    0.86Basic  pro forma
    
    $
    1.30
    
    
    $
    0.14
    
    
    $
    0.44Diluted  as reported
    
    $
    1.31
    
    
    $
    0.43
    
    
    $
    0.80Diluted  pro forma
    
    $
    1.25
    
    
    $
    0.13
    
    
    $
    0.41
 The impact on pro forma income per share and net income in the table above may not be
indicative of the effect in future years as options vest over several years and the Company
continues to grant stock options to new employees.  Income Taxes The Company accounts for income taxes in accordance with the liability method of accounting
for income taxes. Under the liability method, deferred assets and liabilities are recognized based
upon anticipated future tax consequences attributable to differences between financial statement
carrying amounts of assets and liabilities and their respective tax bases. The provision for income
taxes is comprised of the current tax liability and the change in deferred tax assets and
liabilities. The Company establishes a valuation allowance to the extent that it is more likely
than not that deferred tax assets will not be recoverable against future taxable income.  Net Income Per Share Basic net income per share is computed using the weighted-average common shares outstanding
during the period. Diluted net income per share is computed using the weighted average common
shares and potentially dilutive shares outstanding during the period. Potentially dilutive common
shares include incremental common shares issuable upon exercise of stock options, stock purchase
warrants, restricted stock, and potential dilution upon conversion of the convertible debt. Diluted
loss per share is computed using the weighted average number of common shares and excludes
potentially dilutive shares outstanding, as their effect is anti-dilutive.  Warranty The Company offers a warranty on its software and hardware products and records a liability
for the estimated future costs associated with warranty claims, which is based upon historical
experience and the Companys estimate of the level of future costs.  Comprehensive Income (Loss) Unrealized gains (losses) on available-for-sale securities and foreign currency translation
adjustments are included in the Companys components of comprehensive income (loss), which are
excluded from net income. 45




---



##### Table of Contents



For 2004, 2003 and 2002 other comprehensive income (loss) is comprised of the following items
(in thousands): Before
    
    
    
    
    
    
    Net ofIncome Tax
    
    
    Income Tax
    
    
    Income Tax2004Unrealized loss on marketable securities and investments, net
    
    $
    (5,253
    )
    
    $
    2,102
    
    
    $
    (3,151
    )Reclassification adjustment for net loss on marketable
securities recognized during the period
    
    
    1,704
    
    
    
    (682
    )
    
    
    1,022Foreign currency translation loss
    
    
    (4,537
    )
    
    
    
    
    
    
    (4,537
    )Total other comprehensive loss
    
    $
    (8,086
    )
    
    $
    1,420
    
    
    $
    (6,666
    )2003Unrealized gain on marketable securities and investments, net
    
    $
    1,894
    
    
    $
    (757
    )
    
    $
    1,137Reclassification adjustment for net gain on marketable
securities recognized during the period
    
    
    (3,076
    )
    
    
    1,230
    
    

    
    (1,846
    )Foreign currency translation gain
    
    
    10,578
    
    
    
    
    
    
    
    10,578Total other comprehensive income
    
    $
    9,396
    
    
    $
    473
    
    
    $
    9,8692002Unrealized loss on marketable securities and investments, net
    
    $
    (805
    )
    
    $
    322
    
    
    $
    (483
    )Reclassification adjustment for net gain on marketable
securities recognized during the period
    
    
    (3,838
    )
    
    
    1,535
    
    
    
    (2,303
    )Impairment recognized
    
    
    198
    
    
    
    (79
    )
    
    
    119Foreign currency translation gain
    
    

    10,744
    
    
    
    
    
    
    
    10,744Total other comprehensive income
    
    $
    6,299
    
    
    $
    1,778
    
    
    $
    8,077
 Accumulated other comprehensive income is comprised of the following (in thousands): 2004
    
    
    2003
    
    
    2002Unrealized (loss) gain on available-for-sale securities
    
    $
    (1,384
    )
    
    $
    745
    
    
    $
    1,454Cumulative translation adjustment
    
    
    28,745
    
    
    
    33,282
    
    
    
    22,704Total
    
    $
    27,361
    
    
    $
    34,027
    
    
    $
    24,158
  Recent Accounting Pronouncements and Guidance  Stock-based Compensation In December 2004, the FASB issued SFAS 123R, Share Based Payment(SFAS 123R) which
requires the measurement of all employee share-based payments to employees, including grants of
employee stock options, using a fair-value-based method and the recording of such expense in the
consolidated statements of income. The accounting provisions of SFAS 123R are effective for
reporting periods beginning after June 15, 2005. The Company is required to adopt SFAS 123R in the
third quarter of fiscal 2005. The pro forma disclosures previously permitted under SFAS 123 will no
longer be an alternative to financial statement recognition. See Stock-based Compensation above
for the pro forma net income and net income per share amounts, for fiscal 2002 through fiscal 2004,
as if the Company had used a fair-value-based method similar to the methods required under SFAS
123R to measure compensation expense for employee stock incentive awards. Although the Company has
not yet determined whether the adoption of SFAS 123R will result in amounts that are similar to the
current pro forma disclosures under SFAS 123, the Company is evaluating the requirements under SFAS
123R and expects the adoption to have a significant adverse impact on the consolidated results of
operations.  Income Taxes In December 2004, the FASB issued Staff Position (FSP) FAS 109-2, Accounting and Disclosure
Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creations Act of
2004(AJCA) (FSP 109-2). The AJCA introduces a limited time 85% dividends received deduction
on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision),
provided certain criteria are met. FSP 109-2 provides accounting and disclosure guidance for the
repatriation provision. Although FSP 109-2 is effective immediately, the Company does not expect to
be able to complete its evaluation of the repatriation provision until after Congress or the
Treasury Department provides additional clarifying language on key elements of the provision. In
January 2005, the Treasury Department began to issue the first of a series of clarifying guidance
documents related to this provision. The Company expects to complete its evaluation of the effects
of the repatriation provision by the end of fiscal 2005. The range of possible amounts that the
Company is considering for repatriation under this provision is between $0 and $500 million. While
the Company estimates that the related potential range of additional income tax is between $0 and
$30 million, this estimation is subject to change following technical correction legislation that
the Company believes is forthcoming from Congress. The amount of additional income tax would be
reduced by the part of the eligible dividend that is attributable to foreign earnings on which a
deferred tax liability had been previously accrued. 46




---



##### Table of Contents



Inventory In December 2004, the FASB issued SFAS 151, Inventory Costs, an Amendment of ARB No. 43,
Chapter 4.SFAS 151 clarifies the accounting for inventory when there are abnormal amounts of idle
facility expense, freight, handling costs, and wasted materials. Under existing pronouncements,
items such as idle facility expense, excessive spoilage, double freight, and re-handling costs may
be so abnormal as to require treatment as current period charges rather than recorded as
adjustments to the value of the inventory. SFAS 151 requires that those items be recognized as
current-period charges regardless of whether they meet the criterion of so abnormal. In addition,
SFAS 151 requires that allocation of fixed production overheads to the costs of conversion be based
on the normal capacity of the production facilities. The provisions of SFAS 151 shall be effective
for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application
is permitted for inventory costs incurred during fiscal years beginning after the date SFAS 151 is
issued. The adoption of SFAS 151 is not expected to have a material effect on the Companys
consolidated financial position or results of operations as the Company does not manufacture any of
its products.  The Meaning of Other-Than-Temporary Impairment In March 2004, the FASB issued Emerging Issues Task Force Issue No. 03-1 (EITF 03-1), The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,which
provided new guidance for assessing impairment losses on investments. Additionally, EITF 03-1
includes new disclosure requirements for investments that are deemed to be temporarily impaired. In
September 2004, the FASB delayed the accounting provisions of EITF 03-1; however the disclosure
requirements remain effective for annual periods ending after June 15, 2004 (see Note 6). The
Company does not believe that the adoption of EITF 03-01
will have a material impact on its financial position, results of operations or cash flows,
however, the Company will evaluate the impact of EITF 03-1 once final guidance is issued. 3. Cumulative Effect of Change in Accounting Principle Effective January 1, 2003, the Company changed its method for recognizing commission expenses
to sales personnel. Prior to January 1, 2003, the Companys policy had been to expense the
commissions as incurred, however, the Company believed that expensing the commissions as incurred
did not provide a fair representation of the income from operations where part or all of the
revenue related to these sales transactions is deferred and recognized over time. Commission
expense directly related to sales transactions is now deferred and recognized ratably over the same
period as the related revenue is recognized and recorded, which the Company believes will provide
greater transparency into its performance. The cumulative effect of the change in accounting
principle resulted in a one-time credit of $10.3 million, net of taxes of $3.6 million, that was
recorded in 2003. The following table illustrates 2002 after considering the retroactive application of the
adopted principle: Pro Forma forCommissionActual
    
    
    ChangeOperating expenses
    
    $
    763,606
    
    
    $
    774,938Income before cumulative effect of change in accounting principle
    
    $
    128,312
    
    
    $
    121,513Per common share  basic
    
    $
    0.86
    
    
    $
    0.81Per common share  diluted
    
    $
    0.80
    
    
    $
    0.76Net income
    
    $
    128,312
    
    
    $
    121,513Per common share  basic
    
    $
    0.86
    
    
    $
    0.81Per common share  diluted
    
    $
    0.80
    
    
    $
    0.76
 4. Business Combinations and Other Acquisitions  Foundstone, Inc. On October 1, 2004, the Company acquired 100% of the outstanding capital shares of Foundstone,
Inc., (Foundstone), a provider of risk assessment and vulnerability services and products for
$82.5 million in cash and $3.1 million of direct expenses, totaling $85.6 million. Total
consideration paid for the acquisition was $90.4 million including $4.8 million for the fair value
of vested stock options assumed in the acquisition. The Company acquired Foundstone to enhance its
network protection product line. The Company acquired Foundstone to deliver enhanced risk
classification of prioritized assets, automated shielding and risk remediation using intrusion
prevention technology, and automated enforcement and compliance. The results of operations of
Foundstone have been included in these consolidated financial statements since the date of
acquisition. Under the transaction, the Company recorded approximately $27.0 million for developed
technology, $1.0 million for acquired product rights, including revenue related order backlog and
contracts, $0.6 million for trade names/trademarks and non-compete arrangements, $59.2 million for
goodwill (none of which is deductible for tax purposes), $2.6 million for net deferred tax
liabilities and $5.1 million of tangible assets, net of liabilities. The intangible assets acquired
in the acquisition, excluding goodwill, are being 47




---



##### Table of Contents



amortized over their estimated useful lives of
two to 6.5 years or a weighted average period of 6.4 years. The Company accrued $0.3 million in
severance costs for employees terminated at the time of the acquisition, of which less than $0.1
million remains as an accrual as of December 31, 2004. As part of the Foundstone acquisition, the Company assumed a portion of outstanding vested and
unvested Foundstone stock option options. The fair value of the Companys stock options exchanged
was $7.0 million, of which $4.8 million was reflected as part of the purchase price and $2.3
million was reflected as unearned compensation to be recognized by the Company through 2008 as
employment services are provided. The Company cancelled the Foundstone stock options it did not assume, such options being held
by four executives, in exchange for a cash payment equal to the intrinsic value of the cancelled
stock options based on the purchase price per share. Forty percent of this amount was placed into
escrow accounts for the four executives (Key Employee Escrow), along with 40% of the proceeds for
the purchase of shares from the four executives. The four executives also received retention bonus
payments, which were placed into Key Employee Escrow accounts. The Key Employee Escrow amounts are
subject to vesting provisions from the date of acquisition through October 1, 2007. The Company
recorded the $5.6 million paid into Key Employee Escrow as prepaid compensation, which is being
recognized as expense over the vesting period. The Company recognized expense of approximately $0.3
million in 2004. In January 2005, the vesting schedule was amended such that a greater portion of
the escrow amount vests within one year of the close of the transaction. The Company expects to
record approximately $2.9 million in expense for escrow amounts vesting in 2005. Management determined the preliminary purchase price allocation based on estimates of the fair
values of the tangible and intangible assets acquired and liabilities assumed. These estimates were
arrived at utilizing recognized valuation techniques and the assistance of valuation consultants.
The following is a summary of the assets acquired and liabilities assumed in the acquisition of
Foundstone: (In thousands)Technology
    
    $
    27,000Other intangible assets
    
    
    1,600Goodwill
    
    
    59,235Cash
    
    
    920Other assets
    
    
    12,918Deferred tax assets
    
    
    8,721Total assets acquired
    
    
    110,394Liabilities
    
    
    8,740Deferred tax liabilities
    
    
    11,297Total liabilities assumed
    
    
    20,037Net assets acquired
    
    $
    90,357
 The following unaudited pro forma financial information presents the combined results of the
Company and Foundstone as if the acquisitions had occurred at the beginning of 2004 and 2003 (in
thousands except per share amounts): Year Ended December 31,2004
    
    
    2003(Unaudited)Net revenue
    
    $
    927,595
    
    
    $
    954,136Income before cumulative effect of change in accounting principle
    
    $
    212,610
    
    
    $
    46,838Net income
    
    $
    212,610
    
    
    $
    57,175Basic net income per share
    
    $
    1.32
    
    
    $
    0.36Shares used in per share calculation  basic
    
    
    160,714
    
    
    
    160,338Diluted net income per share
    
    $
    1.24
    
    
    $
    0.35Shares used in per share calculation  diluted
    
    
    177,099
    
    
    
    164,489
 The above unaudited pro forma financial information includes adjustments for interest income
on cash disbursed for the acquisitions, amortization of identifiable intangible assets and
adjustments for expenses incurred in conjunction with the acquisitions.  IntruVert Networks, Inc. On May 14, 2003, the Company acquired 100% of the outstanding capital shares of IntruVert
Networks, Inc., (IntruVert) a provider of network-based intrusion prevention solutions designed
to proactively detect and stop system and network security attacks before they occur, for $98.1
million in cash and $5.2 million of direct expenses, totaling $103.3 million. The Company acquired
IntruVert to enhance its intrusion detection product line, improve its position in the emerging
intrusion prevention marketplace, embed the acquired technologies in the Companys current product
offering, and sell IntruVert products to its existing customer base. The results of operations of
IntruVert have been included in these consolidated financial statements since the date of
acquisition. 48




---



##### Table of Contents



The Company recorded approximately $5.7 million for acquired in-process research and
development which was fully expensed at the time of acquisition because technological feasibility
had not been established and there was no alternative use for the projects under development. The
ongoing project at IntruVert at the time of acquisition was the development of the Infinity model
of the IntruShield sensor. The product was completed in the third quarter of 2003. The intangibles acquired in the acquisition, excluding goodwill, are being amortized over
their estimated useful lives of two to five years or a weighted average period of 4.5 years. The
Company also accrued approximately $0.3 million in duplicative site costs for lease space no longer
being utilized and permanently vacated related to the IntruVert acquisition, which has been fully
paid as of December 31, 2004. As part of the IntruVert acquisition, the Company cancelled all outstanding IntruVert
restricted stock and outstanding stock options and agreed to make cash payments to former IntruVert
employees contingent upon their continued employment with the Company based on the same vesting
terms of their restricted stock or stock option agreements. The payments to former IntruVert
employees are recorded ratably over the vesting period as salary expense as the employees are
currently providing services to the Company. Payments under the restricted stock plan are paid
monthly from an escrow account and will total approximately $3.0 million from the purchase date
through the fourth quarter of 2006. The Company recorded expense of approximately $1.4 million and
$1.1 million in 2004 and 2003, respectively. Payments under the stock option plan are being paid
monthly through the Companys payroll, and will total approximately $4.1 million. The Company
recorded expense of approximately $1.4 million and $0.8 million in 2004 and 2003, respectively, and
will record an additional $2.0 million through the first quarter of 2007. Cash payments that were
fully vested at the date of acquisition were included in the purchase price. If a former
IntruVert employee ceases employment with the Company, unvested payment amounts will be returned to
the Company.  Entercept Security Technologies, Inc. On April 30, 2003, the Company acquired 100% of the outstanding capital shares of Entercept
Security Technologies, Inc. (Entercept), a provider of host-based intrusion prevention solutions
designed to proactively detect and stop system and network security attacks before they occur, for
$121.9 million in cash and $3.9 million of direct expenses, totaling $125.8 million. The Company
acquired Entercept to enhance its intrusion detection product line, achieve a leading position in
the emerging intrusion prevention marketplace, embed the acquired technologies in the Companys
current product offering, and sell Entercept products to its existing customer base. The results of
operations of Entercept have been included in these consolidated financial statements since the
date of acquisition. The Company recorded approximately $0.9 million for acquired in-process research and
development which was fully expensed upon purchase because technological feasibility had not been
established and there was no alternative use for the projects under development. The ongoing
project at Entercept at the time of acquisition was a Linux version of their current product. The
project was completed in the fourth quarter of 2004. The intangibles acquired in the acquisition,
excluding goodwill, are being amortized over their estimated useful lives of two to six years or a
weighted average period of 5.6 years. The Company accrued $2.8 for permanently vacated facilities at the acquisition date. The
accrual will be fully utilized by 2006, the end of the original lease term. The Company made
payments of $0.7 million in 2003, and in the fourth quarter of 2003, the Company entered into a
sublease for the vacated facility, and therefore, adjusted the accrual and related goodwill by the
value of the sublease, which was $1.1 million. The following is a summary of activity in the
restructuring accrual related to Entercept (in thousands): Original accrual, April 30, 2003
    
    $
    2,837Cash payments
    
    
    (1,106
    )Adjustments
    
    
    (1,137
    )Balance, December 31, 2004
    
    $
    594
 As part of the Entercept acquisition, the Company assumed all outstanding unvested Entercept
cash bonus units and agreed to make specified per unit cash payments to former Entercept employees
contingent upon their continued employment with the Company for one year based on the vesting terms
of such units, generally one year. The payments to former Entercept employees totaling $2.4 million
have been expensed monthly as salary expense as the employees were providing services to the
Company. The Company recorded expense related to these payments of $0.6 million and $1.8 million in
2004 and 2003, respectively. 49




---



##### Table of Contents



Management determined the purchase price allocation based on estimates of the fair values of
the tangible and intangible assets acquired and liabilities assumed. These estimates were arrived
at utilizing recognized valuation techniques and the assistance of valuation consultants. The
following table summarizes the final fair values of the assets acquired and liabilities assumed in
the acquisitions: Total AssetsIntruVert
    
    
    Entercept Security
    
    
    Acquired andNetworks, Inc.
    
    
    Technologies, Inc.
    
    
    Liabilities Assumed(In thousands)Deferred tax assets
    
    $
    436
    
    
    $
    10,560
    
    
    $
    10,996Technology
    
    
    18,200
    
    
    
    21,700
    
    
    
    39,900Other intangible assets
    
    
    1,900
    
    
    
    2,800
    
    
    
    4,700Cash
    
    
    10,986
    
    
    
    1,028
    
    
    
    12,014Goodwill
    
    
    71,598
    
    
    
    99,565
    
    
    
    171,163Other assets
    
    
    4,984
    
    
    
    3,517
    
    
    
    8,501Total assets acquired
    
    
    108,104
    
    
    
    139,170
    
    
    
    247,274Current liabilities
    
    
    2,649
    
    
    
    4,739
    
    
    
    7,388Deferred tax liabilities
    
    
    7,839
    
    
    
    9,555
    
    
    
    17,394Total liabilities assumed
    
    
    10,488
    
    
    
    14,294
    
    
    
    24,782Net assets acquired
    
    $
    97,616
    
    
    $
    124,876
    
    
    $
    222,492In-process research and development (expensed)
    
    $
    5,700
    
    
    $
    900
    
    
    $
    6,600Total acquisition cost
    
    $
    103,316
    
    
    $
    125,776
    
    
    $
    229,092
 The following unaudited pro forma financial information presents the combined results of the
Company, IntruVert and Entercept as if the acquisitions had occurred at the beginning of 2003 and
2002 (in thousands except per share amounts): Year Ended December 31,2003
    
    
    2002(Unaudited)Net revenue
    
    $
    939,953
    
    
    $
    1,052,474Income before cumulative effect of change in accounting principle
    
    $
    49,721
    
    
    $
    93,367Net income
    
    $
    60,058
    
    
    $
    93,367Basic net income per share
    
    $
    0.38
    
    
    $
    0.62Shares used in per share calculation  basic
    
    
    160,338
    
    
    
    149,441Diluted net income per share
    
    $
    0.37
    
    
    $
    0.59Shares used in per share calculation  diluted
    
    
    164,489
    
    
    
    157,156
 The above unaudited pro forma financial information includes adjustments for interest income
on cash disbursed for the acquisitions, amortization of identifiable intangible assets and
adjustments for expenses incurred in conjunction with the acquisitions. The pro forma financial
information excludes the effects of the in-process research and development totaling $6.6 million
that was expensed immediately.  McAfee.com In September 2002, the Company repurchased the 25% minority interest in its McAfee.com
subsidiary for $219.9 million in cash and stock. The Company issued 8.3 million shares of its
common stock valued at $14.62 per share, which corresponds to the average market price of the
Companys common stock two days before and after the date the terms of the acquisition were agreed
and announced. The acquisition was an effort to reduce or eliminate customer, market and brand
confusion due to the similarity in its products, names and web addresses and to reduce or eliminate
actual and potential conflicts between the companies and their sales forces, and related senior
management distraction, due to confusion over market boundaries. This acquisition increased the
Companys ownership of McAfee.com to 100% and was accounted for using the purchase method of
accounting. As part of the acquisition, McAfee.com was merged with and into the Company. The
results of operations of McAfee.com have always been included in the consolidated income before
minority interest of the Company. Prior to the acquisition, the minority interest in the McAfee.com
income was excluded from the Companys consolidated net income. Since the date of acquisition on September 13, 2002, no minority interest exists in McAfee.com
and accordingly the consolidated net income includes the full amount of McAfee.com results from
this date. The aggregate purchase price was allocated to tangible and identified intangible assets
acquired and liabilities assumed based on estimates of fair value. Identifiable intangible assets
totaled $50.7 million and are amortized using an estimated useful life identified for each type of
intangible ranging from two to seven years, or a weighted average period of 6.7 years. The excess
of the aggregate purchase price over the fair value of the identifiable net assets acquired of
approximately $145.8 million has been recognized as goodwill of which none is deductible for tax
purposes. 50




---



##### Table of Contents



The following table summarizes the final fair values of the assets acquired and liabilities
assumed. (In thousands)Deferred tax assets
    
    $
    25,767Technology
    
    
    1,401Other intangible assets
    
    
    49,335Goodwill
    
    
    145,756Minority interest
    
    
    21,044Total assets acquired
    
    
    243,303Current liabilities
    
    
    2,065Deferred tax liabilities
    
    
    21,345Total liabilities assumed
    
    
    23,410Net assets acquired
    
    $
    219,893
 The following unaudited pro forma financial information presents the combined results of the
Company and McAfee.com as if the acquisition had occurred at the beginning of 2002, after giving
effect to certain adjustments, including amortization of identifiable intangible assets (in
thousands, except per share amounts): (Unaudited)Net revenue
    
    $
    1,043,044Net income
    
    $
    141,334Basic net income per share
    
    $
    0.91Shares used in per share calculation  basic
    
    
    155,245Diluted net income per share
    
    $
    0.84Shares used in per share calculation  diluted
    
    
    183,150
 The above unaudited pro forma financial information includes adjustments for interest income
on cash disbursed for the acquisition, amortization of identifiable intangible assets and
adjustments for the expenses incurred by McAfee.com related to the Companys exchange offer for all
McAfee.com outstanding publicly held shares. 5. Sale of Businesses  McAfee Labs In December 2004, the Company entered into an agreement for the sale of its McAfee Labs assets
to SPARTA, Inc. (SPARTA) for $1.5 million. The transaction is expected to close in the first half
of 2005. The assets and liabilities of McAfee Labs are not presented as held for sale since the
purchase agreement requires the Company to be involved under certain contracts that are in progress
at the close of the transaction until SPARTA obtains government approval as the contractor. As the
Company will continue to be involved in the operations of the McAfee Labs business in 2005, its
results of operations are included in income from operations in the consolidated statements of
income. The cash flows resulting from this continued involvement are not expected to be material to
the Companys consolidated financial statements. The assets and liabilities of McAfee Labs are present in the Companys North American
operating region. Revenues related to McAfee Labs were approximately $6.4 million, $11.0 million
and $17.3 million for 2004, 2003 and 2002, respectively.  Sniffer Technologies In July 2004, the Company completed its sale of the Sniffer product line to Network General
Corporation (the Buyer) for $213.8 million in cash, net of approximately $4.0 million in direct
costs. The Company recorded a gain on sale of $197.4 million in 2004. Sniffer does not represent a
separate component of the Company as its operations and cash flows cannot be sufficiently separated
from the rest of the Company, consequently, its results of operations are included in income from
continuing operations in the consolidated statements of income. 51




---



##### Table of Contents



The following is a detail of assets and liabilities that were sold to or assumed by the Buyer
upon the close of the transaction: (In thousands)Assets:Prepaid expenses
    
    $
    2,227Inventory
    
    
    6,759Equipment, net
    
    
    2,396Goodwill
    
    
    50,547Total assets
    
    $
    61,929Liabilities:Accrued liabilities
    
    $
    2,069Deferred revenue
    
    
    43,477Total liabilities
    
    $
    45,546
 The assets and liabilities of Sniffer were located primarily in the Companys North America
and EMEA operating segments. Sniffer assets and liabilities in the Companys other reporting units
were not material. Revenues related to Sniffer were $90.9 million and $210.2 million in 2004 and
2003, respectively. In conjunction with the sale of Sniffer, the Company entered into a transition services
agreement with the Buyer. Under this agreement, the Company provides certain transitional services,
including initial order processing, use of facilities, transaction processing services and certain
other back office functions for the Buyer. The Company is reimbursed for its costs plus a margin.
Operating expenses under this agreement are included in general and administrative expenses, while
reimbursements for such expenses are included in the caption Reimbursement from transition
services agreement on the accompanying consolidated statements of income. The Company recorded
approximately $6.0 million of reimbursements under the transition services agreement. Also in conjunction with the sale of the Sniffer product line, the Company paid severance and
bonuses to the former executives of Sniffer for their assistance in the transaction. The total
bonuses and severance accrued was $7.7 million in 2004, of which $5.3 million has been paid as of
December 31, 2004, and the remaining $2.4 million will be paid in the first quarter of 2006.
Furthermore, the Company accelerated the vesting of these executives stock options, which resulted
in a stock-based compensation charge of approximately $1.0 million.  Magic Solutions In December 2003, the Company entered into an agreement for the sale of its Magic Solutions
product line (Magic) to BMC Software for $47.1 million in cash. The Company completed the
transaction on January 30, 2004, and recorded a gain of $46.1 million. At December 31, 2003, the
carrying values of assets and liabilities related to Magic sale were presented as held for sale on
the consolidated balance sheet. Magic does not represent a separate component of the Company as its
operations and cash flows cannot be sufficiently separated from the rest of the Company,
consequently, its results of operations are included in income from continuing operations in the
consolidated statements of income. The following were the components of Magic at December 31, 2003: (In thousands)Assets:Accounts receivable
    
    $
    12,991Prepaid expenses
    
    
    888Inventory
    
    
    20Equipment, net
    
    
    1,023Goodwill
    
    
    9,797Assets held for sale
    
    $
    24,719Liabilities:Accounts payable
    
    $
    215Accrued liabilities
    
    
    1,050Deferred revenue
    
    
    22,045Liabilities related to assets held for sale
    
    $
    23,310
 The assets and liabilities of Magic were located primarily in the Companys North American and
EMEA operating regions. Magic assets and liabilities in the Companys other operating regions were
not material. Revenues related to Magic were approximately $2.9 million and $63.2 million in 2004
and 2003, respectively. In conjunction with the Magic sale, the Company paid a $1.4 million bonus to an executive
related to the transaction. 52




---



##### Table of Contents



PGP Product Group In October 2001, the Board of Directors of the Company approved a plan to integrate the
activities of the Companys PGP product group into its other product groups. In addition to the
integration plan, the Company began to look for a buyer for the PGP desktop encryption and Gauntlet
firewall product. In February 2002, the Company announced the sale of Gauntlet firewall/VPN
business to Secure Computing. As a result of the transaction, the Company received common shares of
Secure Computing in exchange for the Gauntlet business. The Company recorded a gain on sale of the
business of $6.7 million. In August 2002, the Company announced the sale of the PGP business to PGP
Corporation, a new venture funded company unrelated to the Company, for $2.0 million in cash and
assumed liabilities. As a result of the transaction, the Company recorded a gain on sale of the
business of $2.6 million. 6. Marketable Securities and Cash and Cash Equivalents Marketable securities, which are classified as available-for-sale, are summarized as follows
as of December 31 (in thousands): 2004Purchase/
    
    
    Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    AggregateCost
    
    
    Gains
    
    
    Losses
    
    
    Fair ValueU.S. Government debt securities
    
    $
    274,594
    
    
    $
    40
    
    
    $
    (1,021
    )
    
    $
    273,613Corporate debt securities
    
    
    340,037
    
    
    
    138
    
    
    
    (1,458
    )
    
    
    338,717Municipal debt securities
    
    
    4,850
    
    
    
    
    
    
    
    
    
    
    
    4,850Time deposits
    
    
    16,350
    
    
    
    
    
    
    
    (4
    )
    
    
    16,346$
    635,831
    
    
    $
    178
    
    
    $
    (2,483
    )
    
    $
    633,526
 2003Purchase/
    
    
    Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    AggregateCost
    
    
    Gains
    
    
    Losses
    
    
    Fair ValueU.S. Government debt securities
    
    $
    190,567
    
    
    $
    401
    
    
    $
    (76
    )
    
    $
    190,892Corporate debt securities and money market funds
    
    
    484,156
    
    
    
    607
    
    
    
    (180
    )
    
    
    484,583Equity securities
    
    
    118
    
    
    
    293
    
    
    
    
    
    
    
    411$
    674,841
    
    
    $
    1,301
    
    
    $
    (256
    )
    
    $
    675,886
 At December 31, 2004, $232.9 million of marketable debt securities had scheduled maturities of
less than one year and are classified as current assets. Marketable securities of $400.6 million
have maturities ranging from greater than one year to less than three years and are classified as
non current assets. The following table summarizes the components of the cash and cash equivalents balance at
December 31 (in thousands): 2004
    
    
    2003Cash and money market funds, at cost which approximates fair value
    
    $
    262,216
    
    
    $
    325,360Corporate debt securities, primarily commercial paper
    
    
    28,939
    
    
    
    8,291Total cash and cash equivalents
    
    $
    291,155
    
    
    $
    333,651
 The Company recognizes realized gains(losses) upon the sale of investments using the specific
identification method. The following table summarizes the gross realized gains (losses) for the
years ending December 31 (in thousands): 2004
    
    
    2003
    
    
    2002Realized gains
    
    $
    922
    
    
    $
    3,753
    
    
    $
    4,670Realized losses
    
    
    (2,626
    )
    
    
    (677
    )
    
    
    (832
    )Net realized (loss) gain
    
    $
    (1,704
    )
    
    $
    3,076
    
    
    $
    3,838
 In accordance with EITF 03-1, the following table summarizes the fair value and gross
unrealized losses related to available-for-sale securities, aggregated by investment category and
length of time that the individual securities have been in a continuous unrealized loss position,
at December 31, 2004 (in thousands): Less Than 12 Months
    
    
    More Than 12 Months
    
    
    TotalGross
    
    
    
    
    
    
    Gross
    
    
    
    
    
    
    GrossUnrealized
    
    
    
    
    
    
    Unrealized
    
    
    
    
    
    
    UnrealizedFair Value
    
    
    Losses
    
    
    Fair Value
    
    
    Losses
    
    
    Fair Value
    
    
    LossesU.S. Government debt securities
    
    $
    242,316
    
    
    $
    (1,056
    )
    
    $
    2,625
    
    
    $
    (33
    )
    
    $
    244,941
    
    
    $
    (1,089
    )Corporate debt securities
    
    
    185,359
    
    
    
    (1,076
    )
    
    
    48,241
    
    
    
    (318
    )
    
    
    233,600
    
    
    
    (1,394
    )$
    427,675
    
    
    $
    (2,132
    )
    
    $
    50,866
    
    
    $
    (351
    )
    
    $
    478,541
    
    
    $
    (2,483
    )
 53




---



##### Table of Contents



Market values were determined for each individual security in the investment portfolio.
The declines in value of these investments are primarily related to changes in interest rates and
are considered to be temporary in nature. The Company invests in government securities and debt
instruments with high credit ratings, and believes that the financial position of the issuers of
these securities are indicators that the securities are not impaired as of December 31, 2004. 7. Derivatives  Forward Exchange Contracts The Company conducts business globally. As a result, it is exposed to movements in foreign
currency exchange rates. The Company enters into forward exchange contracts to reduce exposures
associated with nonfunctional currency monetary assets and liabilities such as accounts receivable
and accounts payable denominated in Euros, British Pound Sterling, Japanese Yen, and Singapore,
Canadian and Australian dollars. The forward contracts typically range from one to three months in
original maturity. In general, the Company does not hedge anticipated foreign currency cash flows
nor does the Company enter into forward contracts for trading purposes. The Company does not use
any foreign exchange derivatives for trading or speculative purposes. The forward contracts do not qualify for hedge accounting and accordingly are marked to market
at the end of each reporting period with any unrealized gain or loss being recognized in the
statement of income as interest and other income. The forward contracts outstanding and their fair values are presented below as of December 31
(in thousands): 2004
    
    
    2003Carrying
    
    
    Fair
    
    
    Carrying
    
    
    FairValue
    
    
    Value
    
    
    Value
    
    
    ValueEuro
    
    $
    116
    
    
    $
    116
    
    
    $
    490
    
    
    $
    490British Pound Sterling
    
    
    288
    
    
    
    288
    
    
    
    54
    
    
    
    54Brazilian Real
    
    
    420
    
    
    
    420
    
    
    
    
    
    
    
    Singapore Dollar
    
    
    
    
    
    
    
    
    
    
    (16
    )
    
    
    (16
    )Japanese Yen
    
    
    1
    
    
    
    1
    
    
    
    
    
    
    
    Australian Dollar
    
    
    4
    
    
    
    4
    
    
    
    75
    
    
    
    75Canadian Dollar
    
    
    39
    
    
    
    39
    
    
    
    255
    
    
    
    255$
    868
    
    
    $
    868
    
    
    $
    858
    
    
    $
    858
  Interest Rate Swaps In July 2002, the Company entered into interest rate swap transactions (the Transactions)
with two investment banks (the Banks) to hedge the interest rate risk of its outstanding 5.25%
Convertible Subordinated Notes due 2006 (the Notes) (see Note 13). The notional amount of the Transactions was $345.0 million to match the entire principal
amount of the Notes. The Company received from the Banks fixed payments equal to 5.25% percent of
the notional amount, payable on February 15 and August 15 which started on August 15, 2002. In
exchange, the Company paid to the Banks floating rate payments based upon the London Interbank
Offered Rate (LIBOR) plus 1.66% multiplied by the notional amount of the Transactions with the
LIBOR resetting every three months which began on August 15, 2002. The Transactions had a termination date of August 15, 2006 (Termination Date), subject to
certain early termination provisions if on or after August 20, 2004 and prior to August 15, 2006
the five-day average closing price of the Companys common stock were to equal or exceed $22.59 per
share. Depending on the timing of the early termination event, the Banks would be obligated to pay
the Company an amount equal to the repurchase premium called for under the terms of the Notes. The Transactions qualified and were designated as a fair value hedge against movements in the
fair value of the Notes due to changes in the benchmark interest rate. Under the fair value hedge
model, the derivative is recognized at fair value on the balance sheet with an offsetting entry to
the income statement. In addition, changes in fair value of the Notes due to changes in the
benchmark interest rate are recognized as a basis adjustment to the carrying amount of the Notes
with an offsetting entry to the income statement. The gain or loss from the change in fair value of
the Transactions and the offsetting change in the fair value of the Notes are recognized as
interest and other expense. The net unrealized gain recorded as of December 31, 2003 was
approximately $5.6 million and the estimated fair value of the Transactions was $9.4 million at
December 31, 2003. The Notes were fully repaid in August 2004, and the Transactions were left intact and became a
speculative investment, with gains and losses being recorded in the consolidated statement of
income. On October 27, 2004, the Transactions automatically terminated as the Companys five-day
average common stock price was equal to $22.59. The Company recorded a loss of $3.2 million in 2004
for the period of time from the repayment of the Notes through the termination of the Transactions. 54




---



##### Table of Contents



To test effectiveness of the hedge, regression analysis was performed at least quarterly
comparing the change in fair value of the Transactions and the Notes. The fair values of the
Transactions and the Notes were calculated at least quarterly as the present value of the
contractual cash flows to the expected maturity date, where the expected maturity date is based on
probability-weighted analysis of interest rates relating to the five-year LIBOR curve and the
Companys stock prices. For 2004 and 2003, the hedge was highly effective until the repayment of
the Notes and therefore, the ineffective portion did not have a material impact on earnings. In support of the Companys obligation under the Transactions, the Company was required to
maintain with the Banks a minimum level of cash and investment collateral of $20.0 million and
periodically adjust the overall level of collateral depending on the fair market value of the
Transactions. This minimum amount of collateral is presented as restricted cash in the consolidated
balance sheet as of December 31, 2003. The swap agreement terminated in October 2004, consequently,
there is no restricted cash balance at December 31, 2004 for the Transactions.  Collar In March 2002, the Company purchased a one-year collar consisting of 300,354 purchased put
options with a strike price of $17.31 and the same number of written call options with a strike
price of $22.04. Underlying both the put and call options were the Secure Computing shares. The
Company designated the purchased collar as a fair value hedge of the Secure Computing
available-for-sale securities received in the sales of Gauntlet assets (see Note 5) in accordance
with SFAS 133. At the inception of the hedge, the Company assessed that the collar was highly
effective based upon expected changes in the collars intrinsic value. In July 2002, the Company
sold its shares in Secure Computing and closed its collar. As a result the Company recorded a net
gain of $0.3 million, which is recorded as a gain of $0.4 million from the sale of the collar
offset by a loss of $0.1 million from the sale of Secure Computing securities for 2002. 8. Consolidated Balance Sheet Detail (in thousands): December 31,2004
    
    
    2003Property and equipment:Building
    
    $
    19,828
    
    
    $
    19,822Furniture and fixtures
    
    
    18,728
    
    
    
    27,469Computers and equipment
    
    
    154,005
    
    
    
    198,737Leasehold improvements
    
    
    21,421
    
    
    
    26,179Construction in progress
    
    
    2,034
    
    
    
    23,505216,016
    
    
    
    295,712Accumulated depreciation
    
    
    (129,363
    )
    
    
    (189,102
    )86,653
    
    
    
    106,610Land
    
    
    5,062
    
    
    
    5,062Total property and equipment, net
    
    $
    91,715
    
    
    $
    111,672
 Depreciation expense for 2004, 2003, and 2002 was $39.3 million, $35.8 million, and $39.8
million, respectively. December 31,2004
    
    
    2003Accrued liabilities:Accrued income taxes, short term
    
    $
    70,778
    
    
    $
    10,123Accrued compensation
    
    
    53,146
    
    
    
    51,183Accrued marketing costs
    
    
    2,806
    
    
    
    3,622Accrued legal and accounting fees
    
    
    9,231
    
    
    
    6,946Accrued interest
    
    
    
    
    
    
    6,843Other accrued expenses
    
    
    61,407
    
    
    
    68,564$
    197,368
    
    
    $
    147,281
 December 31,2004
    
    
    2003Accrued income taxes and other long-term liabilities:Accrued income taxes, long term
    
    $
    188,734
    
    
    $
    209,287Other
    
    
    16,062
    
    
    
    13,478$
    204,796
    
    
    $
    222,765
 Long-term accrued income taxes represent tax accruals for which the Company believes any
related cash flows would occur after December 31, 2005. 55




---



##### Table of Contents



9. Restructurings  2004 Restructurings During 2004, the Company recorded several restructuring charges related to the reduction of
employee headcount. In the first quarter of 2004, the Company recorded a restructuring charge of
approximately $2.2 million related to the severance of approximately 160 employees, of which $0.7
million and $1.5 million was related to the Companys North America and EMEA operating segments,
respectively. The workforce size was reduced primarily due to the Companys sale of Magic in
January 2004 (see Note 5). In the second quarter of 2004, the Company recorded a restructuring
charge of approximately $1.6 million related to the severance of approximately 80 employees in the
Companys sales, technical support and general and administrative functions. Approximately $0.6
million of the restructuring charge was related to the EMEA operating segment and the remaining
$1.0 million was related to the North America operating segment. In the third quarter of 2004, the
Company recorded a restructuring charge related to ten employees which totaled approximately $0.9
million, all of which related to the North America operating segment. In the fourth quarter of
2004, the Company recorded a restructuring charge of $1.3 million related to 111 employees, of
which $0.7 million, $0.2 million, $0.2
million and $0.2 million related to the Latin America, North America, EMEA and Asia-Pacific
(excluding Japan) operating segments, respectively. All employees have been terminated at December
31, 2004. The reductions in the second, third and fourth quarters are part of the previously
announced cost-savings measures being implemented by the Company. In September 2004, the Company announced the move of the European headquarters to Ireland,
which is expected to be substantially completed by the first quarter of 2005. In the third and
fourth quarters of 2004, the Company recorded restructuring charges of $0.2 million and $2.2
million, respectively, related to the severance of approximately 80 employees, all of which was
related to the EMEA operating segment. The costs will be substantially paid in the first half of
2005. Also in September 2004, the Company permanently vacated an additional two floors in its Santa
Clara headquarters building. The Company recorded a $7.8 million accrual for the estimated lease
related costs associated with the permanently vacated facility, partially offset by a $1.3 million
write-off of deferred rent liability. The remaining costs associated with vacating the facility are
primarily comprised of the present value of remaining lease obligations, net of estimated sublease
income along with estimated costs associated with subleasing the vacated facility. The remaining
costs will generally be paid over the remaining lease term ending in 2013. The Company also
recorded a non-cash charge of approximately $0.8 million related to disposals of certain leasehold
improvements. The restructuring charge of $6.5 million and related cash outlay are based on
managements current estimates. In the fourth quarter of 2004, the Company permanently vacated several leased facilities and
recorded a $2.2 million accrual for estimated lease related costs associated with the permanently
vacated facilities. The remaining costs associated with vacating the facilities are primarily
comprised of the present value of remaining lease obligations, along with estimated costs
associated with subleasing the vacated facility. During 2004, the Company adjusted the restructuring accruals related to severance costs and
lease termination costs recorded in 2004. The Company recorded a $0.3 million adjustment to reduce
the EMEA severance accrual for amounts that were no longer necessary after paying out substantially
all accrued amounts to the former employees. The Company also recorded a $0.2 million reduction in
lease termination costs due to changes in estimates related to the sublease income to be received
over the remaining lease term of its Santa Clara headquarters building. The following table summarizes the Companys restructuring accruals established in 2004 (in
thousands): LeaseTermination
    
    
    Severance and
    
    
    OtherCosts
    
    
    Other Benefits
    
    
    Costs
    
    
    TotalBalance, January 1, 2004
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Restructuring accrual
    
    
    8,685
    
    
    
    7,932
    
    
    
    480
    
    
    
    17,097Cash payments
    
    
    (579
    )
    
    
    (4,175
    )
    
    
    (63
    )
    
    
    (4,817
    )Adjustment to liability
    
    
    (222
    )
    
    
    (275
    )
    
    
    
    
    
    
    (497
    )Accretion
    
    
    74
    
    
    
    
    
    
    
    
    
    
    
    74Balance, December 31, 2004
    
    $
    7,958
    
    
    $
    3,482
    
    
    $
    417
    
    
    $
    11,857
 As of December 31, 2004, $5.8 million of the restructuring accrual is due within 12 months and
has been classified as current accrued liabilities, while the remaining balance of $6.1 million has
been classified as other long term liabilities, and will be paid through March 31, 2013. Lease
termination costs are net of estimated sublease income of $5.2 million at December 31, 2004. 56




---



##### Table of Contents



2003
    Restructuring In January 2003, as part of a restructuring effort to gain operational efficiencies, the
Company consolidated operations formerly housed in three leased facilities in the Dallas, Texas
area into its regional headquarters facility in Plano, Texas. The facility houses employees working
in finance, information technology, and the customer support and telesales groups servicing the
McAfee System Protection Solutions and McAfee Network Protection Solutions businesses. As part of the consolidation of activities into the Plano facility, the Company relocated
employees from the Santa Clara, California headquarters site. As a result of this consolidation, in
March 2003, the Company recorded a $15.6 million accrual for estimated lease related costs
associated with the permanently vacated facilities, partially offset by a $1.9 million write off of
deferred rent liability. The remaining costs associated with vacating the facility are primarily
comprised of the present value of remaining lease obligations, net of estimated sublease income,
along with estimated costs associated with subleasing the vacated facility. The remaining costs
will generally be paid over the remaining lease term ending in 2013. The Company also recorded a
non-cash charge of approximately $2.1 million related to asset disposals and discontinued use of
certain leasehold improvements and furniture and equipment. The total restructuring charge of $15.8
million and related cash outlay are based on managements current estimates. This restructuring
charge was allocated to the Companys North American segment. During the second and third quarters of 2003, the Company recorded restructuring charges of
$6.8 million and $0.6 million, respectively, which consisted of $6.7 million related to a headcount
reduction of 210 employees and $0.7 million related to other expenses such as legal expenses
incurred in international locations in conjunction with the headcount reduction. The restructuring
charge related to headcount reductions was $0.9 million and $5.8 million in the Companys North
American and EMEA operating segments, respectively. The employees were located in the Companys
domestic and international locations and were primarily in the sales, product development and
customer support areas. In the third and fourth quarters of 2003, the Company reversed a total of
$0.7 million of restructuring accrual in EMEA that was no longer necessary after paying out
substantially all accrued amounts to the former employees. In 2004 and 2003, the Company adjusted the restructuring accrual related to lease termination
costs previously recorded in 2003. The adjustments decreased the liability by approximately $0.6
million and $0.3 million in 2004 and 2003, respectively, due to changes in estimates related to the
sublease income to be received over the remaining lease term. Also in 2004, the Company recorded a
$0.1 million adjustment to reduce the restructuring accrual for severance and benefits from its
EMEA operating segment that would not be utilized. The following table summarizes the Companys restructuring accrual established in 2003 and
activity through December 31, 2004 (in thousands): LeaseTermination
    
    
    Severance and
    
    
    OtherCosts
    
    
    Other Benefits
    
    
    Costs
    
    
    TotalBalance, January 1, 2003
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Restructuring accrual
    
    
    15,734
    
    
    
    6,692
    
    
    
    739
    
    
    
    23,165Cash payments
    
    
    (1,707
    )
    
    
    (6,259
    )
    
    
    (167
    )
    
    
    (8,133
    )Adjustment to liability
    
    
    (273
    )
    
    
    (116
    )
    
    
    (572
    )
    
    
    (961
    )Accretion
    
    
    463
    
    
    
    
    
    
    
    
    
    
    
    463Balance, December 31, 2003
    
    
    14,217
    
    
    
    317
    
    
    
    
    
    
    
    14,534Cash payments
    
    
    (1,841
    )
    
    
    (194
    )
    
    
    
    
    
    
    (2,035
    )Adjustment to liability
    
    
    (623
    )
    
    
    (123
    )
    
    
    
    
    
    
    (746
    )Accretion
    
    
    548
    
    
    
    
    
    
    
    
    
    
    
    548Balance, December 31, 2004
    
    $
    12,301
    
    
    $
    
    
    
    $
    
    
    
    $
    12,301
 As of December 31, 2004, $1.3 million of the restructuring accrual is due within 12 months and
has been classified as current accrued liabilities, while the remaining balance of $11.0 million
has been classified as other long term liabilities and will be paid through March 31, 2013. Lease
termination costs are net of estimated sublease income of $10.9 million at December 31, 2004. The Companys estimate of the excess facilities charges recorded during 2003 and 2004 may vary
significantly depending, in part, on factors which may be beyond the Companys control, such as the
Companys success in negotiating with its lessor, the time periods required to locate and contract
suitable subleases and the market rates at the time of such subleases. Adjustments to the
facilities accrual will be made if actual lease exit costs or sublease income differ from amounts
currently expected. As part of the plan to integrate certain activities of the Companys PGP product group into
its other product groups and to dispose of other product lines, the Company sold its Gauntlet
business during the first quarter of 2002. In connection with this process, a restructuring charge
of approximately $1.1 million was recorded. The restructuring charge consists of costs of severance
packages for 44 employees as well as related legal and outplacement services. All amounts were paid
at December 31, 2002. 57




---



##### Table of Contents



10. Goodwill and Intangible Assets The Company accounts for goodwill and other intangible assets in accordance with SFAS No. 142,
Goodwill and Other Intangible Assets.In lieu of amortization, the Company performs an impairment
review of its goodwill on at least an annual basis. The impairment review requires a two-step
process. The Company performs its annual goodwill impairment review as of October 1, of its fiscal
year. In 2004, 2003, and 2002, these analyses have indicated that goodwill was not impaired. The
fair value of the reporting units was estimated using the average of the expected present value of
future cash flows and of the market multiple value. The Company will continue to test for
impairment on an annual basis and on an interim basis if an event occurs or circumstances change
that would more likely than not reduce the fair value of the Companys reporting units below their
carrying amounts. An interim impairment analysis was performed in the second quarter of 2004 to
coincide with the sale of the Companys Sniffer product line. Goodwill information is as follows (in thousands): Effects of
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Effects ofForeign
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    ForeignJanuary 1,
    
    
    Goodwill
    
    
    
    
    
    
    Currency
    
    
    December 31,
    
    
    Goodwill
    
    
    
    
    
    
    Currency
    
    
    December 31,2003
    
    
    Acquired
    
    
    Adjustments
    
    
    Exchange
    
    
    2003
    
    
    Acquired
    
    
    Adjustments
    
    
    Exchange
    
    
    2004North America
    
    $
    232,122
    
    
    $
    137,636
    
    
    $
    (6,671
    )
    
    $
    1,238
    
    
    $
    364,325
    
    
    $
    59,235
    
    
    $
    (59,007
    )
    
    $
    571
    
    
    $
    365,124EMEA
    
    $
    25,424
    
    
    $
    21,477
    
    
    $
    (2,830
    )
    
    $
    289
    
    
    $
    44,360
    
    
    $
    
    
    
    $
    (2,930
    )
    
    $
    221
    
    
    $
    41,651Japan
    
    $
    12,071
    
    
    $
    4,678
    
    
    $
    (1
    )
    
    $
    
    
    
    $
    16,748
    
    
    $
    
    
    
    $
    (351
    )
    
    $
    
    
    
    $
    16,397Asia-Pacific (excluding Japan)
    
    $
    2,301
    
    
    $
    3,814
    
    
    $
    (28
    )
    
    $
    
    
    
    $
    6,087
    
    
    $
    
    
    
    $
    (520
    )
    
    $
    
    
    
    $
    5,567Latin America
    
    $
    2,016
    
    
    $
    3,905
    
    
    $
    5,454
    
    
    $
    698
    
    
    $
    12,073
    
    
    $
    
    
    
    $
    (1,724
    )
    
    $
    92
    
    
    $
    10,441Total
    
    $
    273,934
    
    
    $
    171,510
    
    
    $
    (4,076
    )
    
    $
    2,225
    
    
    $
    443,593
    
    
    $
    59,235
    
    
    $
    (64,532
    )
    
    $
    884
    
    
    $
    439,180
 Goodwill was acquired during 2004 as a result of the purchase of Foundstone, and during
2003 as part of the purchases of Entercept and Intruvert (see Note 4). For 2004, the adjustments column consists primarily of a reduction of $50.5 million due to the
sale of Sniffer in 2004 (see Note 5), $13.6 million in adjustments related to the realization of
net deferred tax assets from the Cybermedia, BySupport and IntruVert acquisitions and $0.4 million
related to purchase price adjustments. For 2003, the adjustments column reflects a $6.2 million
increase due to purchase price adjustments related to the BySupport acquisition in 2002, and a $9.8
million decrease due to the reclassification of Magic goodwill to assets held for sale. The
goodwill adjustments related to each of the businesses were allocated based on the relative
percentage of their respective estimated fair values to the Companys fair value by reporting unit. The components of intangible assets are as follows (in thousands): December 31, 2004
    
    
    December 31, 2003Accumulated
    
    
    
    
    
    
    
    
    
    
    AccumulatedAmortization
    
    
    
    
    
    
    
    
    
    
    AmortizationWeighted
    
    
    
    
    
    
    (Including Effects
    
    
    
    
    
    
    
    
    
    
    (Including EffectsAverage
    
    
    Gross
    
    
    of Foreign
    
    
    Net
    
    
    Gross
    
    
    of Foreign
    
    
    NetUseful
    
    
    Carrying
    
    
    Currency
    
    
    Carrying
    
    
    Carrying
    
    
    Currency
    
    
    CarryingLife

    
    Amount
    
    
    Exchange)
    
    
    Amount
    
    
    Amount
    
    
    Exchange)
    
    
    AmountOther Intangible assets:Purchased technologies
    
    6.0 years
    
    $
    139,509
    
    
    $
    (74,400
    )
    
    $
    65,109
    
    
    $
    116,037
    
    
    $
    (64,439
    )
    
    $
    51,598Trademarks, patents
customer base, and
other intangibles
    
    6.4 years
    
    
    90,335
    
    
    
    (48,311
    )
    
    
    42,024
    
    
    
    103,431
    
    
    
    (49,077
    )
    
    
    54,3546.1 years
    
    $
    229,844
    
    
    $
    (122,711
    )
    
    $
    107,133
    
    
    $
    219,468
    
    
    $
    (113,516
    )
    
    $
    105,952
 The aggregate amortization expenses for the intangible assets listed above totaled $27.4
million, $27.0 million, and $13.9 million for 2004, 2003, and 2002, respectively. 2004
    
    
    2003(In thousands)Intangible assets, beginning of year
    
    $
    219,468
    
    
    $
    177,255Add: Purchased technologies (amortized over one to seven years)
    
    
    27,000
    
    
    
    40,523Add: Trademarks, patents and other intangibles (amortized over one to seven years)
    
    
    1,600
    
    
    
    4,704Add: Change in value due to foreign exchange
    
    
    2,122
    
    
    
    2,738250,190
    
    
    
    225,220Less: Transfers to goodwill
    
    
    
    
    
    
    (5,752
    )Dispositions
    
    
    (20,346
    )
    
    
    Intangible Assets, end of year
    
    $
    229,844
    
    
    $
    219,468
 The additions in 2004 are a result of the Foundstone acquisition. The dispositions consist of
the sale of the Magic and Sniffer product lines in 2004. The additions in 2003 consist of the
IntruVert and Entercept acquisitions. The transfers to goodwill in 2003 are a result of purchase
accounting adjustments for BySupport. 58




---



##### Table of Contents



Expected future intangible asset amortization expense is as follows (in thousands): Fiscal Years:2005
    
    $
    27,5852006
    
    
    24,8962007
    
    
    21,9542008
    
    
    16,5862009
    
    
    10,727Thereafter
    
    
    5,385$
    107,133
 11. Restated Commitments The Company leases most of its facilities under operating leases, which expire at various
times ranging from the year 2005 through 2017. The Companys operating leases for facilities
typically include renewal periods which are at the option of the Company, and annual contractual
escalations in lease payments. Several of the Companys significant leases are subject to rent
increases to market rates based on periodic rent reviews (typically every 5 years). The Company
owns its regional office in Plano, Texas. A description of the Companys significant operating
leases is as follows: Lease Expiration
    
    Renewal OptionCorporate Headquarters, Santa Clara, California
    
    March 2013
    
    NoneEuropean Headquarters, Cork, Ireland
    
    December 2014
    
    One 5-year and one
6-year renewalAmsterdam, The Netherlands
    
    June 2008
    
    5-year renewalSlough, England
    
    December 2017
    
    NoneParis, France
    
    April 2006
    
    NoneTokyo, Japan
    
    February 2006
    
    None
 In addition, the Company has leased certain office equipment with various lease expiration
dates through 2007. Subsequent to the issuance of the Companys 2004 consolidated financial statements, the
Companys management determined that future minimum lease payments and sublease rental income under
non-cancelable operating leases as of December 31, 2004 had been improperly calculated. As a
result, future minimum lease payments and sublease rental income have been restated from amounts
previously reported. A summary of the effects of this restatement are as follows (in thousands): As Previously Reported
    
    
    As RestatedSublease
    
    
    
    
    
    
    SubleasePayments
    
    
    Income
    
    
    Payments
    
    
    Income2005
    
    $
    24,197
    
    
    $
    1,294
    
    
    $
    20,025
    
    
    $
    1,5182006
    
    
    20,643
    
    
    
    737
    
    
    
    15,002
    
    
    
    1,1462007
    
    
    16,558
    
    
    
    
    
    
    
    10,422
    
    
    
    2008
    
    
    15,392
    
    
    
    
    
    
    
    9,051
    
    
    
    2009
    
    
    14,889
    
    
    
    
    
    
    
    8,629
    
    
    
    Thereafter
    
    
    61,810
    
    
    
    
    
    
    
    37,449
    
    
    
    Total
    
    $
    153,489
    
    
    $
    2,031
    
    
    $
    100,578
    
    
    $
    2,664
 Included in the above amounts are future minimum payments related to leases that the Company
has ceased using and consequently, in connection with recording the related restructuring
liabilities, has expensed prior to December 31, 2004 the present value of such future minimum
payments, net of related projected sub-lease income. Rent expense for 2004, 2003, and 2002 was $21.2 million, $21.3 million, and $25.2 million,
respectively. Sublease rental income under non-cancelable subleases was $1.5 million, $0.4 million,
and $0.1 million for 2004, 2003, and 2002, respectively. 12. Warranty Provision and Guarantees The Company offers warranty on its hardware and software products and records a liability for
the estimated future costs associated with warranty claims, which is based upon historical
experience and the Companys estimate of the level of future costs. A reconciliation of the change
in the Companys warranty obligation for the years ended December 31 follows (in thousands): 59




---



##### Table of Contents



2004
    
    
    2003
    
    
    2002Warranty provision, beginning of year
    
    $
    1,103
    
    
    $
    1,153
    
    
    $
    982Additional accruals
    
    
    8,037
    
    
    
    3,881
    
    
    
    4,624Disposition of Sniffer
    
    
    (807
    )
    
    
    
    
    
    
    Expenses incurred during the period
    
    
    (6,515
    )
    
    
    (3,931
    )
    
    
    (4,453
    )Warranty provision, end of year
    
    $
    1,818
    
    
    $
    1,103
    
    
    $
    1,153
 In November 2002, the FASB issued Interpretation No. 45 (FIN 45), Guarantors Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others.FIN 45 requires that a guarantor recognize, at the inception of a guarantee, a liability
for the fair value of the obligation undertaken in issuing the guarantee or indemnification. FIN 45
also requires additional disclosure by a guarantor in its interim and annual consolidated financial
statements about its obligations under certain guarantees and indemnifications. The following is a
summary of the agreements that the Company has determined are within the scope of FIN 45 as of
December 31, 2004:  
    Under the terms of the Companys software license agreements with its customers, the
Company agrees that in the event the software sold infringes upon any patent, copyright,
trademark, or any other proprietary right of a third party, it will indemnify its customer
licensees against any loss, expense, or liability from any damages that may be awarded
against its customer. The Company includes this infringement indemnification in all of its
software license agreements and selected managed service arrangements. In the event the
customer cannot use the software or service due to infringement and the Company can not
obtain the right to use, replace or modify the license or service in a commercially feasible
manner so that it no longer infringes then the Company may terminate the license and provide
the customer a pro-rata refund of the fees paid by the customer for the infringing license
or service. The Company has recorded no liability associated with this indemnification, as
it is not aware of any pending or threatened infringement actions that are probable losses.
The Company believes the estimated fair value of these intellectual property indemnification
clauses is minimal.
    Under the terms of certain vendor agreements, in particular, vendors used as part of the
Companys managed services, the Company has agreed that in the event the service provided to
the customer by the vendor on behalf of the Company infringes upon any patent, copyright,
trademark, or any other proprietary right of a third party, it will indemnify its vendor,
against any loss, expense, or liability from any damages that may be awarded against its
customer. No maximum liability is stipulated in these vendor agreements. The Company has
recorded no liability associated with this indemnification, as it is not aware of any
pending or threatened infringement actions or claims that are probable losses. The Company
believes the estimated fair value of these indemnification clauses is minimal.
    The Company has agreed to indemnify members of the board of directors, as well as
officers of the Company, if they are made a party or are threatened to be made a party to
any proceeding (other than an action by or in the right of the Company) by reason of the
fact that they are an agent of the Company, or by reason of anything done or not done by
them in any such capacity. The indemnity is for any and all expenses and liabilities of any
type whatsoever (including judgments, fines and amounts paid in settlement) actually and
reasonably incurred by the directors or officers in connection with the investigation,
defense, settlement or appeal of such proceeding, provided they acted in good faith. The
Company maintains insurance coverage for directors and officers liability (D&O insurance).
No maximum liability is stipulated in these agreements that include indemnifications of
members of the board of directors and officers of the Company. The Company has recorded no
liability associated with these indemnifications as it is not aware of any pending or
threatened actions or claims against its members of the board of directors or officers that
are probable losses in excess of amounts covered by its D&O insurance. As a result of the
insurance policy coverage, the Company believes the estimated fair value of these
indemnification agreements is minimal.
    Under the terms of the Companys agreement to sell Magic in January 2004, the Company
agreed to indemnify the purchaser for any breach of representations or warranties in the
agreement as well as for any liabilities related to the assets prior to sale that are not
included in the purchaser assumed liabilities (undiscovered liabilities). Subject to limited
exceptions, the maximum potential loss related to the indemnification is $10.0 million. To
date, the Company has paid no amounts under the representations and warranties
indemnification. The Company has not recorded any accruals related to these agreements.
    Under the terms of the Companys agreement to sell Sniffer in July 2004, the Company
agreed to indemnify the purchaser for any breach of representations or warranties in the
agreement as well as for any liabilities related to the assets prior to sale that are not
included in the purchaser assumed liabilities (undiscovered liabilities). Subject to limited
exceptions, the maximum potential loss related to the indemnification is $200.0 million. To
date, the Company has paid no amounts under the representations and warranties
indemnification. The Company has not recorded any accruals related to these agreements.
    Under the terms of the Companys agreement to sell McAfee Labs assets in December 2004,
the Company agreed to indemnify the purchaser for any breach of representations or
warranties in the agreement as well as for any liabilities related to the assets prior to
sale that are not included in the purchaser assumed liabilities (undiscovered liabilities).
Subject to limited exceptions, 60




---



##### Table of Contents



the maximum potential loss related to the indemnification is $1.5 million. The Company has not
recorded any accruals related to these agreements.
    Under the terms of the Companys agreements to sell the PGP and Gauntlet assets in 2002,
the Company agreed to indemnify the purchasers for any breach of representations or
warranties in the agreement as well as for any liabilities related to the assets prior to
sale that are not included in the purchaser assumed liabilities (undiscovered liabilities).
The maximum potential loss related to the indemnification for breach of representations or
warranties is $2.4 million. No maximum liability is stipulated in the agreement related to
any undiscovered liabilities. To date, the Company has paid $0.4 million under the
representations and warranties indemnification. If the Company believes a liability associated with any of the aforementioned indemnifications
becomes probable and the amount of the liability is reasonably estimable or the maximum amount of a
range of loss is reasonably estimable, then an appropriate liability will be established. 13. Convertible Debt and Line of Credit The convertible debt balance was $0 and $347.4 million, net of accumulated fair value
adjustment of $0 and $2.4 million (see Note 7), at December 31, 2004 and 2003, respectively.  Zero Coupon Convertible Debentures Due 2018 In February 1998, the Company completed a private placement of zero coupon convertible
subordinated debentures due in 2018 (the Debentures). The Debentures, with an aggregate face
amount at maturity of $885.5 million, generated net proceeds to the Company of approximately $337.6
million. The initial price to the public for the debentures was $391.06 per $1,000 of face amount
at maturity, which equates to a yield to maturity over the term of the Debentures of 4.75% (on a
semi-annual Debentures equivalent basis). The Debentures were convertible into common stock at the
rate of 8.538 shares per $1,000 of face amount at maturity, which equated to an initial conversion
price of $45.80 per share. The Debentures were subordinated in right of payment to all existing and
future Senior Indebtedness (as defined in the related indenture) and effectively subordinated in
right of payment to all indebtedness and other liabilities of the Companys subsidiaries. In accordance with the indenture, in 2002, the Company redeemed a portion of the Debentures,
which had an aggregate face amount at maturity of $140.0 million, at a net price of $66.2 million,
which was financed from the Companys investment portfolio. In connection with this repurchase, the
Company recognized a net gain of approximately $26,000 in 2002. The gain was calculated as the
difference between the accreted value of the debt, net of unamortized issuance costs and the cost
of repurchase. In February 2003, outstanding Debentures, with an aggregate face amount at maturity of $358.5
million, became redeemable for cash at the option of the holders thereof, at which time the Company
repurchased Debentures which had an aggregate face amount at maturity of $358.0 million for a net
price of $177.1 million. In June 2003, the Company repurchased the remaining Debentures with an
aggregate face amount at maturity of $0.5 million for a net price of $0.2 million. The Company
recognized a loss of $2.7 million on the repurchase of Debentures during 2003.  5.25% Convertible Subordinated Note Due 2006 In August 2001, the Company issued 5.25% convertible subordinated notes (Notes) due 2006
with an aggregate principal amount of $345.0 million. The issuance generated net proceeds (after
deducting fees and expenses) of $335.1 million. The amortization of the issuance costs related to
the Notes has been calculated using the effective interest method and recorded as additional
interest expense in the statements of income. The Notes were unsecured and were subordinated to all
existing and future Senior Indebtedness (as defined in the related indenture). The Notes had no
restrictive financial covenants. The Notes had a maturity date of August 15, 2006, unless earlier redeemed by the Company at
its option or converted at the holders option. At the option of the holder, the Notes were
convertible into the Companys common stock at any time, unless previously redeemed, at a
conversion price of $18.07 per share. The Notes could also be redeemed at the option of the holder
in the event of a Change of Control (as defined in the related indenture). At any time between
August 20, 2004 and August 14, 2005, the Company would be able to redeem all or a portion of the
Notes for cash at a repurchase price of 101.3125% of the principal amount. After August 14, 2005,
the repurchase price would be 100.0% of the principal amount. In August 2004, the Company redeemed all of the outstanding Notes at a net price of $265.6
million. Prior to the redemption date, approximately $83.4 million in aggregate principal amount of
the Notes converted into approximately 4.6 million shares of the Companys common stock. The
Company recorded a loss on redemption of approximately $15.1 million, which represented the
write-off of unamortized debt issuance costs, fair value adjustment and the 1.3125% premium paid
for redemption. 61




---



##### Table of Contents



In July 2002, the Company entered into an interest rate swap transaction with two investment
banks, which resulted in the convertible notes being carried at fair value (see Note 7). The estimated fair value of the Companys long-term debt outstanding at December 31, 2003,
which consisted of Notes with a carrying amount of $347.4, was $373.1 million.  Line of Credit The Company has a $17.0 million credit facility with a bank. The credit facility is available
on an offering basis, meaning that transactions under the credit facility will be on such terms and
conditions, including interest rate, maturity, representations, covenants and events of default, as
mutually agreed between the Company and the bank at the time of each specific transaction. The
credit facility is intended to be used for short term credit requirements, with terms of one year
or less. The credit facility can be cancelled at any time. No balances are outstanding as of
December 31, 2004. 14. Employee Benefit Plans  Company401(k)and Profit Sharing Plan The Companys 401(k) and Profit Sharing Plan cover substantially all full-time employees.
Employees can elect to defer the lesser of 40% of their compensation or $13,000 per year. The board
of directors, at its discretion, can match employee contributions in an amount not to exceed a
maximum of $4,000 per year. The number of plan participants was impacted by headcount reductions
resulting from the Magic and Sniffer dispositions, as well as general headcount reductions. Annual
amounts contributed by the Company under the plan were $4.0 million, $4.7 million, and $4.3 million
in 2004, 2003 and 2002, respectively.  Company Employee Stock Purchase Plan In April 2002, the Companys board of directors adopted McAfees 2002 Employee Stock Purchase
Plan (2002 Purchase Plan) and an initial 2.0 million shares of the Companys common stock were
reserved for issuance. In December 2003, the Companys stockholders approved an additional 2.0
million shares for issuance under the 2002 Purchase Plan for a total of 4.0 million shares. All
employees are eligible to participate in the 2002 Purchase Plan. The 2002 Purchase Plan is
comprised of two year offering periods with four six-month purchase periods. Purchase periods occur
twice yearly and each offering effectively contains a six, twelve, eighteen and twenty-four month
option. Shares are purchased through employees contributions at exercise prices equal to 85% of
the lesser of the fair market value of the Companys common stock at either the first day of an
offering period or the last day of the purchase period. No participant may purchase more than
$25,000 of common stock in any one calendar year and the maximum number of shares a participant may
purchase during a single offering period is 10,000 shares. In 2004 and 2003, approximately 0.8
million and 1.6 million shares were issued under the 2002 Purchase Plan at a weighted average
purchase price of $10.41 and $9.89, respectively. Under the 1994 Employee Qualified Stock Purchase Plan (1994 Purchase Plan), the Company
could grant stock purchase rights to all eligible employees during one year offering periods with
exercise dates approximately every six months (beginning each August and February). The Company had
reserved 3.8 million shares of common stock for issuance under the plan. Shares were purchased
through employees payroll deductions at exercise prices equal to 85% of the lesser of the fair
value of the Companys common stock at either the first day of an offering period or the last day
of such offering period. No participant could purchase more than $25,000 of common stock in any one
calendar year. After the purchase on January 31, 2002, the 1994 Purchase Plan was terminated. In
2002, approximately 0.7 million shares were issued under the 1994 Purchase Plan at a weighted
average purchase price of $7.24.  McAfee.com Employee Stock Purchase Plan In September 1999, McAfee.coms board of directors adopted McAfee.coms Employee Stock
Purchase Plan (the 1999 Purchase Plan). A total of 0.5 million shares of McAfee.com Class A
common stock were initially reserved for issuance under the 1999 Purchase Plan. All McAfee.com
full-time employees were eligible to participate in the 1999 Purchase Plan. The 1999 Purchase Plan
was comprised of two-year offering periods with exercise dates approximately every six months
(beginning each August and February), with the exception of the first offering period, which
commenced on December 2, 1999, with the first exercise date on January 31, 2000. Shares were
purchased through McAfee.com employees payroll deductions at exercise prices equal to 85% of the
lesser of the fair market value of McAfee.coms Class A common stock at either the first day of an
offering period or the last day of such offering period. No participant could purchase more than
$25,000 worth of Class A common stock in any one calendar year and the maximum number of shares a
participant could purchase during a single purchase period was 2,500 shares. Purchase periods
occurred twice yearly and each offering effectively contained a six, twelve, eighteen and
twenty-four month option. On September 13, 2002, the Company acquired the minority interest in
McAfee.com and therefore the McAfee.com employee stock purchase plan was terminated. In 2002,
approximately 0.2 million of McAfee.com shares were issued under the 1999 Purchase Plan at weighted
average purchase price of $6.66. There was no activity under this plan in 2004 and 2003. 62




---



##### Table of Contents



15. Stockholders Equity  Common Stock In November 2003, the Companys board of directors authorized the repurchase up to $150.0
million of the Companys common stock in the open market. In August 2004, the board of directors
authorized the repurchase of an additional $200.0 million of common stock through August 2006. The
Company repurchased approximately 12.6 million and 0.4 million shares of its common stock in 2004
and 2003 for $221.8 million and $4.7 million, respectively. As of December 31, 2004, the Company
may repurchase an additional $123.6 million of its common stock. The timing and size of future
repurchases are subject to market conditions, stock prices, the Companys cash position and other
cash requirements. In 2004, the Company retired approximately 13.0 million shares of its common stock which had
been purchased on the open market in 2003 and 2004. In 1998, the Company deposited approximately 1.7 million shares of common stock with a trustee
for the benefit of the employees of the Dr. Solomons acquisition to cover the stock options
assumed in the acquisition of this company. These shares, which have been included in the
outstanding share balance, were to be issued upon the exercise of stock options by Dr. Solomons
employees. The Company determined in June 2004 that Dr. Solomons employees had exercised
approximately 1.6 million options, and that it had issued new shares in connection with these
exercises rather than the trust shares. The trustee returned the 1.6 million shares to the Company
in June 2004, at which time they were retired and were no longer included in the outstanding share
balance. In December 2004, the trustee sold the remaining 133,288 shares in the trust for proceeds
of $3.8 million, and remitted the funds to the Company. The terms of the trust prohibited the
trustee from returning the shares to the Company and stipulated that only employees could benefit
from the shares. The Company paid out the $3.8 million to its employees as a bonus in 2004.  Preferred Stock The Company has authorized 5.0 million shares of preferred stock, par value $0.01 per share.
The Companys board of directors has authority to provide for the issuance of the shares of
preferred stock in series, to establish from time to time the number of shares to be included in
each such series and to fix the designation, powers, preferences and rights of the shares of each
such series and the qualifications, limitations or restrictions thereof, without any further vote
or action by the shareholders.  Company Stock Option Plans Under the amended 1997 Plan, the Company has reserved 32.5 million shares for issuance to
employees, officers, directors, third party contractors and consultants. The plan provides for an
option price no less than 100% of the fair value of the Companys common stock on the date of grant
for incentive stock options granted to employees and officers (including directors who are also
employees) or 85% of the fair value on the date of grant for all others. The options may be
exercisable immediately, or over time, but generally become exercisable 25% one year after
commencing employment or from date of grant and thereafter in monthly increments over three years.
All options under the option plan expire ten years after grant. Under the Stock Option Plan for Outside Directors, the Company has reserved 1.1 million shares
of its common stock for issuance to certain members of its board of directors who are not employees
of the Company or any affiliated corporation. The plan provides for an option price at fair value
of the Companys common stock on the date of grant. The initial grant to each outside director
generally vests ratably over a three-year period. Subsequent option grants will become exercisable
after three years from the date of grant. All options under the option plan expire ten years after
grant. The Company assumed the Foundstone, Inc. 2000 Stock Plan as part of the acquisition of
Foundstone in October 2004 (see Note 4). The Company has reserved 747,144 shares of its common
stock for issuance under this plan. The plan provides for an option price no less than 85% of the
fair value of the Companys common stock on the date of grant. The options generally become
exercisable 25% one year after commencing employment or from the date of grant and thereafter in
monthly increments over three years. All options under the plan expire ten years after grant. The
Company assumed 428,696 options to purchase its common stock as a result of the acquisition. In September 2002, the Company acquired the minority interest in McAfee.com. At that time, all
outstanding options under McAfee.coms 1999 Stock Plan and 1999 Director Option Plan were converted
and transferred into the Companys option plans and the McAfee.com stock option plans were
terminated. 63




---



##### Table of Contents



Aggregate activity under the Companys stock option plans is as follows (in thousands, except
per share data): Outstanding OptionsWeightedShares
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    AverageAvailable
    
    
    Number of
    
    
    
    
    
    
    Aggregate
    
    
    Exercisefor Grant
    
    
    Shares
    
    
    Price per Share
    
    
    Price
    
    
    PriceBalances, January 1, 2002
    
    
    9,104
    
    
    
    31,771
    
    
    $
    0.23-$48.72
    
    
    $
    421,493
    
    
    $
    13.27Additional options reserved
    
    
    5,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Option plan expirations
    
    
    (984
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Options granted
    
    
    (8,302
    )
    
    
    8,302
    
    
    $
    0.01-$30.26
    
    
    
    190,401
    
    
    $
    22.93Options issued in exchange of McAfee.com outstanding stock options
    
    
    
    
    
    
    2,761
    
    
    $
    4.63-$71.26
    
    
    
    46,748
    
    
    $
    16.93Options exercised
    
    
    
    
    
    
    (8,197
    )
    
    $
    0.01-$28.50
    
    
    
    (107,454
    )
    
    $
    13.11Options canceled
    
    
    6,335
    
    
    
    (6,335
    )
    
    $
    4.19-$34.69
    
    
    
    (124,025
    )
    
    $
    19.58Balances, December 31, 2002
    
    
    11,153
    
    
    
    28,302
    
    
    $
    0.01-$71.26
    
    
    $
    427,163
    
    
    $
    15.09Option plan expirations
    
    
    (1,326
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Options granted
    
    
    (7,807
    )
    
    
    7,807
    
    
    $
    10.80-$20.28
    
    
    
    118,364
    
    
    $
    15.16Options exercised
    
    
    
    
    
    
    (2,548
    )
    
    $
    1.78-$29.82
    
    
    
    (20,532
    )
    
    $
    8.06Options canceled
    
    
    3,821
    
    
    
    (3,821
    )
    
    $
    4.19-$65.38
    
    
    
    (69,982
    )
    
    $
    18.32Balances, December 31, 2003
    
    
    5,841
    
    
    
    29,740
    
    
    $
    0.01-$71.26
    
    
    $
    455,013
    
    
    $
    15.30Additional options of acquired company reserved
    
    
    747
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Option plan expirations
    
    
    (1,993
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Options granted
    
    
    (5,674
    )
    
    
    5,674
    
    
    $
    14.96-$33.39
    
    
    
    102,131
    
    
    $
    18.00Options assumed in conjunction with acquisition
    
    
    (429
    )
    
    
    429
    
    
    $
    1.11-$3.68
    
    
    
    1,153
    
    
    $
    2.69Options exercised
    
    
    
    
    
    
    (9,152
    )
    
    $
    0.65-$38.23
    
    
    
    (106,235
    )
    
    $
    11.61Options canceled
    
    
    7,262
    
    
    
    (7,262
    )
    
    $
    2.80-$58.71
    
    
    
    (139,753
    )
    
    $
    19.24Balances, December 31, 2004
    
    
    5,754
    
    
    
    19,429
    
    
    $
    0.01-$71.26
    
    
    $
    312,309
    
    
    $
    16.08
 Net proceeds from exercise of stock options was $105.7 million, $19.6 million and $99.7
million for 2004, 2003 and 2002, respectively, which is net of a reduction in stock option exercise
proceeds of $0.5 million, $0.9 million and $7.8 million, respectively. This reduction is for the
payment of the Companys cash obligation, not exceeding the full exercise price, which is triggered
upon exercise of the Company stock options that were granted in exchange for the McAfee.com options
(see Note 16). During 2004 the Company granted 1.1 million stock options to employees for which the exercise
price was below the fair value of its common stock on the date of grant. The Company is recognizing
approximately $0.1 million in compensation expense over the vesting period of the options. During
2002, the Company exchanged approximately 2.3 million options in the McAfee.com acquisition at
exercise prices below fair value as of the acquisition date (see Note 16). No options were granted
to employees below or above fair value during 2003. For various price ranges, weighted average characteristics of outstanding stock options of the
Company at December 31, 2004 were as follows (in thousands, except per share data): Options Outstanding
    
    
    Options ExercisableWeightedAverage
    
    
    Weighted
    
    
    
    
    
    
    WeightedRemaining
    
    
    Average
    
    
    
    
    
    
    AverageNumber
    
    
    Contractual
    
    
    Exercise
    
    
    Number
    
    
    ExerciseRange of Exercise Prices
    
    Outstanding
    
    
    Life (Yrs)
    
    
    Price
    
    
    Exercisable
    
    
    Price$0.01-$1.98
    
    
    98
    
    
    
    4.3
    
    
    $
    0.63
    
    
    
    51
    
    
    $
    1.21$1.99-$4.12
    
    
    359
    
    
    
    5.1
    
    
    $
    2.88
    
    
    
    237
    
    
    $
    2.80$4.13-$6.19
    
    
    2,370
    
    
    
    5.1
    
    
    $
    4.66
    
    
    
    2,269
    
    
    $
    4.67$6.20-$9.30
    
    
    534
    
    
    
    5.5
    
    
    $
    7.63
    
    
    
    421
    
    
    $
    7.58$9.31-$13.97
    
    
    2,926
    
    
    
    7.2
    
    
    $
    12.22
    
    
    
    1,399
    
    
    $
    11.98$13.98-$20.97
    
    
    9,169
    
    
    
    8.1
    
    
    $
    17.27
    
    
    
    2,339
    
    
    $
    17.09$20.98-$31.47
    
    
    3,817
    
    
    
    6.3
    
    
    $
    25.17
    
    
    
    2,432
    
    
    $
    24.98$31.48-$47.22
    
    
    133
    
    
    
    6.0
    
    
    $
    35.47
    
    
    
    99
    
    
    $
    36.13$47.23-$74.00
    
    
    23
    
    
    
    3.7
    
    
    $
    57.39
    
    
    
    23
    
    
    $
    57.5319,429
    
    
    
    7.1
    
    
    $
    16.08
    
    
    
    9,270
    
    
    $
    14.76
 At December 31, 2003 and 2002, the Company had 14.1 million and 10.0 million options that
were exercisable with weighted average exercise prices of $15.33 and $14.27, respectively. 64




---



##### Table of Contents



Proforma Stock Compensation Disclosure The fair value of options granted by the Company and McAfee.com has been calculated using the
Black-Scholes option-pricing model using the single option approach. A typical option grant vests
over a four-year period. Parameters for the option analysis are listed below. 2004
    
    
    2003
    
    
    2002The Company:Risk free interest rate
    
    
    3.07
    %
    
    
    2.44
    %
    
    
    3.46
    %Expected life (years)

    
    
    4
    
    
    
    4
    
    
    
    4Volatility
    
    
    63
    %
    
    
    96
    %
    
    
    84
    %Dividend yield
    
    
    
    
    
    
    
    
    
    
    
 The weighted average grant date fair value of options granted by the Company in 2004, 2003 and
2002 was $9.08, $10.38 and $10.07, respectively. The weighted average fair value of restricted stock granted by the Company in 2002 was $27.19. OptionsOptions
    
    
    Granted toGranted to
    
    
    Non-Employees
    
    
    Employees2002
    
    
    2002McAfee.com:Risk free interest rate
    
    
    3.82
    %
    
    
    3.82
    %Expected life (years)
    
    
    5
    
    
    
    10Volatility
    
    
    110
    %
    
    
    110
    %Dividend yield
    
    
    
    
    
    
    
 The weighted average expected life of the option grants was estimated based on historical
exercise patterns. The weighted average grant date fair value of options granted by McAfee.com to employees in
2002 was $7.76. The Company and McAfee.com have also estimated the fair value of purchase rights issued under
their employee stock purchase plans. Rights under these plans were also valued using the
Black-Scholes option pricing model. Parameters for the purchase rights analysis are listed below:  The Company: 2004
    
    
    2003
    
    
    2002Risk free interest rate
    
    
    2.03
    %
    
    
    1.43
    %
    
    
    2.05
    %Expected life (years)
    
    
    1.25
    years
    
    
    1.25
    years
    
    
    6
    monthsVolatility
    
    
    48
    %
    
    
    72
    %
    
    
    84
    %Dividend yield
    
    
    
    
    
    
    
    
    
    
    
 The weighted average fair value of rights issued pursuant to the Companys employee stock
purchase plans in 2004, 2003 and 2002, was $6.58, $13.75, and $14.62, respectively.  McAfee.com: 2002Risk free interest rate
    
    
    1.72
    %Expected life (years)
    
    
    6
    monthsVolatility
    
    
    110
    %Dividend yield
    
    
    
 The weighted average fair value of rights issued by McAfee.com pursuant to its employee stock
purchase plan until September 13, 2002 was $39.60.  Preferred Shares Rights Agreement On October 19, 1998, pursuant to a Preferred Shares Rights Agreement between the Company and
BankBoston, N.A. as Rights Agent, the board of directors of the Company announced that it had
declared a dividend distribution of one preferred share purchase 65




---



##### Table of Contents



right (a Right) on each
outstanding share of the Companys common stock. Each Right will entitle stockholders to buy one
one-thousandth of a share of the Companys Series B Participating Preferred Stock at an exercise
price of $200.00. The Rights will become exercisable following the tenth day after a person or
group announces the acquisition of 15% or more of the Companys common stock or announces
commencement of a tender or exchange offer, the consummation of which would result in ownership by
the person or group of 15% or more of the common stock of the Company. The Company will be entitled
to redeem the Rights at $0.01 per Right at any time on or before the tenth day following
acquisition by a person or group of 15% or more of the Companys common stock. The dividend
distribution was made on November 3, 1998, payable to the stockholders of record on November 3,
1998. The Rights expire on October 20, 2008. 16. Stock-Based Compensation The Company recorded $14.3 million, $12.5 million, and $22.4 million in 2004, 2003 and 2002,
respectively, of stock-based compensation. Stock-based compensation charges relate primarily to the
exchange of McAfee.com options in connection with the Companys acquisition of the publicly traded
minority interest in McAfee.com, non-recurring stock compensation charges related to
executive compensation and the repricing of employee stock options. The Company expects
significant future stock-based compensation charges related to the exchange of McAfee.com options,
repriced employee stock options and the adoption of SFAS 123R (see Note 2). The following is a summary of the Companys compensation charges for the years presented (in
thousands): Years Ended December 31,2004
    
    
    2003
    
    
    2002Exchange of McAfee.com options
    
    $
    6,669
    
    
    $
    3,369
    
    
    $
    16,101Former employees
    
    
    1,216
    
    
    
    1,125
    
    
    
    10,118New and existing executives and employees
    
    
    1,928
    
    
    
    424
    
    
    
    1,478Extended life of vested options of terminated employees
    
    
    1,164
    
    
    
    3,720
    
    
    
    Extended vesting term of options
    
    
    
    
    
    
    
    
    
    
    193Extended period of Employee Stock Purchase Plan
    
    
    
    
    
    
    3,869
    
    
    
    Shares purchased outside Employee Stock Purchase Plan and other
    
    
    
    
    
    
    
    
    
    
    62Repriced options
    
    
    3,343
    
    
    
    
    
    
    
    (5,548
    )Total stock-based compensation
    
    $
    14,320
    
    
    $
    12,507
    
    
    $
    22,404
 Exchange of McAfee.com options.On September 13, 2002, the Company acquired the minority
interest in McAfee.com. McAfee.com option holders received options for 0.675 of a share of the
Companys common stock plus $8.00 in cash, $11.85 after applying the option exchange ratio, which
is paid to the option holder upon exercise of the option and without interest. McAfee.com options
to purchase 4.1 million shares were converted into options to purchase 2.8 million shares of the
Companys common stock. The assumed options have been accounted for under the guidance in EITF
Issue No. 00-23, Issues Related to the Accounting for Stock Compensation under APB Opinion No.
25,and FASB Interpretation No. 44 (FIN 44), Accounting for Certain Transactions Involving
Stock Compensation  an Interpretation of APB Opinion No. 25.Accordingly, these options are
subject to variable accounting treatment, which means that a compensation charge has been measured
initially at the date of the closing of the acquisition and then remeasured at the end of each
reporting period. The initial charge was based on the excess of the closing price of the Companys common stock
over the exercise price of the options plus the $11.85 per share payable in cash. This compensation
charge has been and will be remeasured using the same methodology until the earlier of the date of
exercise, forfeiture or cancellation without replacement. This compensation charge is recorded as
an expense over the remaining vesting period of the options using the accelerated method of
amortization under FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other
Variable Stock Option or Award Plans.For those options that were fully vested at the date of the
closing of the acquisition, the Company immediately recorded compensation expense of $10.5 million.
Charges related to unvested options are recorded as deferred stock-based compensation in
stockholders equity in the consolidated balance sheet, and recognized as expense as the options
vest. During 2004, 2003 and 2002, the Company recorded charges of approximately $6.7 million, $3.4
million and $16.1 million, including the $10.5 million described above, respectively, related to
exchanged options subject to variable accounting. These stock-based compensation charges were based
on the Companys closing stock prices of $28.93, $15.04 and $16.09 on December 31, 2004, 2003 and
2002, respectively. As of December 31, 2004, the Company had outstanding exchanged options to
acquire approximately 0.4 million shares subject to this variable accounting. Further fluctuations
in the stock price may result in significant additional stock based compensation charges in future
periods. Former Employees.In November and December 2003, the Company extended the vesting period of
two employees and also extended the period after which vesting ends to exercise their options.
These employees options continued to vest after termination and their exercise period was extended
an additional 90 days. The Company recorded a one time stock-based compensation charge of
approximately $0.1 million in 2004. 66




---



##### Table of Contents



As a result of the sale of the Companys Sniffer product line in July 2004, the Company
modified the stock option agreements of several Sniffer executives by accelerating the vesting of
their unvested outstanding options. The Company recorded a stock-based compensation charge of
approximately $1.0 million in 2004. In October 2002, the Company terminated the employment of four former McAfee.com executives.
These executives held McAfee.com exchanged options, which are subject to variable accounting as
discussed above. Upon termination, the options were modified in accordance with a change in control
provision. As a result, the Company recorded a stock compensation charge of approximately $1.1
million and $9.9 million in 2003 and 2002, respectively. In July 2002, one of the Companys employees became a non-employee, but continued to provide
services to the Company. As he was allowed to continue to vest his options, the Company recorded a
stock-based compensation charge corresponding to the fair market value of his vested options. The
Company recorded stock-based compensation of $0.2 million in 2002. New and Existing Executives and Employees.In January 2002, the Companys board of directors
approved a grant of 50,000 shares of restricted stock to its chief executive officer. The price of
the underlying shares is $0.01 per share. The shares will vest and the Companys right to
repurchase such shares will lapse as follows: 3,000 vested as of the grant date and 47,000 are
restricted until January 15, 2005. The fair value of the restricted stock was determined to be
approximately $1.4 million and was determined based on the difference between the exercise price of
the restricted stock and the fair value of the common stock on January 15, 2002. During 2004, 2003
and 2002, the Company recorded approximately $0.4 million, $0.4 million and $0.5 million related to
stock-based compensation associated with the chief executive officers 2002 restricted stock grant. In September 2004, the Companys chief financial officer and chief operating officer announced
that he was retiring from the Company effective December 31, 2004. Under the terms of his
transition agreement, his options were modified such that all remaining unvested outstanding stock
options would immediately vest on December 31, 2004 under specified conditions. The total stock
based compensation charge related to this modification was approximately $1.3 million, which was
recorded as expense in 2004. In connection with the acquisition of Foundstone in October 2004, the Company exchanged
options to purchase shares of its common stock for Foundstone stock options. The fair value of the
Companys stock options was included in the Foundstone purchase price. In accordance with FIN 44,
the Company recorded $2.3 million of deferred stock-based compensation related to the exchange of
unvested stock options which are subject to vesting provisions as employment services are provided
by the former Foundstone employees. The unvested stock options granted to Foundstone employees vest
over periods ranging through 2008. The Company recorded stock-based compensation of $0.2 million in
2004 related to the unvested stock options exchanged in the Foundstone acquisition. On January 3, 2001, the Company entered into an employment agreement with its current chief
executive officer. In accordance with the terms of the agreement, the Company issued 400,000 shares
of restricted stock to its chief executive officer. The price of the underlying shares was $0.01
per share. The shares vested and the Companys right to repurchase such shares lapsed as follows:
12.5% on the first four quarterly anniversaries of employment and the remaining 50% on the second
year anniversary of employment. The fair value of the restricted stock was determined to be
approximately $2.0 million and was estimated based on the difference between the exercise price of
the restricted stock and the fair value of the Companys common stock on the employment
commencement date. During 2002, the Company recorded approximately $1.0 million in stock-based
compensation. Extended life of vested options held by terminated employees.In connection with the
Foundstone acquisition, the Company exchanged vested options to purchase shares of its common stock
for vested Foundstone options. Certain Foundstone employees terminated their employment in October
2004 subsequent to the acquisition. Under the terms of their options, the terminated employees had
90 days to exercise their options before they would expire. The Company determined prior to the end
of 2004 that it would not be able to file the required public company reports with the SEC that
would allow the terminated Foundstone employees to exercise their options within the 90 day period.
On December 7, 2004, the Company extended the expiration date of the options through the end of
January 2005. In accordance with FIN 44, this modification was considered to result in a new
measurement of compensation cost as if the options were newly granted. The compensation charge was
calculated based on the difference between the Companys closing stock price on December 7, 2004,
the date of modification, and the closing stock price on the date of the Foundstone acquisition.
The Company recorded a stock-based compensation charge of $1.0 million in 2004. In March 2003, the Company announced that the filing of its Form 10-K for 2002 would be
postponed in order to restate prior financial results for 2000, 1999 and 1998. As a result,
effective April 9, 2003, the Company suspended all exercises of stock options until the 2002 Form
10-K and all required quarterly reports on Form 10-Q were filed with the SEC, as these reports are
incorporated by reference into the securities registration statements for each of the stock option
plans. The period during which all stock option exercises were suspended was known as the blackout
period. Due to the blackout period, the Company extended the exercisability of any options that
would otherwise terminate during the blackout period for a period of time equal to a specified
period after termination of the blackout period. Accordingly, the Company recorded a stock-based
compensation charge on the date the options should have 67




---



##### Table of Contents



terminated based on the intrinsic value of
the option on the modification date and the option price. The Company recorded stock-based
compensation charges of approximately $0.1 million and $3.7 million for 2004 and 2003. Extended Vesting Term of Options.In the second quarter of 2002, the Company recorded a
one-time stock-based compensation charge of approximately $0.2 million as a result of the
modification of the terms of the options previously granted to certain employees. Extended period of Employee Stock Purchase Plan.In March 2003, the Company announced that
the filing of its Form 10-K for 2002 would be postponed in order to restate prior financial results
for 2000, 1999 and 1998. As a result, effective April 9, 2003, the Company suspended all stock
purchases until the 2002 Form 10-K and all required quarterly reports on Form 10-Q were filed with
the SEC, as these reports are incorporated by reference into the securities registration statements
for the 2002 Employee Stock Purchase Plan (2002 Purchase Plan). The period during which all stock
purchases were suspended was known as the blackout period. Due to the blackout period, the Company
extended the purchase period of the 2002 Purchase Plan that would otherwise had been purchased on
July 31, 2003. Accordingly, during 2003, the Company recorded a stock-based compensation charge of
approximately $3.9 million
for the extended period of the 2002 Purchase Plan. The blackout period ended in November 2003,
and therefore no additional stock-based compensation will be recorded. Shares Purchased Outside Employee Stock Purchase Plan.On January 31, 2002, the Company
experienced a shortfall in the number of shares available under the 1994 Employee Qualified Stock
Purchase Plan to meet the requirements of the open purchase period. Although the Company reduced
the number of shares plan participants could purchase by a pro rata amount, additional shares were
required to be purchased outside of the plan in order to meet this shortfall. As a result, the
Company recorded a one-time stock-based compensation charge of approximately $0.1 million in 2002.
The charge was based on the difference between the fair value of the shares purchased outside of
the plan and the price the shares were sold to plan participants. Repriced Options.On April 22, 1999, the Company offered to substantially all of its
employees, excluding executive officers, the right to cancel certain outstanding stock options and
receive new options with an exercise price of $11.063, the then current fair value of the stock.
Options to purchase a total of 9.5 million shares were cancelled and the same number of new options
were granted. These new options vest at the same rate that they would have vested under previous
option plans and are subject to variable accounting. Accordingly, the Company has and will continue
to remeasure compensation cost for these repriced options until these options are exercised,
cancelled, or forfeited without replacement. The first valuation period began July 1, 2000. The amount of stock-based compensation recorded was and will be based on any excess of the
closing stock price at the end of the reporting period or date of exercise, forfeiture or
cancellation without replacement, if earlier, over the fair value of the Companys common stock on
July 1, 2000, which was $20.375. The resulting compensation charge to earnings is recorded over the
remaining vesting period, using the accelerated method of amortization required by FASB
Interpretation 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or
Award Plans  an Interpretation of APB Opinions No. 15 and 25.At December 31, 2004, these options
were fully vested. Depending upon movements in the market value of the Companys common stock, this
variable accounting treatment can result in additional stock-based compensation charges in future
periods until the options are exercised, forfeited or cancelled. During 2004, the Company recorded a stock-based compensation charge of $3.3 million, and
during 2002, the Company recorded a credit to earnings of approximately $6.5 million. For 2004 and
2002, the Companys stock-based compensation charge (credit) was based on year-end per share prices
of its stock of $28.93 and $16.09, respectively. There was no charge or credit recorded by the
Company in 2003 as the stock price was below $20.375 as of December 31, 2002 and throughout 2003.
As of December 31, 2004, the Company had 0.3 million options outstanding subject to variable
accounting. The Company also incurred an initial stock-based compensation charge in connection with the
initial issuance of the repriced options. This charge was calculated based on the difference
between the exercise price of the new options and their market value on the date of acceptance by
employees. Approximately $1.0 million was expensed during 2002. 17. Provision for Income Taxes The domestic and foreign components of income before provision for income taxes were as
follows (in thousands): 2004
    
    
    2003
    
    
    2002Domestic
    
    $
    180,462
    
    
    $
    17,303
    
    
    $
    278Foreign
    
    
    136,009
    
    
    
    69,752
    
    
    
    129,655$
    316,471
    
    
    $
    87,055
    
    
    $
    129,933
 68




---



##### Table of Contents



Significant components of the provision (benefit) for income taxes attributable to continuing
operations are as follows (in thousands): Years Ended December 31,2004
    
    
    2003
    
    
    2002Federal:Current
    
    $
    2,630
    
    
    $
    18,148
    
    
    $
    39,916Deferred
    
    
    68,370
    
    
    
    (23,332
    )
    
    
    (61,674
    )Total Federal
    
    
    71,000
    
    
    
    (5,184
    )
    
    
    (21,758
    )State:Current
    
    
    (1,834
    )
    
    
    5,863
    
    
    
    5,189Deferred
    
    
    8,439
    
    
    
    (4,802
    )
    
    
    (2,362
    )Total State
    
    
    6,605
    
    
    
    1,061
    
    
    
    2,827Foreign:Current
    
    
    21,648
    
    
    
    18,167
    
    
    
    19,829Deferred
    
    
    (7,847
    )
    
    
    2,766
    
    
    
    (1,172
    )Total Foreign
    
    
    13,801
    
    
    
    20,933
    
    
    
    18,657Provision for (benefit from) income taxes
    
    $
    91,406
    
    
    $
    16,810
    
    
    $
    (274
    )
 Approximately $3.6 million of the provision for income taxes in 2003 was reflected as part of
the cumulative effect of a change in accounting principal in the consolidated statement of income. Significant components of net deferred tax assets are as follows (in thousands): Years Ended December 31,2004
    
    
    2003ASSETSDeferred revenue
    
    $
    154,910
    
    
    $
    124,932Accrued liabilities and allowances
    
    
    74,627
    
    
    
    61,802Depreciation and amortization
    
    
    165,279
    
    
    
    137,554Tax credits
    
    
    107,871
    
    
    
    117,998Deferred stock compensation
    
    
    7,870
    
    
    
    4,116Net operating loss carryover
    
    
    27,948
    
    
    
    51,332538,505
    
    
    
    497,734Valuation allowance
    
    
    (65,820
    )
    
    
    (88,283
    )Total deferred tax assets
    
    
    472,685
    
    
    
    409,451LIABILITIESIntangibles not amortizable for tax purposes
    
    
    39,677
    
    
    
    40,178Accrued liabilities and allowances
    
    
    11,947
    
    
    
    9,527Total deferred tax liability
    
    
    51,624
    
    
    
    49,705Net deferred tax asset
    
    $
    421,061
    
    
    $
    359,746Current portion
    
    $
    200,459
    
    
    $
    160,550Noncurrent portion
    
    
    220,602
    
    
    
    199,196$
    421,061
    
    
    $
    359,746
 At December 31, 2004, the Company has net operating loss carryovers for federal income tax
purposes of approximately $74.2 million. These net operating loss carryovers relate to acquisitions
and are limited in the amount that can be recognized in any one year, and have expiration dates
ranging from 2008 to 2024. The net decrease in the valuation allowance primarily relates to the
utilization of foreign tax credits and net operating loss carryforwards from acquisitions for which
there was uncertainty of future utilization prior to 2004. This decrease was partially offset by
approximately a $2.2 million valuation allowance recorded related to deferred tax assets of
Foundstone. Management believes that it is more likely than not that the results of future
operations will generate sufficient taxable income to realize the net deferred tax assets, other
than certain acquired net operating loss and credit carryforwards and certain other foreign tax
credits for which a valuation allowance has been provided. United States income taxes have not been provided for on a cumulative total of approximately
$341.3 million of earnings of certain non-U.S. subsidiaries, as the Companys historical intent has
been to reinvest these earnings indefinitely in operations outside the U.S. See Recent Accounting
Pronouncements and Guidance in Note 2 of the Consolidated Financial Statements for discussion of
recent legislation regarding the repatriation of foreign earnings. 69




---



##### Table of Contents



The Companys effective tax rate on income before income taxes differs from the U.S. Federal
statutory tax rate as follows (in thousands): Years Ended December 31,2004
    
    
    2003
    
    
    2002U.S. Federal income tax provision at statutory rate
    
    $
    110,765
    
    
    $
    30,470
    
    
    $
    45,469State provision
    
    
    8,979
    
    
    
    1,258
    
    
    
    2,725Non deductible acquisition and other costs
    
    
    
    
    
    
    2,310
    
    
    
    5,343Foreign earnings taxed at rates different than the U.S. Rate
    
    
    (10,266
    )
    
    
    (3,480
    )
    
    
    (26,724
    )Other permanent differences
    
    
    (2,335
    )
    
    
    867
    
    
    
    (957
    )Tax credits
    
    
    (12,183
    )
    
    
    (2,532
    )
    
    
    (26,096
    )Difference between book and tax basis of businesses sold
    
    
    22,840
    
    
    
    
    
    
    
    Benefit from accruals for tax exposures no longer required
    
    
    (25,036
    )
    
    
    (12,083
    )
    
    
    Other
    
    
    (1,358
    )
    
    
    
    
    
    
    (34
    )$
    91,406
    
    
    $
    16,810
    
    
    $
    (274
    )
 In 2004, the Company realized the benefit of certain tax deductions related to a prior period
acquisition. The $27.0 million benefit has been recorded as a credit to additional paid in capital
in the consolidated statement of stockholders equity in 2004 as the acquisition was accounted for
under the pooling of interests method. 18. Net Income Per Share A reconciliation of the numerator and denominator of basic and diluted net income per share is
provided as follows (in thousands, except per share amounts): Years Ended December 31,2004
    
    
    2003
    
    
    2002Numerator  BasicIncome before cumulative effect of change in accounting principle
    
    $
    225,065
    
    
    $
    59,905
    
    
    $
    128,312Cumulative effect of change in accounting principle, net of tax
    
    
    
    
    
    
    10,337
    
    
    
    Net income
    
    $
    225,065
    
    
    $
    70,242
    
    
    $
    128,312Numerator  DilutedIncome before cumulative effect of change in accounting principle
    
    $
    225,065
    
    
    $
    59,905
    
    
    $
    128,312Cumulative effect of change in accounting principle, net of tax
    
    
    
    
    
    
    10,337
    
    
    
    Interest on convertible debentures(1)
    
    
    7,556
    
    
    
    
    
    
    
    12,042Net income, adjusted
    
    $
    232,621
    
    
    $
    70,242
    
    
    $
    140,354Denominator  BasicWeighted average shares of common stock outstanding
    
    
    160,714
    
    
    
    160,338
    
    
    
    149,641Less: weighted average shares of common stock subject to repurchase
    
    
    
    
    
    
    
    
    
    
    (200
    )Basic weighted average common shares outstanding
    
    
    160,714
    
    
    
    160,338
    
    
    
    149,441Denominator  DilutedBasic weighted average common shares outstanding
    
    
    160,714
    
    
    
    160,338
    
    
    
    149,641Effective of dilutive securities:Convertible debentures(1)
    
    
    12,154
    
    
    
    
    
    
    
    19,092Common stock options(2)
    
    
    4,207
    
    
    
    3,992
    
    
    
    7,333Warrants
    
    
    24
    
    
    
    159
    
    
    
    183Diluted weighted average shares
    
    
    177,099
    
    
    
    164,489
    
    
    
    176,249Basic net income per share:Income before cumulative effect of change in accounting principle
    
    $
    1.40
    
    
    $
    0.37
    
    
    $
    0.86Cumulative effect of change in accounting principle, net of tax
    
    
    
    
    
    
    0.07
    
    
    
    Net income per share  Basic
    
    $
    1.40
    
    
    $
    0.44
    
    
    $
    0.86Diluted net income per share:Income before cumulative effect of change in accounting principle
    
    $
    1.31
    
    
    $
    0.36
    
    
    $
    0.80Cumulative effect of change in accounting principle, net of tax
    
    
    
    
    
    
    0.07
    
    
    
    Net income per share  Diluted
    
    $
    1.31
    
    
    $
    0.43
    
    
    $
    0.80
   (1)
    
    Convertible debt interest and related 19.1 million as-if converted shares were excluded from
the calculation since the effect was anti-dilutive in 2003. The total number of shares
excluded from the calculation related to as-if converted shares was 3.1 million for 2002.(2)
    
    At December 31, 2004, 2003 and 2002, 5.1 million, 15.6 million, and 9.9 million options to
purchase common stock, respectively, were excluded from the calculation since the effect was
anti-dilutive. 70




---



##### Table of Contents



19. Business Segment and Major Customer Information The Company has concluded that it has one business and operates in one industry, developing,
marketing, distributing and supporting computer security solutions for large enterprises,
governments, small and medium sized business and consumer users, as well as resellers and
distributors. Management measures profitability based on the Companys five geographic regions:
North America; EMEA; Japan; Asia-Pacific (excluding Japan) and Latin America. The regions are
evidence of the operating structure of the Companys internal organization. The Company markets and sells, through its geographic regions, anti-virus and security
software, hardware and services; network management software, hardware and services; and help desk
software and services. These products and services are marketed and sold worldwide primarily
through resellers, distributors, systems integrators retailers, and directly by the Company. In
addition, the Company offers web sites, which provide suites of on-line products and services
personalized for the user based on the users PC configuration, attached peripherals and resident
software. The Company also offers managed security and availability applications to corporations
and governments on the Internet. The accounting policies of the businesses and geographic segments are the same as disclosed in
Note 2. To reconcile to the consolidated financial statements, where applicable, Corporate
represents costs and expenses associated with corporate activities. Corporate activities include
general and administrative expenses and corporate marketing expenses of $65.0 million, $61.9
million, and $37.3 million in 2004, 2003 and 2002, respectively; stock-based compensation charges;
and acquisition, restructuring and other
related costs. These corporate expenses are not considered attributable to any specific
geographic region. The $25.0 million litigation reimbursement received in 2004 and the $70.0
million litigation charge incurred in 2002 were recorded in North America. Summarized financial
information concerning the Companys net revenue and operating income by geographic region is as
follows (in thousands): Years Ended December 31,2004
    
    
    2003
    
    
    2002Net revenue by region:North America
    
    $
    554,641
    
    
    $
    606,685
    
    
    $
    653,532EMEA
    
    
    241,724
    
    
    
    240,616
    
    
    
    298,659Japan
    
    
    54,609
    
    
    
    40,519
    
    
    
    39,369Asia-Pacific (excluding Japan)
    
    
    38,494
    
    
    
    29,014
    
    
    
    33,595Latin America
    
    
    21,074
    
    
    
    19,502
    
    
    
    17,889Net revenue
    
    $
    910,542
    
    
    $
    936,336
    
    
    $
    1,043,044Operating income (loss) by region:North America
    
    $
    195,195
    
    
    $
    215,027
    
    
    $
    156,080EMEA
    
    
    90,612
    
    
    
    88,884
    
    
    
    135,629Japan
    
    
    18,650
    
    
    
    11,061
    
    
    
    8,710Asia-Pacific (excluding Japan)
    
    
    11,903
    
    
    
    5,962
    
    
    
    6,682Latin America
    
    
    4,188
    
    
    
    1,338
    
    
    
    2,436Corporate
    
    
    2,123
    
    
    
    (257,870
    )
    
    
    (185,509
    )Operating income
    
    $
    322,671
    
    
    $
    64,402
    
    
    $
    124,028
 Following is a summary of the Companys total assets by geographic region. Assets purchased to
support infrastructure and general and administrative activities, including land purchases, are
included in Corporate in the table below. These corporate assets are not assigned to any specific
geographic region. Summarized financial information concerning the Companys total assets by
business and geographic region is as follows (in thousands): December 31,2004
    
    
    2003North America
    
    $
    1,579,401
    
    
    $
    1,452,407EMEA
    
    
    533,987
    
    
    
    485,613Japan
    
    
    64,736
    
    
    
    51,331Asia-Pacific (excluding Japan)
    
    
    25,794
    
    
    
    25,479Latin America
    
    
    19,729
    
    
    
    17,839Corporate
    
    
    14,029
    
    
    
    87,829Total assets
    
    $
    2,237,676
    
    
    $
    2,120,498
 71




---



##### Table of Contents



Property and equipment based on the physical location of the assets is as follows (in
thousands): 2004
    
    
    2003
    
    
    2002United States
    
    $
    72,769
    
    
    $
    89,857
    

    
    $
    73,990Japan
    
    
    4,038
    
    
    
    5,484
    
    
    
    4,560India
    
    
    3,667
    
    
    
    4,261
    
    
    
    1,506The Netherlands
    
    
    2,354
    
    
    
    3,991
    
    
    
    1,835Other countries
    
    
    8,887
    
    
    
    8,079
    
    
    
    7,386Total
    
    $
    91,715
    
    
    $
    111,672
    
    
    $
    89,277
 Net revenues attributed to countries based on the location of the customer for the years ended
December 31 is as follows (in thousands): 2004
    
    
    2003
    
    
    2002United States
    
    $
    520,211
    
    
    $
    573,263
    
    
    $
    618,936United Kingdom
    
    
    67,443
    
    
    
    67,229
    
    
    
    87,010Germany
    
    
    41,910
    
    
    
    43,717
    
    
    
    50,533Japan
    
    
    54,609
    
    
    
    40,519
    
    
    
    39,369Other countries
    
    
    226,369
    
    
    
    211,608
    
    
    
    247,196Total
    
    $
    910,542
    
    
    $
    936,336
    
    
    $
    1,043,044
 Net revenue information on a business unit basis is as follows for the years ended December 31
(in thousands): 2004
    
    
    2003McAfee
    
    $
    766,696
    
    
    $
    634,812Sniffer
    
    
    90,878
    
    
    
    210,176Magic
    
    
    2,850
    
    
    
    63,164IntruShield
    
    
    43,707
    
    
    
    15,510McAfee Labs
    
    
    6,411
    
    
    
    11,023PGP
    
    
    
    
    
    
    1,651Total net revenue
    
    $
    910,542
    
    
    $
    936,336
 Net revenue information on a business unit basis is not available for 2002. Net revenue information on a product and service basis is as follows for the years ended
December 31 (in thousands): 2004
    
    
    2003
    
    
    2002Software licenses
    
    $
    157,983
    
    
    $
    341,188
    
    
    $
    459,707Support and maintenance
    
    
    436,299
    
    
    
    313,731
    
    
    
    310,473Hardware
    
    
    79,828
    
    
    
    99,502
    
    
    
    93,359Retail
    
    
    27,787
    
    
    
    45,993
    
    
    
    63,236Consulting
    
    
    19,157
    
    
    
    27,421
    
    
    
    36,740Training
    
    
    8,394
    
    
    
    9,486
    
    
    
    12,527On-line subscription arrangements
    
    
    152,529
    
    
    
    72,088
    
    
    
    51,754Other
    
    
    28,565
    
    
    
    26,927
    
    
    
    15,248Total
    
    $
    910,542
    
    
    $
    936,336
    
    
    $
    1,043,044
 At December 31, 2004 and 2003, one customer had an accounts receivable balance which comprised
23% and 22%, respectively, of the Companys total accounts receivable balance. During 2004, 2003
and 2002, one customer accounted for 22%, 24% and 25%, respectively, of the total net revenue for
each year. During 2004 and 2002, another customer accounted for 11% and 10%, respectively, of the
net revenue. The net revenue derived from these customers is reported primarily in the Companys
North American and EMEA geographic segments. 20. Litigation  General From time to time, the Company has been subject to litigation including the pending litigation
described below. The Companys current estimated range of liability related to some of the pending
litigation below is based on claims for which management can estimate the amount and range of loss.
The Company has recorded the minimum estimated liability related to those claims, where there is a
range of loss. Because of the uncertainties related to the range of loss on the remaining pending
litigation, management is unable to make a reasonable estimate of the liability that could result
from an unfavorable outcome. As additional information becomes available, the Company will assess
its potential liability and revise its estimates. Pending or future litigation could be costly, 72




---



##### Table of Contents



could cause the diversion of managements attention and could upon resolution, have a material
adverse effect on the business, results of operations, financial condition and cash flow. In addition, the Company is engaged in certain legal and administrative proceedings incidental
to its normal business activities and believes that these matters will not have a material adverse
effect on the Companys financial position, results of operations or cash flows.  Securities Cases In September 2003, the Company entered into a settlement agreement with the plaintiffs in the
In re Network Associates, Inc. II Securities Litigation, which was originally filed in September
2001. Under the settlement agreement the Company paid $70.0 million, which was recorded as
litigation settlement in the consolidated statement of income for 2002. The settlement was approved
by the court in February 2004, and the case was dismissed with prejudice to all parties and claims.
In 2004, the Company received approximately $25.0 million from its insurance carriers related to
this litigation, which was recorded as litigation reimbursement in the consolidated statement of
income for 2004. Certain investment bank underwriters, the Company, and certain of its directors and officers
have been named in a putative class action for violation of the federal securities laws in the
United States District Court for the Southern District of New York, captioned In re McAfee.com
Corp. Initial Public Offering Securities Litigation, 01 Civ. 7034 (SAS). This is one of a number of
cases challenging underwriting practices in the initial public offerings (IPOs) of more than 300
companies. These cases have been coordinated for pretrial proceedings as In re Initial Public
Offering Securities Litigation, 21 MC 92 (SAS). Plaintiffs generally allege that certain
underwriters engaged in undisclosed and improper underwriting activities, namely the receipt of
excessive brokerage commissions and customer agreements regarding post-offering purchases of stock
in exchange for allocations of IPO shares. Plaintiffs also allege that various investment bank
securities analysts issued false and misleading analyst reports. The complaint against the Company
claims that the purported improper underwriting activities were not disclosed in the registration
statements for McAfee.coms IPO and seeks unspecified damages on behalf of a purported class of
persons who purchased the Companys securities
or sold put options during the time period from December 1, 1999 to December 6, 2000. On
February 19, 2003 the Court issued an Opinion and Order dismissing certain of the claims against
the Company with leave to amend. A settlement proposal was accepted by the Company on July 15, 2003
and is awaiting Court approval. Under this settlement proposal, the Company may assign its claims
against certain underwriters to the plaintiffs, and the Company would be dismissed from the lawsuit
without paying any monetary damages.  Other Matters On June 6, 2002, Paul Cozza filed a Complaint in the United States District Court, District of
Massachusetts alleging breach of contract, fraud and bad faith arising out of a dispute concerning
the licensing of certain technology used in the Companys Virex 6.1 product. The Complaint seeks
royalties on the Companys sale of Virex 6.1 products from January 1, 2002 to the present. The
Company filed papers in opposition to the Complaint and asserted various defenses. The Company also
moved to compel arbitration, which was denied by the District Court and the First Circuit Court of
Appeals. In September 2004 the parties filed cross-motions for partial summary judgment on
liability, but not damages, issues relating to whether the contract claims extend beyond the Virex
6.1 product. The District Court has heard argument on the pending cross-motions for partial summary
judgment but has not yet issued any decision. On March 22, 2002, the Securities and Exchange Commission notified the Company that it has
commenced a Formal Order of Private Investigation into the Companys accounting practices. The
SEC investigation is continuing, and the Company continues to provide documents and information to
the SEC. 21. Related Party Transactions Under the terms of the amended and restated employment agreement for Mr. George Samenuk,
Chairman of the Board and Chief Executive Officer, the Company agreed to loan Mr. Samenuk the funds
necessary to pay the taxes due on each vesting date for the 400,000 shares of restricted stock
granted to Mr. Samenuk on January 3, 2001. In addition, the Company agreed to loan Mr. Samenuk the
funds necessary to pay the taxes due on the 3,000 shares of stock granted to Mr. Samenuk on January
15, 2002. In accordance with the provisions of the Sarbanes-Oxley Act of 2002, no additional loans
were made to Mr. Samenuk after July 30, 2002 and no material modifications were made to any loan
outstanding on that date. In total, the Company extended five separate loans to Mr. Samenuk. As of December 31, 2002,
four loans in an aggregate amount of approximately $955,000 were outstanding. The loans each had a
two-year maturity and bore interest at the applicable federal rate. The loans were full recourse
and secured by Mr. Samenuks restricted stock and 3,000 shares of stock. The last remaining loan
was fully repaid in October 2003. 73




---



##### Table of Contents



22. Subsequent Events In March 2005, the Company repurchased approximately 2.0 million shares of its common stock in
the open market for approximately $47.4 million. 74




---



##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as
amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized, in the City of Santa Clara, State of California, on the 23rd day of May,
2005. MCAFEE, INC.By:
    /s/ GEORGE SAMENUKGeorge SamenukChairman of the Board and
Chief Executive Officer POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby
constitutes and appoints George Samenuk and Eric F. Brown, and each of them acting individually, as
his or her attorney-in-fact, each with full power of substitution, for him or her in any and all
capacities, to sign any and all amendments to this Annual Report on Form 10-K/A, and to file the
same, with exhibits thereto and other documents in connection therewith, with the Securities and
Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or
any substitute, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Report
has been signed on May 23, 2005 by the following persons on behalf of the Registrant in the
capacities indicated: Signature
    
    Title
    
    Date/s/ GEORGE SAMENUK

(George Samenuk)
    
    Chairman of the Board and Chief
Executive Officer
    
    May 23, 2005/s/ ERIC F. BROWN

(Eric F. Brown)
    
    Chief Financial Officer
    
    May 23, 2005/s/ ROBERT B. BUCKNAM

(Robert B. Bucknam)
    
    Director
    
    May 23, 2005/s/ LESLIE G. DENEND

(Leslie G. Denend)
    
    Director
    
    May 23, 2005/s/ ROBERT DUTKOWSKY

(Robert Dutkowsky)
    
    Director
    
    May 23, 2005/s/ DENIS J. OLEARY

(Denis J. OLeary)
    
    Director
    
    May 23, 2005/s/ ROBERT PANGIA

(Robert Pangia)
    
    Director
    
    May 23, 2005/s/ LIANE WILSON

(Liane Wilson)
    
    Director
    
    May 23, 2005
 75




---



##### Table of Contents



EXHIBIT INDEX ExhibitNumber
    
    
    
    Description2.1
    
    
    
    Asset Purchase Agreement made and entered into as of April 22, 2004, by and among, Network General
Corporation (formerly named Starburst Technology Holdings, Inc.), on the one hand; and (ii)
McAfee, Inc. (formerly named Networks Associates, Inc.), Network Associates Technology, Inc.,
Network Associates International BV, Network Associates (India) Private Limited, McAfee Japan Co.,
Ltd. (formerly named Network Associates Japan Co., Ltd.), on the other hand, as amended by
Amendment No. 1 thereto dated as of July 15, 2004.(1)3.1
    
    
    
    Second Restated Certificate of Incorporation of the Registrant, as amended on December 1, 1997.(3)3.2
    
    
    
    Certificate of Ownership and Merger between Registrant and McAfee, Inc.(2)3.3
    
    
    
    Amended and Restated Bylaws of the Registrant.(2)3.4
    
    
    
    Certificate of Designation of Series A Preferred Stock of the Registrant.(5)3.5
    
    
    
    Certificate of Designation of Series B Participating Preferred Stock of the Registrant.(6)4.3
    
    
    
    Indenture dated as of August 17, 2001 between the Registrant and State Street Bank and Trust
Company of California.(7)10.1
    
    
    
    Lease Assignment dated November 17, 1997 for facility at 3965 Freedom Circle, Santa Clara,
California by and between Informix Corporation and McAfee Associates, Inc.(8)10.2
    
    
    
    Consent to Assignment Agreement dated December 19, 1997 by and among Birk S. McCandless, LLC,
Guaranty Federal Bank, F.S.B., Informix Corporation and the Registrant.(8)10.3
    
    
    
    Subordination, Nondisturbance and Attornment Agreement dated December 18, 1997, between Guaranty
Federal Bank, F.S.B., the Registrant and Birk S. McCandless, LLC.(8)10.4
    
    
    
    Lease dated November 22, 1996 by and between Birk S. McCandless, LLC and Informix Corporation for
facility at 3965 Freedom Circle, Santa Clara, California.(8)10.5
    *
    
    
    2002 Employee Stock Purchase Plan.(9)10.6
    *
    
    
    1997 Stock Incentive Plan, as Amended.(9)10.7
    *
    
    
    Amended and Restated 1993 Stock Option Plan for Outside Directors.(4)10.8
    *
    
    
    2000 Nonstatutory Stock Option Plan.(10)10.9
    *
    
    
    Amended and Restated Employment Agreement between George Samenuk and the Registrant, dated October
9, 2001.(11)10.10
    *
    
    
    Employment agreement between Stephen C. Richards and the Registrant, dated April 3, 2001.(12)10.11
    
    
    
    1st Amendment to Lease dated March 20, 1998 between Birk S. McCandless, LLC and the Registrant.(13)10.12
    
    
    
    Confirmation, Amendment and Notice of Security Agreement dated March 20, 1998 among Informix
Corporation, Birk S. McCandless, LLC and the Registrant.(13)10.13
    
    
    
    Second Amendment to Lease dated September 1, 1998 among Informix Corporation, Birk S. McCandless,
LLC and the Registrant.(13)10.14
    
    
    
    Subordination, Nondisturbance and Attornment Agreement dated June 21, 2000, among Column
Financial, Inc., Informix Corporation, Birk S. McCandless, LLC, and the Registrant.(13)10.15
    
    
    
    Lease Agreement dated November 14, 1996 between Blue Lake Partners and McAfee Associates, Inc.(13)10.16
    
    
    
    Lease Amendment dated November 24, 1997 between Blue Lake Partners and McAfee Software, Inc.(13)10.17
    
    
    
    Lease Amendment dated March 17, 1998 between Blue Lake Partners and McAfee Software, Inc.(13)
 76




---



##### Table of Contents



ExhibitNumber
    
    
    
    Description10.18
    
    
    
    Lease Amendment dated March 27, 1998 between Blue Lake Partners and McAfee Software, Inc.(13)10.19
    
    
    
    Lease Amendment dated June 4, 1998 between Blue Lake Partners and McAfee Software, Inc.(13)10.20
    
    
    
    Lease Amendment dated July 21, 1998 between Blue Lake Partners and McAfee Software, Inc.(13)10.21
    
    
    
    Lease Amendment dated November 20, 1998 between Blue Lake Partners and McAfee Software, Inc.(13)10.22
    
    
    
    Lease Amendment dated March 18, 1999 between Blue Lake Partners and McAfee Software, Inc.(13)10.23
    
    
    
    Lease Amendment dated June 3, 1999 between Blue Lake Partners and McAfee Software, Inc.(13)10.24
    
    
    
    Lease Amendment dated October 7, 1999 between Blue Lake Partners and McAfee Software, Inc.(13)10.25
    
    
    
    Lease Amendment dated March 25, 2000 between Daltex Centre LP and the Registrant.(13)10.26
    
    
    
    Lease Amendment dated July 31, 2000 between Daltex Centre LP and the Registrant.(13)10.27
    
    
    
    Lease Amendment dated January 24, 2001 between Daltex Centre LP and the Registrant.(13)10.28
    
    
    
    Lease Amendment dated May 31, 2001 between Daltex Centre LP and the Registrant.(13)10.29
    *
    
    
    Employment Agreement between Kent H. Roberts and the Registrant, dated October 9, 2001.(14)10.30
    *
    
    
    Employment Agreement between Vernon Gene Hodges and the Registrant, dated December 3, 2001.(14)10.31
    *
    
    
    Employment Agreement between Raymond J. Smets and the Registrant, dated October 7, 2002(14)10.32
    *
    
    
    Employment Agreement between Kevin M. Weiss and the Registrant Dated October 15, 2002.(17)10.33
    
    
    
    Form of Indemnification Agreement between the Registrant and its Executive Officers(17)10.34
    *
    
    
    Summary of Pay for Performance Plan.(4)10.35
    *
    
    
    Network Associates, Inc. Tax Deferred Savings Plan.(16)10.36
    
    
    
    Umbrella Credit Facility of Registrant dated April 15, 2004.(18)10.37
    
    
    
    Fifth Amendment to Network Associates, Inc. Tax Deferred Savings Plan.(18)10.38
    
    
    
    Amendment to Employment Agreement of George Samenuk effective as of January 20, 2004.(18)10.39
    
    
    
    Amendment to Employment Agreement of Stephen C. Richards effective as of January 20, 2004.(18)10.40
    
    
    
    Sniffer Bonus Plan.(18)10.41
    
    
    
    Form of Sniffer Bonus Plan Participation Agreement (Ray Smets).(18)10.42
    
    
    
    Addendum to Raymond J. Smets Employment Agreement.(20)10.43
    
    
    
    Sixth Amendment to Network Associates, Inc. Tax Deferred Savings Plan.(20)10.44
    
    
    
    Transition Agreement by and between Registrant and Stephen C. Richards.(19)10.45
    
    
    
    Employment Agreement between Registrant and Eric F. Brown dated December 10, 2004 (22)10.46
    *
    
    
    2005 Independent Director Cash Compensation Plan21.1
    
    
    
    Subsidiaries of the Registrant23.1
    
    
    
    Consent of Deloitte & Touche LLP, Independent Registered Public Accounting Firm23.2
    
    
    
    Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm
 77




---



##### Table of Contents



ExhibitNumber
    
    
    
    Description31.1
    
    
    
    Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of
the Sarbanes-Oxley Act of 200232.1
    
    
    
    Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
   (1)
    
    Incorporated by reference from the Registrants Report on Form 8-K filed with the Commission
on July 16, 2004.(2)
    
    Incorporated by reference from the Registrants Report on Form 10-Q for the quarter ended
September 30, 2004, filed with the Commission on November 8, 2004.(3)
    
    Incorporated by reference from the Registrants Registration Statement on Form S-4 filed with
the Commission on March 25, 1998.(4)
    
    Incorporated by reference from the Registrants Annual Report on Form 10-K for the year ended
December 31, 2002, filed with the Commission on October 31, 2003.(5)
    
    Incorporated by reference from the Registrants Report on Form 10-Q for the quarter ended
September 30, 1996, filed with the Commission on November 14, 1996.(6)
    
    Incorporated by reference from the Registrants Report on Form 8-A filed with the Commission
on October 22, 1998.(7)
    
    Incorporated by reference from the Registrants Registration Statement on Form S-3 filed with
the Commission on November 9, 2001.(8)
    
    Incorporated by reference from the Registrants Registration Statement on Form S-3, filed
with the Commission on February 11, 1998.(9)
    
    Incorporated by reference from the Registrants Registration Statement on Form S-8 filed with
the Commission on June 28, 2002.(10)
    
    Incorporated by reference from the Registrants report on Form 10-K for the year ended
December 31, 2000, filed with the Commission on April 2, 2001.(11)
    
    Incorporated by reference from the Registrants report on Form 10-K for the year ended
December 31, 2001, filed with the Commission on February 8, 2002.(12)
    
    Incorporated by reference from the Registrants report on Form 10-Q for the quarter ended
March 31, 2001, filed with the Commission on May 15, 2001.(13)
    
    Incorporated by reference from the Registrants report on Form 10-Q for the quarter ended
September 30, 2001, filed with the Commission on November 13, 2001.(14)
    
    Incorporated by reference from the Registrants report on Form 10-K for the year ended
December 31, 2001, filed with the Commission on February 8, 2002.(15)
    
    Incorporated by reference from the Registrants report on Form 10-Q for the quarter ended
September 30, 2002, filed with the Commission on November 12, 2002.(16)
    
    Incorporated by reference from the Registrants Registration Statement on Form S-8 filed with
the Commission on November 5, 2003.(17)
    
    Incorporated by reference from the Registrants report on Form 10-K for the year ended
December 31, 2003, filed with the Commission on March 9, 2004.(18)
    
    Incorporated by reference from the Registrants report on Form 10-Q for the quarter ended
March 31, 2004, filed with the Commission on May 10, 2004.(19)
    
    Incorporated by reference from the Registrants report on Form 8-K filed with the Commission
on September 7, 2004. 78




---



##### Table of Contents



(20)
    
    Incorporated by reference from the Registrants report on Form 10-Q for the quarter ended
June 30, 2004, filed with the Commission on August 9, 2004.(21)
    
    Incorporated by reference from the Registrants report on Form 10-Q for the quarter ended
September 30, 2004, filed with the Commission on November 8, 2004.(22)
    
    Incorporated by reference from the Registrants report on Form 8-K filed with the Commission
on December 14, 2004.*
    
    Management contracts or compensatory plans or arrangements covering executive officers or
directors of McAfee, Inc. 79




---



##### Table of Contents



SCHEDULE II NETWORKS ASSOCIATES, INC. VALUATION AND QUALIFYING ACCOUNTS Provision forDoubtfulAccounts,
    
    
    Write-Offs ofBalance at
    
    
    Additions Charged
    
    
    Previously
    
    
    Balance atBeginning of
    
    
    to Expense or
    
    
    Provided
    
    
    End ofPeriod
    
    
    Revenue Net(1)
    
    
    Accounts
    
    
    Period(In thousands)Year Ended December 31, 2004Allowance for Doubtful Accounts
    
    $
    3,070
    
    
    $
    1,716
    
    
    $
    (2,250
    )
    
    $
    2,536Year Ended December 31, 2003Allowance for Doubtful Accounts(2)
    
    $
    6,638
    
    
    $
    (1,216
    )
    
    $
    (2,352
    )
    
    $
    3,070Year Ended December 31, 2002Allowance for Doubtful Accounts
    
    $
    8,394
    
    
    $
    (219
    )
    
    $
    (1,537
    )
    
    $
    6,638
   (1)
    
    Provision for Doubtful Accounts, Net.The provision for doubtful accounts, net consists of
our estimates with respect to the uncollectibility of our receivables, net of recoveries of
amounts previously written off. Our management must make estimates of the uncollectibility of
our accounts receivables. Management specifically analyzes accounts receivable and analyzes
historical bad debts, customer concentrations, customer credit-worthiness, current economic
trends and changes in our customer payment terms when evaluating the adequacy of the allowance
for doubtful accounts.(2)
    
    The allowance for doubtful accounts in the consolidated balance sheet as of December 31, 2003
is net of the $0.2 million allowance for Magic, which is included in assets held for sale. Provision forBalance at
    
    
    Sales Returns
    
    
    Actual
    
    
    Balance atBeginning of
    
    
    and Other
    
    
    Returns and
    
    
    End ofPeriod
    
    
    Allowances(3)
    
    
    Allowances
    
    
    Period(In thousands)Year Ended December 31, 2004Sales Returns and Allowances
    
    $
    39,599
    
    
    $
    65,350
    
    
    $
    (75,725
    )
    
    $
    29,224Year Ended December 31, 2003Sales Returns and Allowances
    
    $
    32,337
    
    
    $
    85,612
    
    
    $
    (78,350
    )
    
    $
    39,599Year Ended December 31, 2002Sales Returns and Allowances
    
    $
    32,586
    
    
    $
    130,163
    
    
    $
    (130,412
    )
    
    $
    32,337
   (3)
    
    Provision for Sales Returns and Allowances.The provision for sales returns and allowances
consists of our estimates of potential future product returns related to current period
product revenue, and specific provisions for distributor, reseller, and retailer sales
incentives (allowances) that are reductions in the revenue to be realized. Management
analyzes historical returns, current economic trends, and changes in customer demand and
acceptance of our products when evaluating the adequacy of the sales returns and allowances.
Significant management judgments and estimates must be made and used in connection with
establishing the sales returns and allowances in any accounting period. Material differences
may result in the amount and timing of our revenue for any period if management made different
judgments or utilized different estimates. 80