##### Table of Contents




---

UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, D.C. 20549





---




FORM 10-Q


(Mark
one)





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




For the quarterly period ended March 31, 2002





OR





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




For the transition period from              to





Commission file number 0-33387





---




NETSCREEN TECHNOLOGIES, INC.


(Exact name of Registrant as specified in its
charter)








Delaware (State or other jurisdiction of incorporation or organization)

77-0469208 (I.R.S. Employer Identification Number)








350 Oakmead Parkway


Sunnyvale, California 94085


(Address of principal executive office and zip code)





(408) 730-6000


(Registrants telephone number, including area code)





Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports, and (2) has been subject to such filing requirements for the past 90 days.





YES x    NO  ̈





As of April 30, 2002, 73,771,456 shares of the Registrants common stock, $0.001 par
value per share, were outstanding.





---



---

##### Table of Contents




NETSCREEN TECHNOLOGIES, INC.





FORM 10-Q





March 31, 2002





INDEX





PagePART I  FINANCIAL INFORMATIONItem 1.    Financial Statements:a.   
Condensed Consolidated Balance Sheets as of March 31, 2002 (Unaudited) and September 30, 2001

3b.   
Condensed Consolidated Statements of Operations for the three and six months ended March 31, 2002 and 2001 (Unaudited)

4c.   
Condensed Consolidated Statements of Cash Flows for the six months ended March 31, 2002 and 2001 (Unaudited)

5d.   
Notes to Condensed Consolidated Financial Statements (Unaudited)

6Item 2.    
Managements Discussion and Analysis of Financial Condition and Results of Operations

10Item 3.    
Qualitative and Quantitative Disclosure About Market Risk

25PART II  OTHER INFORMATIONItem 1.    
Legal Proceedings

26Item 2.    
Changes in Securities and Use of Proceeds

26Item 3.    
Defaults upon Senior Securities

26Item 4.    
Submission of Matters to a Vote of Security Holders

26Item 5.    
Other Information

26Item 6.    
Exhibits and Reports on Form 8-K

26SIGNATURE

27




2




---

##### Table of Contents




PART IFINANCIAL INFORMATION





Item 1.    Financial Statements


NETSCREEN TECHNOLOGIES, INC.


CONDENSED CONSOLIDATED BALANCE SHEETS


(in thousands, except share and per share amounts)





Mar. 31, 2002


Sep. 30, 2001*(Unaudited)ASSETSCurrent assets:Cash and cash equivalents

$
68,610


$
11,505Short-term investments


157,761



6,150Restricted cash


2,952



3,236Accounts receivable, net


17,548



16,355Inventories


1,052



1,877Deferred income taxes


3,370



Other current assets


2,890



2,814Total current assets


254,183



41,937Property and equipment


5,748



6,186Restricted cash






1,377Other assets


638



701Total assets

$
260,569


$
50,201LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS EQUITY (NET CAPITAL DEFICIENCY)Current liabilities:Accounts payable

$
3,641


$
4,586Accrued expenses


8,660



6,977Accrued compensation


5,107



4,632Accrued income taxes


3,934



164Deferred revenue


19,257



15,737Current portion of debt and capital lease obligations


1,832



1,511Total current liabilities


42,431



33,607Long-term portion of debt and capital lease obligations


2,378



2,663CommitmentsRedeemable convertible preferred stock, $0.001 par value, issuable in series:Authorized shares  10,000,000 at March 31, 2002; 33,600,000 at September 30, 2001Issued and outstanding shares  none at March 31, 2002; 32,473,082 at September 30, 2001






56,542Stockholders equity (net capital deficiency):Convertible preferred stock, $0.001 par value:Authorized shares  10,000,000 at March 31, 2002; none at September 30, 2001






Issued and outstanding  none at March 31, 2002 and September 30, 2001Common stock, $0.001 par value:Authorized shares  500,000,000 at March 31, 2002; 100,000,000 at September 30, 2001Issued and outstanding shares  73,730,785 at March 31, 2002; 23,780,742 at September 30, 2001


74



24Additional paid-in capital


369,400



105,267Accumulated deficit


(96,818
)


(91,436
)Accumulated other comprehensive loss


(165
)


Deferred stock compensation


(55,160
)


(54,895
)Stockholders notes receivable


(1,571
)


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


215,760



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

$
260,569


$
50,201





* Derived from audited financial statements. Reclassified for
comparative purposes.





See accompanying notes.




3




---

##### Table of Contents




NETSCREEN TECHNOLOGIES, INC.


CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)


(in thousands, except per share amounts)





Three Months Ended March 31,


Six Months Ended March 31,2002


2001


2002


2001Revenues:Product

$
26,494


$
15,840


$
50,593


$
30,349Maintenance and service


5,543



3,228



10,417



5,875Total revenues


32,037



19,068



61,010



36,224Cost of revenues:Product*


6,566



5,119



13,856



9,280Maintenance and service*


1,963



730



3,165



1,776Total cost of revenues


8,529



5,849



17,021



11,056Gross margin


23,508



13,219



43,989



25,168Operating expenses:Research and development*


8,061



6,439



15,378



11,517Sales and marketing*


15,161



13,749



29,827



26,055General and administrative*


4,196



1,629



8,434



4,493Total operating expenses


27,418



21,817



53,639



42,065Loss from operations


(3,910
)


(8,598
)


(9,650
)


(16,897
)Interest and other income, net


955



351



1,285



850Loss before taxes


(2,955
)


(8,247
)


(8,365
)


(16,047
)Provision for income taxes


(339
)






(639
)


Net loss


(3,294
)


(8,247
)


(9,004
)


(16,047
)Deemed dividend on Series E and F redeemable convertible preferred stock






(731
)


(28,743
)


(1,462
)Net loss applicable to common stockholders

$
(3,294
)

$
(8,978
)

$
(37,747
)

$
(17,509
)Basic and diluted net loss per share applicable to common stockholders

$
(0.05
)

$
(0.56
)

$
(0.77
)

$
(1.15
)Shares used in computing basic and diluted net loss per share applicable to common stockholders


70,573



15,891



49,071



15,271*Includes stock-based compensation of the following:Cost of product revenues

$
411


$
316


$
821


$
670Cost of maintenance and service revenues


238



317



468



731Research and development


1,947



1,524



3,767



3,119Sales and marketing


2,764



2,272



5,592



4,694General and administrative


691



(1,553
)


1,340



(431
)Total stock-based compensation

$
6,051


$
2,876


$
11,988


$
8,783








See accompanying notes.




4




---

##### Table of Contents




NETSCREEN TECHNOLOGIES, INC.


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)


(in thousands)





Six Months Ended March 31,2002


2001Operating activitiesNet loss

$
(9,004
)

$
(16,047
)Adjustments to reconcile net loss to net cash provided by (used in) in operating activities:Depreciation and amortization


1,562



753Amortization of deferred stock compensation


11,988



8,783Compensation expense related to accelerated vesting of stock options


360



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


16



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


(1,193
)


(3,996
)Inventories


825



539Deferred income taxes


(3,370
)


Other current assets


(76
)


(726
)Other assets


47



(219
)Accounts payable


(945
)


(818
)Accrued expenses


1,683



1,461Accrued compensation


475



913Accrued income taxes


3,770



Deferred revenue


3,520



2,540Net cash provided by (used in) operating activities


9,658



(6,817
)Investing activitiesPurchase of property and equipment


(1,124
)


(3,612
)Purchases of short-term investments


(215,526
)


(17,900
)Maturities of short-term investments


63,750



12,200Net cash used in investing activities


(152,900
)


(9,312
)Financing activitiesProceeds from borrowing arrangements


944



Principal payments on debt and capital lease obligations


(908
)


(144
)Restricted cash


1,661



(6,231
)Proceeds from initial public offering of common stock, net


168,639



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


289



64Proceeds from issuance of convertible preferred stock, net


29,722



(10
)Net cash provided by (used in) financing activities


200,347



(6,321
)Net increase (decrease) in cash and cash equivalents


57,105



(22,450
)Cash and cash equivalents at beginning of period


11,505



26,069Cash and cash equivalents at end of period

$
68,610


$
3,619Supplemental disclosures of cash flow information:Cash paid for interest

$
275


$
54Cash paid for taxes

$
239


$
Supplemental schedule of noncash investing and financing activities:Property and equipment acquired under capital lease

$



$
514Deferred stock compensation related to options issued below fair market value

$
13,461


$
214Reversal of deferred stock compensation for terminated employees

$
1,208


$
12,155Deemed dividends on Series E and F preferred stock

$
28,743


$
1,462Conversion of preferred stock to common stock

$
115,007


$









See accompanying notes.




5




---

##### Table of Contents




NETSCREEN TECHNOLOGIES, INC.





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(UNAUDITED)





Note 1.    Background and Basis of Presentation





The Company





NetScreen Technologies, Inc. (the Company or NetScreen) was incorporated in Delaware on October 30, 1997. NetScreen provides a broad family of
network security systems and appliances that deliver high performance, cost-effective security for enterprises and service providers. The Companys security systems and appliances deliver integrated firewall, virtual private network, or VPN,
and network traffic management capabilities in a single device using the Companys GigaScreen application specific integrated circuit and ScreenOS security operating system and applications. NetScreens products are used by enterprises and
service providers.





The accompanying condensed consolidated financial statements of NetScreen Technologies, Inc. have been prepared, without audit, in
accordance with generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission (the SEC). Certain information and disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or omitted in accordance with these rules and regulations. The information in this report should be read in conjunction with the Companys financial statements and
notes thereto included in its Prospectus filed with the SEC pursuant to Rule 424(b)(4) on December 12, 2001.





In the opinion of management, the
accompanying unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary to summarize fairly the Companys financial position, results of operations and cash flows
for the interim periods presented. The operating results for the three and six month periods ended March 31, 2002 are not necessarily indicative of the results that may be expected for the year ending September 30, 2002 or for any other future
period.





Recent Events





The Company
completed the sale of a total of 11,500,000 shares of common stock in December 2001 in an initial public offering (IPO) at a price of $16.00 per share. The Company received total net proceeds of approximately $168.6 million upon the
consummation of the IPO. See Note 4, Initial Public Offering, for additional information.





Critical Accounting Policies





Revenue recognition  general





The Company derives revenues primarily from sales of its hardware-based security systems and appliances and maintenance arrangements, and, to a lesser extent, from sales of software products and services. The Company
generally recognizes revenues when persuasive evidence of an arrangement exists, delivery or customer acceptance, where applicable, has occurred, the fee is fixed or determinable, and collection is probable.





Revenue recognition  distributors and value added resellers





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







6




---

##### Table of Contents




Revenue recognition  maintenance and service revenues





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





Accounts receivable





The Company has a large, diversified customer base, which includes customers located in foreign countries. The Company monitors the creditworthiness of its customers but has experienced losses related to its accounts
receivable in the past. The Company records an allowance for doubtful accounts based on past history, current economic conditions and the composition of its accounts receivable aging. Actual write-offs may differ from the allowances for doubtful
accounts, and this difference may have a material effect on the Companys financial position and results of operations.





Inventory





Given the volatility of the networking market, the rapid obsolescence of technology and short product life
cycles, the Company writes down inventories to net realizable value based on backlog and forecasted demand. However, backlog is subject to revisions, cancellations and rescheduling. Actual demand may differ from forecasted demand and this difference
may have a material effect on the Companys financial position and results of operations.





Warranty
obligations





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





Net loss per share





Basic and diluted net loss per share is presented in conformity with SFAS No. 128, Earnings per Share (SFAS 128), for all periods presented.
In accordance with SFAS 128, basic net loss per share is calculated using the weighted-average number of shares of common stock outstanding during the period, less shares subject to repurchase. Potentially dilutive securities include convertible
preferred stock, stock options, shares subject to repurchase and warrants (using the treasury stock method). Potentially dilutive securities have been excluded from the Companys diluted net loss per share computations as their inclusion would
be antidilutive due to net losses for all periods presented. The total number of shares excluded from the computations of diluted net loss per share was approximately 10,473,000 for the three and six months ended March 31, 2002 and 39,310,000 for
the three and six months ended March 31, 2001.





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





Three Months Ended March 31,


Six Months Ended March 31,2002


2001


2002


2001Net loss applicable to common stockholders

$
(3,294
)

$
(8,978
)

$
(37,747
)

$
(17,509
)Basic and diluted:Weighted-average shares of common stock outstanding


73,711



24,422



52,543



24,570Less weighted-average shares subject to repurchase


3,138



8,531



3,472



9,299Shares used in computing basic and diluted net loss per share applicable to common stockholders


70,573



15,891



49,071



15,271Basic and diluted net loss per share applicable to common stockholders

$
(0.05
)

$
(0.56
)

$
(0.77
)

$
(1.15
)







7




---

##### Table of Contents




Comprehensive Loss





Comprehensive loss includes certain unrealized gains and losses that are recorded as a component of stockholders equity and excluded from the determination of net loss. The Companys only component of accumulated other
comprehensive loss was unrealized loss on investments in the three and six month periods ended March 31, 2002. The unrealized loss was $165,000 in the three and six month periods ended March 31, 2002.





Recent Accounting Pronouncements





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





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





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





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





Note 2. Inventories





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





Inventories
consist of the following (in thousands):





Mar. 31, 2002

Sep. 30, 2001Raw materials

$
428

$
709Finished goods


624


1,168$
1,052

$
1,877





Given the volatility of the networking market, the rapid obsolescence of technology and short product life
cycles, the Company writes down inventories to net realizable value based on backlog and forecasted demand. However, backlog is subject to revisions, cancellations and rescheduling. Actual demand may differ from forecasted demand and this difference
may have a material effect on the Companys financial position and results of operations.







8




---

##### Table of Contents




Note 3. Business Segment Information


The Company
operates in one business segment, the sale of security and traffic management solutions for network environments. The Company sells its products and technology primarily to customers in North America, Asia and Europe. Revenues by geographic regions
were as follows (in thousands):





Three Months Ended March 31,

Six Months Ended March 31,2002

2001

2002

2001North America

$
14,552

$
10,370

$
28,529

$
20,878Asia


9,661


4,749


18,282


9,046Europe


7,197


3,740


12,966


6,017Others


627


209


1,233


283Total

$
32,037

$
19,068

$
61,010

$
36,224





Note 4. Initial Public Offering





On December 17, 2001, the Company closed the sale of 11,500,000 shares of common stock, including the underwriters exercise of an over-allotment option, in an initial public offering at a price of $16.00 per
share. A total of $184.0 million in gross proceeds was raised from these transactions. After deducting the underwriting discount of approximately $12.9 million and approximately $2.5 million of offering expenses, net proceeds were $168.6 million.
Upon the closing of the IPO, all preferred shares were automatically converted into common shares.





Note 5. Series F Convertible Preferred Stock





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





The Series F convertible preferred stock was entitled to a cumulative dividend at an annual rate of approximately $0.42 per share. Dividends on the Series F convertible preferred stock accrued from the date
of issuance whether or not earned or declared, however, the accrued and unpaid dividends were not payable in the event of an automatic conversion prior to the third anniversary of the original issue date. The Series F convertible preferred shares
were automatically converted into common shares upon the closing of the Companys IPO in December 2001. The Company recorded a deemed dividend totaling approximately $493,000 to account for the cumulative dividend on the Series F convertible
preferred stock.







9




---

##### Table of Contents




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





This Managements
Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the accompanying condensed consolidated financial statements and notes included in this report. This Form 10-Q contains forward-looking
statements within the meaning of Section 21E of the Securities Exchange Act of 1934 that involve risks and uncertainties identified in our final Prospectus filed with the Securities and Exchange Commission pursuant to Rule 424(b)(4) on December 12,
2001, as well as other reports that we will file from time to time with the Securities and Exchange Commission. Any statements contained in this report that are not statements of historical fact may be deemed to be forward-looking statements. In
many cases, you can identify forward-looking statements by terms such as may, will, should, expect, plan, anticipate, believe, estimate,
predict, potential, intend or continue, the negative of these terms or other comparable terminology. These statements are only predictions. Our actual results may differ materially from those
anticipated in these forward-looking statements as a result of a variety of factors, including, but not limited to, those presented in Risk Factors and elsewhere in this report. We undertake no obligation to update publicly any
forward-looking statements for any reason, except as required by law, even if new information becomes available or other events occur in the future.





Overview





We develop, market and sell a broad family of network security systems and appliances that deliver high performance,
cost-effective security for enterprises and service providers. Our security systems and appliances deliver integrated firewall, virtual private network, and network traffic management capabilities in a single device using our proprietary application
specific integrated circuits, referred to as the GigaScreen ASIC and GigaScreen-II ASIC, and our proprietary security operating system and applications, referred to as ScreenOS. Our security systems and appliances can be centrally managed with our
suite of flexible management software, which enables secure, scalable monitoring of devices, network traffic and security events, and policy administration for both enterprises and service providers. Our products are based on industry standard
communication protocols so that they may be integrated easily into networks and interoperate with other security devices and software applications based on these industry standard communication protocols.





From our inception in October 1997 through May 1998, our activities were primarily devoted to expanding our research and development capabilities, designing our ASICs,
developing our ScreenOS, and developing and testing our NetScreen-100 and NetScreen-10 security appliances. We began shipping the NetScreen-100 and NetScreen-10 security appliances in June 1998, the NetScreen-5 security appliance in September 1999,
the NetScreen-1000 security system in May 2000, the NetScreen-500 security system in May 2001, the NetScreen-5XP security appliance, the successor to the NetScreen-5, in June 2001, and the NetScreen-50 and NetScreen-25 security appliances, which
replaced the NetScreen-10, in November 2001. We began shipping the NetScreen-204 and NetScreen-208 security appliances in January 2002 and the NetScreen-5200 security system in April 2002. We began shipping NetScreen-Remote VPN client software in
August 1998, NetScreen-Global Manager management software in September 1999 and NetScreen-Global PRO management software in March 2001. We have incurred significant losses in each fiscal period and, as of March 31, 2002, we had an accumulated
deficit of $96.8 million.





We derive revenues primarily from sales of our hardware-based security systems and appliances and maintenance arrangements,
and, to a lesser extent, from sales of software products and services. Cost of product revenues consists primarily of the costs associated with manufacturing, assembling and testing our products, related overhead costs, and compensation and other
costs related to manufacturing support and logistics. We rely on contract manufacturers to manufacture our hardware products. Accordingly, a significant portion of our cost of product revenues consists of payments to these contract manufacturers,
which represent costs of materials plus a fair margin. Cost of maintenance and service revenues consists of customer support costs, training and professional service expenses and warranty-related costs.





Our gross margin has been and will continue to be affected by a variety of factors, including competition, the mix and average selling prices of products, maintenance and
services, new product introductions and enhancements, the cost of components and manufacturing labor, fluctuations in manufacturing volumes, component shortages, and the mix of distribution channels through which our products are sold. Our gross
margin will be adversely affected by price declines if we are unable to reduce costs on existing products and to continue to introduce new products with higher margins.





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







10




---

##### Table of Contents




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





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





In connection with the granting of employee stock options that had exercise prices subsequently deemed to be below fair market value on the date of grant, we have recorded
deferred stock-based compensation. Deferred stock compensation represents the difference between the deemed fair market value of our common stock for financial reporting purposes on the date of grant and the exercise price of these options.
Restricted stock acquired through the exercise of unvested stock options is subject to our right to repurchase the unvested stock at the price paid, which right lapses over the vesting period of the exercised option. Deferred stock compensation is
included as a reduction of stockholders equity and is amortized over the vesting period of the applicable options or the repurchase period for the applicable restricted stock, generally four years, using the straight-line vesting method. This
stock-based compensation expense relates to stock options granted to individuals in all cost of revenues and operating expense categories and has been included with other expenses in those categories. As of March 31, 2002, $55.2 million of deferred
stock compensation remained unamortized.





We recorded a deemed dividend of $27.6 million in the six months ended March 31, 2002 related to the issuance
of our Series F preferred stock at a price below its deemed fair value. We also recorded deemed dividends of $1.1 million and $1.5 million in the six months ended March 31, 2002 and 2001, respectively, to account for cumulative dividends on our
Series E and F preferred stock.





Critical Accounting Policies





We derive our revenues primarily from sales of our hardware-based security systems and appliances and maintenance arrangements, and, to a lesser extent, from sales of software products and services. We generally
recognize revenues when persuasive evidence of an arrangement exists, delivery or customer acceptance, where applicable, has occurred, the fee is fixed or determinable, and collection is probable.





We sell to value-added resellers, distributors and end customers. We derived approximately 84% of our total revenues from value-added resellers and distributors in the six
months ended March 31, 2002. We defer revenues on all sales to our distributors until the distributor has sold our products to its customers. Our agreements with distributors provide for limited stock rotation and price protection rights. Stock
rotation rights provide distributors with the right to exchange unsold inventory for alternate products of equal or greater value. Price protection rights grant distributors the right to credit on future purchases in the event of decreases in the
prices of our products. Our agreements with value-added resellers typically do not include stock rotation or price protection rights. At the time of shipment to value-added resellers, we reserve for estimated returns and exchanges. These revenue
reserves are estimated and adjusted periodically based on historical rates of returns and allowances, inventory levels for value-added resellers that submit inventory or sell-through reports, the volume of sales to value added-resellers that we ship
directly to end customers, and for sales to value-added resellers that do not submit inventory or sell-through reports, accounts receivable balances, payment history and other related factors.





We defer a portion of our product revenues based on the value of maintenance arrangements included with each product sale and recognize these revenues over the applicable maintenance period. We also derive
a portion of our revenues from sales of separate extended maintenance arrangements. We sell hardware maintenance, 24 hours a day, seven days a week technical support, and software maintenance to end customers. These arrangements are sold as a bundle
or as discrete offerings providing only hardware maintenance, technical support or software maintenance. For bundled arrangements, revenues are allocated among the elements at the time of sale based on their relative fair values, as determined by
the prices we charge when each element is sold separately (renewal rate). Revenue from maintenance arrangements is recognized over the period of the related maintenance obligation.





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







11




---

##### Table of Contents




Given the volatility of the networking market, the rapid obsolescence of technology and short product life cycles, we
write down inventories to net realizable value based on backlog and forecasted demand. However, backlog is subject to revisions, cancellations and rescheduling. Actual demand may differ from forecasted demand and this difference may have a material
effect on our financial position and results of operations.





Our hardware products carry a one-year warranty that includes factory repair services or
replacement parts as needed. We accrue estimated expenses for warranty obligations at the time products are shipped.





Results of Operations for the
Three Months Ended March 31, 2002 and 2001





Revenues





Product Revenues. Revenues from sales of our products increased 67% to $26.5 million in the three months ended March 31, 2002 from $15.8 million in the three months ended March 31, 2001. This increase was attributable to a higher
volume of products shipped and increasing demand in our markets. Hardware revenue units increased to approximately 18,000 units in the three months ended March 31, 2002 from approximately 6,000 units in the three months ended March 31, 2001.





Maintenance and Service Revenues. Revenues from maintenance and services increased 72% to $5.5 million in the three months ended March 31, 2002
from $3.2 million in the three months ended March 31, 2001. This increase was the result of the higher volume of products shipped and the related recognition of revenues associated with the portion of product revenues attributable to maintenance and
services over the applicable maintenance period, as well as increased maintenance renewals.





No single customer accounted for 10% or more of our total
revenues in either three-month period. North American sales accounted for approximately 45% of our total revenues in the three months ended March 31, 2002 and 54% of our total revenues in the three months ended March 31, 2001.





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





Cost of Revenues; Gross Margin





Cost of revenues including
stock-based compensation increased to $8.5 million in the three months ended March 31, 2002 from $5.8 million in the three months ended March 31, 2001. Excluding stock-based compensation of approximately $649,000 and $633,000 in the three months
ended March 31, 2002 and 2001, respectively, cost of revenues increased to $7.9 million in the three months ended March 31, 2002 from $5.2 million in the three months ended March 31, 2001. This increase, excluding stock-based compensation, was
related primarily to the increase in our revenues and, to a lesser extent, to increases in product warranty costs and costs related to the expansion of our customer support infrastructure. These increases were partially offset by reductions in the
price we purchase our products at. Gross margin, excluding stock-based compensation, as a percentage of total revenues was 75.4% in the three months ended March 31, 2002 compared to 72.6% in the three months ended March 31, 2001. The increase in
gross margin percentage was primarily attributable to sales of higher-margin products, partially offset by declining margins on our maintenance and service business as we expand our worldwide customer service infrastructure in order to grow that
business. Despite this increase, we expect our gross margin percentage to decline over time.





Operating Expenses





Research and Development Expenses. Research and development expenses including stock-based compensation increased 25.2% to $8.1 million in the three months ended March
31, 2002 from $6.4 million in the three months ended March 31, 2001. Excluding stock-based compensation of $1.9 million and $1.5 million in the three months ended March 31, 2002 and 2001, respectively, research and development expenses increased
24.4% to $6.1 million in the three months ended March 31, 2002 from $4.9 million in the three months ended March 31, 2001. These expenses, excluding stock-based compensation, represented 19.1% and 25.8% of total revenues for the three months ended
March 31, 2002 and 2001, respectively. The dollar increase was primarily attributable to increased personnel costs as a result of increased headcount and increased prototype and product certification expenses associated with the development of new
products and increased product development efforts.





Sales and Marketing Expenses. Sales and marketing expenses including stock-based compensation
increased 10.3% to $15.2 million in the three months ended March 31, 2002 from $13.7 million in the three months ended March 31, 2001. Excluding stock-based compensation of $2.8 million and $2.3 million in the three months ended March 31, 2002 and
2001, respectively, sales and marketing expenses increased 8.0% to $12.4 million in the three months ended March 31, 2002 from $11.5 million in the three months ended March 31, 2001. These expenses, excluding stock-based compensation, were 38.7% and
60.2% of total revenues for the three months ended March 31, 2002 and 2001, respectively. The dollar increase was primarily related to the expansion of our sales and marketing organizations, including growth in our domestic and international sales
forces and associated sales office expenses and, to a lesser extent, increases in marketing-related program costs. These increases were partially offset by a reduction in advertising expenses.




12




---

##### Table of Contents




General and Administrative Expenses. General and administrative expenses including stock-based compensation
increased 157.6% to $4.2 million in the three months ended March 31, 2002 from $1.6 million in the three months ended March 31, 2001. Excluding stock-based compensation of approximately $691,000 and a $1.6 million credit to stock-based compensation
expense in the three months ended March 31, 2002 and 2001, respectively, general and administrative expenses increased 10.2% to $3.5 million in the three months ended March 31, 2002 from $3.2 million in the three months ended March 31, 2001. These
expenses, excluding stock-based compensation, were 10.9% and 16.7% of total revenues for the three months ended March 31, 2002 and 2001, respectively. The dollar increase was primarily related to the expansion of our general and administrative
organization to support additional finance, human resource, legal and other administrative activities and greater infrastructure requirements, including those associated with being a public company. These increased costs were partially offset by a
reduction in outside services.





Stock-based Compensation. During the three months ended March 31, 2002 and 2001, we recorded stock-based
compensation expense of $6.1 and $2.9 million, respectively. As of March 31, 2002, $55.2 million of deferred stock compensation remained unamortized.





Interest and Other Income, Net





Interest and other income, net, was approximately $955,000 in the three months ended March 31, 2002
compared to approximately $351,000 in the three months ended March 31, 2001. The increase in interest and other income, net, was primarily a result of increased interest income earned on higher average cash, cash equivalent and short-term investment
balances in the three months ended March 31, 2002. The increased interest income was partially offset by higher interest expense in the three months ended March 31, 2002 due to higher levels of debt and capital lease obligations in that period.





Provision for Income Taxes





We recorded an income
tax provision of approximately $339,000 for the three months ended March 31, 2002, primarily related to income taxes currently payable on income generated in non-U.S. tax jurisdictions for which no U.S. benefit is currently recognizable. As of March
31, 2002, we reduced a portion of the valuation allowance against deferred tax assets because it is more likely than not that we will realize the benefit of such assets based on projected taxable income for the year ended September 30,
2002. Due to operating losses and the uncertainty regarding the ability to recognize an income tax benefit from these losses, there was no provision for income taxes for the three months ended March 31, 2001.





Results of Operations for the Six Months Ended March 31, 2002 and 2001





Revenues





Product Revenues. Revenues from sales of our products increased 66.7% to $50.6 million in the six months ended March 31,
2002 from $30.3 million in the six months ended March 31, 2001. This increase was attributable to a higher volume of products shipped and increasing demand in our markets. Hardware revenue units increased to approximately 34,000 units in the six
months ended March 31, 2002 from approximately 13,000 units in the six months ended March 31, 2001.





Maintenance and Service Revenues. Revenues
from maintenance and services increased 77.3% to $10.4 million in the six months ended March 31, 2002 from $5.9 million in the six months ended March 31, 2001. This increase was the result of the higher volume of products shipped and the related
recognition of revenues associated with the portion of product revenues attributable to maintenance and services over the applicable maintenance period, as well as increased maintenance renewals.





No single customer accounted for 10% or more of our total revenues in either six-month period. North American sales accounted for approximately 47% of our total revenues in the six months ended March 31,
2002 and 58% of our total revenues in the six months ended March 31, 2001.





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





Cost of Revenues; Gross Margin





Cost of revenues including stock-based compensation increased to $17.0 million in the six months ended March 31, 2002 from $11.1 million in the six months ended March 31, 2001.
Excluding stock-based compensation of $1.3 million and $1.4 million in the six months ended March 31, 2002 and 2001, respectively, cost of revenues increased to $15.7 million in the six months ended March 31, 2002 from $9.7 million in the six months
ended March 31, 2001. This increase, excluding stock-based compensation, was related primarily to the increase in our revenues and, to a lesser extent, to increases in costs related to the expansion of our customer support infrastructure and product
warranty costs. These increases were partially offset by reductions in the price we purchase our products at. Gross margin, excluding stock-based compensation, as a percentage of total revenues was 74.2% in the six months ended March 31, 2002
compared to 73.3% in the six months ended March 31, 2001. The increase in gross margin




13




---

##### Table of Contents

percentage was primarily attributable to sales of higher-margin products, partially offset by declining margins on our maintenance and service business as we expand our worldwide customer support
infrastructure in order to grow that business. We expect our gross margin percentage to decline over time.





Operating Expenses





Research and Development Expenses. Research and development expenses including stock-based compensation increased 33.5% to $15.4 million in the six months
ended March 31, 2002 from $11.5 million in the six months ended March 31, 2001. Excluding stock-based compensation of $3.8 million and $3.1 million in the six months ended March 31, 2002 and 2001, respectively, research and development expenses
increased 38.3% to $11.6 million in the six months ended March 31, 2002 from $8.4 million in the six months ended March 31, 2001. These expenses, excluding stock-based compensation, represented 19.0% and 23.2% of total revenues for the six months
ended March 31, 2002 and 2001, respectively. The dollar increase was primarily attributable to increased personnel costs as a result of increased headcount and increased prototype and product certification expenses associated with the development of
new products and increased product development efforts.





Sales and Marketing Expenses. Sales and marketing expenses including stock-based
compensation increased 14.5% to $29.8 million in the six months ended March 31, 2002 from $26.1 million in the six months ended March 31, 2001. Excluding stock-based compensation of $5.6 million and $4.7 million in the six months ended March 31,
2002 and 2001, respectively, sales and marketing expenses increased 13.5% to $24.2 million in the six months ended March 31, 2002 from $21.4 million in the six months ended March 31, 2001. These expenses, excluding stock-based compensation, were
39.7% and 59.0% of total revenues for the six months ended March 31, 2002 and 2001, respectively. The dollar increase was primarily related to the expansion of our sales and marketing organizations, including growth in our domestic and international
sales forces and associated sales office expenses. These increases were partially offset by reductions in certain marketing-related program costs, primarily advertising expenses.





General and Administrative Expenses. General and administrative expenses including stock-based compensation increased 87.7% to $8.4 million in the six months ended March 31, 2002 from $4.5 million in the six
months ended March 31, 2001. Excluding stock-based compensation of $1.3 million and an approximately $431,000 credit to stock-based compensation expense in the six months ended March 31, 2002 and 2001, respectively, general and administrative
expenses increased 44.1% to $7.1 million in the six months ended March 31, 2002 from $4.9 million in the six months ended March 31, 2001. These expenses, excluding stock-based compensation, were 11.6% and 13.6% of total revenues for the six months
ended March 31, 2002 and 2001, respectively. The dollar increase was primarily related to the expansion of our general and administrative organization to support additional finance, human resource, legal and other administrative activities and
greater infrastructure requirements, including those associated with being a public company.





Stock-based Compensation. During the six months
ended March 31, 2002 and 2001, we recorded stock-based compensation expense of $12.0 and $8.8 million, respectively. As of March 31, 2002, $55.2 million of deferred stock compensation remained unamortized.





Interest and Other Income, Net





Interest and other income, net, was $1.3
million in the six months ended March 31, 2002 compared to approximately $850,000 in the six months ended March 31, 2001. The increase in interest and other income, net, was primarily a result of increased interest income earned on higher average
cash, cash equivalent and short-term investment balances in the six months ended March 31, 2002. The increased interest income was partially offset by higher interest expense in the six months ended March 31, 2002 due to higher levels of debt and
capital lease obligations in that period.





Provision for Income Taxes





We recorded an income tax provision of approximately $639,000 for the six months ended March 31, 2002, primarily related to income taxes currently payable on income generated in non-U.S. tax jurisdictions for which no
U.S. benefit is currently recognizable.As of March 31, 2002, we reduced a portion of the valuation allowance recorded against deferred tax assets because it is more likely than not that we will realize the benefit of such assts on
projected taxable income for the year ended September 30, 2002. Due to operating losses and the uncertainty regarding the ability to recognize an income tax benefit from these losses, there was no provision for income taxes for the six months ended
March 31, 2001.





Liquidity and Capital Resources





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







14




---

##### Table of Contents




In December 2001, we completed the sale of a total of 11,500,000 shares of common stock in our initial public offering.
We realized total net proceeds of $168.6 million upon the close of the IPO. See Note 4, Initial Public Offering, of the Notes to Condensed Consolidated Financial Statements for additional information.





Net cash provided by operating activities was $9.7 million for the six months ended March 31, 2002, compared to $6.8 million of net cash used in operating activities for the six
months ended March 31, 2001. Net cash provided by operating activities for the six months ended March 31, 2002 was primarily the result of cash generated from net loss after adjusting for noncash operating expenses of $4.9 million and increases in
accrued income taxes and deferred revenue, partially offset by increases in deferred taxes and accounts receivable. Net cash used by operating activities for the six months ended March 31, 2001 was primarily the result of our net loss after noncash
operating expenses and an increase in accounts receivable, partially offset by increases in deferred revenue and accrued expenses.





Net cash used in
investing activities was $152.9 million for the six months ended March 31, 2002, compared to $9.3 million of net cash used in investing activities for the six months ended March 31, 2001. Net cash used in investing activities for the six months
ended March 31, 2002 was almost entirely due to net purchases of short-term investments. Net cash used in investing activities for the six months ended March 31, 2001 was the result of net purchases of short-term investments and purchases of
property and equipment.





Net cash provided by financing activities for the six months ended March 31, 2002 was $200.3 million, compared to $6.3 million
of net cash used in financing activities for the six months ended March 31, 2001. Net cash provided by financing activities for the six months ended March 31, 2002 was primarily due to the net proceeds from our IPO and the net proceeds from the sale
of our Series F convertible preferred stock. Net cash used in financing activities for the six months ended March 31, 2001 was primarily due to an increase in restricted cash.





As of March 31, 2002, our principal source of liquidity was $226.4 million of cash, cash equivalents and short-term investments. At that date, we had future minimum lease payments under noncancelable operating leases
of $3.2 million, which were secured by restricted cash of $3.0 million, and long-term debt obligations, including the current portion, of $4.2 million. At March 31, 2002, we had no material commitments for capital expenditures, but we expect to
spend over $2.0 million on capital expenditures during the remaining six months of our fiscal year ending September 30, 2002 and over $4.5 million on capital expenditures during the next 12 months.





In October 1998, we issued a secured promissory note for approximately $482,000 that bears interest at 7.25% per annum. The note does not require us to meet any financial
covenants. The note is due in May 2002 and is secured by our assets. The loan is payable in equal monthly installments of principal and interest of approximately $13,000. All interest accumulated under the loan had been paid as of March 31, 2002. As
of March 31, 2002, the amount outstanding under the loan was approximately $96,000.





In October 1998, we entered into a $318,000 (later adjusted to
$404,000) equipment leasing arrangement with the same lender. During the year ended September 30, 2000, we expanded the equipment leasing arrangement by an additional $500,000. As of March 31, 2002, there was no availability for future purchases of
equipment under this leasing arrangement. As of March 31, 2002, the amount outstanding under the arrangement was approximately $312,000.





In February
2001, we entered into an equipment leasing arrangement of approximately $514,000. The lease is payable in monthly installments of principal and interest of approximately $15,000 through February 2004.





In April 2001, we entered into a loan and security agreement for $3.5 million. Under the agreement, we could borrow amounts to finance eligible equipment purchases. The lender
has a security interest in the equipment. Borrowings under the agreement bear interest at the U.S. Treasury note rate for notes with a three-year maturity plus 3.75% and are payable in equal monthly installments over a three-year term. A final
payment equal to 9% of the amount borrowed, due at the end of the three-year term, has been treated as an additional finance charge and is being amortized over the term of the loan. We are not required to meet any financial covenants. The commitment
terminated on November 30, 2001. As of March 31, 2002, we had borrowed $2.0 million at an annual interest rate of 8.2% under this agreement.





In August
2001, we entered into a loan and security agreement for $3.0 million. Under the agreement, we could borrow amounts to finance eligible equipment purchases. The lender has a security interest in the equipment. Borrowings under the agreement bear
interest at the U.S. Treasury note rate for notes with a three-year maturity plus 9.5% and are payable in equal monthly installments over terms ranging from 33 to 36 months. We are required to maintain an unrestricted cash balance of $11.0 million
while borrowings are outstanding under the agreement. The commitment terminated on November 30, 2001. As of March 31, 2002, we had borrowed $1.3 million at an annual interest rate of 13.8% and approximately $944,000 at an annual rate of 13.3% under
this arrangement.





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







15




---

##### Table of Contents




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





Year ending March 31:2003

$
1,8322004


1,7162005


662Total future minimum payments

$
4,210





We lease our office facilities under noncancelable operating leases expiring at various dates through May
2003.





In August 2000, we entered into a lease for approximately 51,000 square feet of office space in Sunnyvale, California, which commenced on January
21, 2001 and will terminate on February 14, 2003. The related cost of the lease is approximately $270,000 per month. The lease is secured by a $3.0 million standby letter of credit as of March 31, 2002.





We have entered into several facilities leases for foreign sales offices. The leases expire at various dates through May 2003. The related cost of the leases is approximately
$47,000 per month.





Future minimum lease payments under noncancelable operating leases were as follows (in thousands):





Year ending March 31:2003

$
3,2012004


7Total future minimum payments

$
3,208





Flash Electronics, Inc. manufactures, assembles and tests the NetScreen-100, NetScreen-50, NetScreen-25,
NetScreen-204 and NetScreen-208 products. C-MAC Industries, Inc., manufactures, assembles and tests the Net-Screen-5200, NetScreen-1000, NetScreen-500 and NetScreen-5XP products. We purchase from these manufactures on a purchase order basis, and do
not have long-term supply contracts. We are obligated to pay for costs of material plus a fair material margin. At March 31, 2002, we had noncancellable purchase orders of $4.7 million to Flash Electronics, Inc. and C-MAC Industries, Inc.





We currently anticipate that our cash, cash equivalent and short-term investment balances of $226.4 million at March 31, 2002 will be sufficient to meet
our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. However, we may need to raise additional funds sooner to fund more rapid expansion, to develop new or enhance existing products or services, to
respond to competitive pressures or to acquire complementary businesses, products or technologies.





Recent Accounting Pronouncements





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





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





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





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







16




---

##### Table of Contents




RISK FACTORS





If any of the following risks actually occur, our business, results of operations and financial condition could suffer significantly.





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





The market for our products depends on economic conditions affecting the broader Internet infrastructure, network security and related markets. Downturns in these markets may cause enterprises and service providers to delay or cancel
security projects, reduce their overall or security-specific information technology budgets or reduce or cancel orders for our products. In this environment, customers may experience financial difficulty, cease operations or fail to budget for the
purchase of our products. This, in turn, may lead to longer sales cycles, delays in payment and collection, and price pressures, causing us to realize lower revenues and margins. In particular, capital spending in the information technology sector
has decreased in the past 18 months, and many of our customers and potential customers have experienced declines in their revenues and operations. In addition, the terrorist acts of September 11, 2001 have created an uncertain economic environment
and we cannot predict the impact of these events, any future terrorist acts or any related military action, on our customers or business. We believe that, in light of these events, some businesses may curtail or eliminate capital spending on
information technology. If capital spending in our markets declines, it may be necessary for us to gain significant market share from our competitors in order to achieve our financial goals and achieve profitability.





Competition may decrease our revenues, market share and gross margins.





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





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





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

| | 
| | 

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

| | 
| | 

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

| | 
| | 

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

| | 
| | 

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

| | 
| | 

| |  |  | emerging intrusion detection companies that intend to position their intrusion detection systems as replacements for firewalls.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------




Many of our current or potential competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical,
sales, marketing and other resources than we do. In addition, some of our competitors currently combine their products with other companies networking and security products to compete with our products. These competitors also often combine
their sales and marketing efforts to compete with our products. This competition may result in reduced prices and longer sales cycles for our products. If any of our larger competitors were to commit greater technical, sales, marketing and other
resources to our markets, our ability to compete would be adversely affected.





We anticipate continued losses and may not achieve profitability.





We have incurred significant losses since our inception in October 1997. As of March 31, 2002, we had an accumulated deficit of $96.8 million. We
expect to continue to incur losses for the foreseeable future. We had net losses applicable to common stockholders of $34.2 million for the year ended September 30, 2001 and $37.7 million for the six months ended March 31, 2002. We have large fixed
expenses, and we expect to continue to incur significant and increasing sales and marketing, research and development and administrative expenses. As a result, we will need to generate significantly higher total revenues to achieve profitability.
Revenue growth depends on many factors, including those described elsewhere in these Risk Factors. Our revenues may not grow, and we may never achieve profitability. A failure to achieve profitability or a delay in any anticipated timing
to achieve profitability could cause our stock price to decline.







17




---

##### Table of Contents

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





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





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





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





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





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




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




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




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




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




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




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




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




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




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




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





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





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





In the six months ended March 31, 2002, we derived approximately 84% of our total revenues from
value-added resellers and distributors. We derived approximately 80% of our total revenues from value-added resellers and distributors in the year ended September 30, 2001. In addition, on December 17, 2001, we entered into a non-exclusive North
American Distribution Agreement with Ingram Micro Inc. under which Ingram will distribute a subset of NetScreens product line to selected resellers approved and authorized by NetScreen, including value added resellers that previously
maintained a direct relationship with us.




18




---

##### Table of Contents




We expect our revenues to continue to depend in large part on the performance of these third-party distributors and
resellers. We have no long-term contracts or minimum purchase commitments with any of our value-added resellers and distributors. In addition, our value-added resellers and distributors may be unsuccessful selling our products and services, may sell
products and services that are competitive with ours, may devote more resources to competitive products and may cease selling our products and services altogether. In addition, we may lose value added resellers as a result of the introduction of
Ingram Micro Inc. The loss of or reduction in sales to our value-added resellers or distributors could materially reduce our revenues. If we fail to develop and maintain additional relationships with these distribution partners, or if these partners
are not successful in their sales efforts, sales of our products may decrease and our operating results would suffer.





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





Our ability to sell our products and
implement our business plan successfully in a volatile and growing market requires effective management systems and a system of financial processes and controls. Growth is likely to place a considerable strain on our systems, processes and controls.
In connection with our year 2000 audit, weaknesses were identified in our ability to produce accurate financial statements on a timely basis. Deficiencies in our infrastructure and our finance personnel adversely affected our ability to record,
process and report financial data on a timely basis. These deficiencies also impaired our ability to apply revenue recognition policies consistently, to balance and analyze our accounts receivable, and to track data relating to distributor and
value-added reseller sales and ending inventory levels on a timely basis. We believe that we have addressed all of these issues. We have improved our infrastructure, personnel, processes and controls to allow us to produce accurate financial
statements on a timely basis. Our anticipated growth in future operations will continue to place a strain on our management systems, controls and resources. To address these issues, we will need to continue to improve our financial and managerial
controls, reporting systems and procedures, and will need to continue to expand, train and manage our work force worldwide. If we are unable to maintain an adequate level of financial processes and controls, we may not be able to accurately report
our financial performance on a timely basis and our business and stock price would be harmed.





Our limited operating history makes it difficult to
evaluate our business and prospects.





As a result of our limited operating history, we have little meaningful historical financial data upon which to
plan operating expenses or forecast our revenues accurately. Specifically, we began operations in October 1997, and we began shipping the NetScreen-100 and NetScreen-10 in June 1998, the NetScreen-5 in September 1999, the NetScreen-1000 in May 2000,
the NetScreen-500 in May 2001, the NetScreen-5XP, the successor to the NetScreen-5, in June 2001, and the NetScreen-50 and NetScreen-25, which replaced the NetScreen-10, in November 2001. We began shipping the NetScreen-204 and NetScreen-208
security appliances in January 2002 and the NetScreen-5200 security system in April 2002. We began shipping NetScreen-Remote VPN client software in August 1998, NetScreen-Global Manager management software in September 1999, NetScreen-Global PRO
management software in March 2001 and NetScreen-Global PRO Express management software in November 2001. The revenue and income potential of our products and business is unproven, and the markets that we are addressing are volatile. If our products
are not successful, our operating results would be below our expectations and the expectations of investors and market analysts, which would likely cause the price of our common stock to decline.





If we fail to address evolving standards in the network security industry, our business could be harmed.





The market for network security products is characterized by rapid technological change, frequent new product introductions, changes in customer requirements and evolving industry standards. In developing and introducing our products, we
have made, and will continue to make, assumptions with respect to which features, security standards and performance criteria will be required by our customers. If we implement features, security standards and performance criteria that are different
from those required by our customers, market acceptance of our products may be significantly reduced or delayed and our business would be seriously harmed. In this environment, we may have difficulty selling one or more of our products, which could
lead to reduced market share and lower revenues. In addition, the introduction of products embodying new technologies could render our existing products obsolete, which would have a direct, adverse effect on our market share and revenues.





Failure to develop or introduce new products or product enhancements might cause our revenues to decline.





We expect to introduce new products and enhancements in the future to address current and evolving customer requirements. We also expect to develop products with strategic
partners and incorporate third-party advanced security capabilities into our products. We may not be able to develop new products or product enhancements in a timely manner, or at all. Any failure to develop or introduce these new products and
product enhancements might cause our products to be less competitive and our revenues to decline. In addition, our assumptions about customer requirements may be wrong. Even if we are able to develop and introduce new products and enhancements,
these products or enhancements may not achieve widespread market acceptance. Any failure of our future products or product enhancements to achieve market acceptance could cause our revenues to decline.







19




---

##### Table of Contents




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





We have
established subsidiaries in Hong Kong, Japan, Korea, Singapore and the United Kingdom, representative offices in Australia and China and a registered branch in France to market, sell and service our products. We intend to expand substantially our
existing international operations and to enter new international markets. This expansion will require significant management attention and financial resources. We currently have limited experience in marketing and distributing our products
internationally and in developing versions of our products that comply with local standards.





We may not be able to maintain or increase international
market demand for our products. In addition, international operations are subject to other inherent risks, including:





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




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




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




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




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




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




Revenues from outside
of North America were 48% of our total revenues for the year ended September 30, 2001 and 53% of our total revenues for the six months ended March 31, 2002. We expect revenues from outside of North America will continue to represent a substantial
portion of our total revenues for the foreseeable future. To the extent we are unable to favorably renew our distributor and value-added reseller agreements or make alternative arrangements, revenues from our international operations may decrease.





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





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





Flash Electronics, Inc. manufactures, assembles and tests the NetScreen-100, NetScreen-50,
NetScreen-25, NetScreen-204 and NetScreen-208 products at its Fremont, California facility. C-MAC Industries, Inc. manufactures, assembles and tests the NetScree-5200, NetScreen-1000, NetScreen-500 and NetScreen-5XP products at its San Jose,
California facility. We currently do not have a long-term supply contract with either Flash Electronics or C-MAC Industries, and we purchase from these manufacturers on a purchase order basis. If we should fail to manage our relationship with Flash
Electronics or C-MAC Industries effectively, or if either of these manufacturers experiences delays, disruptions or quality control problems in its manufacturing operations, our ability to ship products to our customers could be delayed.





The absence of dedicated capacity with Flash Electronics and C-MAC Industries means that, with little or no notice, they could refuse to continue
manufacturing some or all of our products. Qualifying a new contract manufacturer and commencing volume production is expensive and time-consuming. If we are required or choose to change contract manufacturers, we would lose revenues and damage our
customer relationships. C-MAC Industries was acquired by Solectron Corporation in December 2001. Failure to work efficiently and effectively with the combined company following the acquisition would have an adverse effect on revenues and damage our
customer relationships.





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







20




---

##### Table of Contents




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





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




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




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




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




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




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




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




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





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





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





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





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





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





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





Because we are in the business of providing network security, our own networks may be more
likely to become a target of hacker attacks. If attacks on our internal networks are successful, public perception of our products would be harmed.




21




---

##### Table of Contents




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





We offer a warranty on all of our products, allowing the end customer to have any defective unit repaired, or to receive a replacement product
for it. Our products may contain undetected errors or defects. If there is a product failure, we may have to replace all affected products without being able to record revenue for the replacement units, or we may have to refund the purchase price
for the defective units. Some errors are discovered only after a product has been installed and used by end customers. Any errors discovered after commercial release could result in loss of revenues and claims against us.





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





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




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




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




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




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




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




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




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





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





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





Because we currently do not have long-term supply contracts with our contract manufacturers,
they are not obligated to supply products to us for any specific period, in any specific quantity or at any certain price, except as may be provided in a particular purchase order. We provide forecasts of our demand to our contract manufacturers up
to six months prior to scheduled delivery of products to our customers. If we overestimate our requirements, our contract manufacturers may have excess inventory, which would increase our costs. If we underestimate our requirements, our contract
manufacturers may have an inadequate component inventory, which could interrupt manufacturing of our products and result in delays in shipments and revenues. In addition, lead times for materials and components that we order vary significantly and
depend on factors such as the specific supplier, contract terms and demand for each component at a given time. We may also experience shortages of components from time to time, which also could delay the manufacturing of our products.





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





Because our products and services provide and monitor network security and may protect valuable information, we could face claims for product liability, tort or breach of
warranty. Anyone who circumvents our security measures could misappropriate the confidential information or other property of end customers using our products or interrupt their operations. If that happens, affected end customers or others may sue
us. In addition, we may face liability for breaches caused by faulty installation of our products by our service and support organizations. Provisions in our contracts relating to warranty disclaimers and liability limitations may be unenforceable.
Some courts, for example, have found contractual limitations of liability in standard computer and software contracts to be unenforceable in some circumstances. Defending a lawsuit, regardless of its merit, could be costly and could divert
management attention. Our business liability insurance coverage may be inadequate or future coverage may be unavailable on acceptable terms or at all. Our business liability insurance has no specific provisions for product liability for network
security breaches.




22




---

##### Table of Contents




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





We rely and plan to continue to
rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We also enter into confidentiality agreements with our employees, consultants and corporate
partners, and control the use, access to and distribution of our software, documentation and other proprietary information. Unauthorized parties may attempt to copy or otherwise to obtain and use our products or technology. Monitoring unauthorized
use of our products is difficult, and the steps we have taken may not prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States.





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





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





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




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




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




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





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





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





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





We have granted stock options under our stock option plan since November 1997. We are required to recognize, as
a reduction of stockholders equity, deferred stock compensation equal to the difference between the deemed fair market value of our common stock for financial reporting purposes and the exercise price of these options at the date of grant.
This deferred compensation is amortized over the vesting period of the applicable options, generally four years, using the straight-line vesting method. At March 31, 2002, approximately $55.2 million of deferred stock compensation related to
employee stock options remained unamortized. The resulting amortization expense will have a material negative impact on our results of operations in future periods through the quarter ending December 31, 2005.





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





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





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




23




---

##### Table of Contents




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





Our corporate headquarters and our key third-party manufacturers are located in Northern California near major earthquake faults
that have experienced earthquakes in the past. An earthquake or other natural disaster near our headquarters or near one or more of the facilities of third parties upon which we rely could disrupt our operations or the operations of those parties.
Additionally, the loss of electric power, such as the temporary loss of power caused by power shortages in the grid servicing of our facilities or the facilities of these third parties in Northern California, could disrupt operations or impair
critical systems. None of these disruptions would be covered by insurance, so the supply of our products could be limited, our business could be hampered and our financial condition and results of operations could be harmed.





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





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





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





Our executive officers, our directors, our current greater than 5%
stockholders and entities affiliated with any of them together beneficially own a majority of our outstanding common stock. As a result, these stockholders are be able to exercise control over all matters requiring approval by our stockholders,
including the election of directors and approval of significant corporate transactions. This concentration of ownership might also have the effect of delaying or preventing a change in our control that might be viewed as beneficial by other
stockholders.





Management could invest or spend the proceeds from our initial public offering in ways that might not enhance our results of operations
or market share.





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





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





If our existing stockholders sell, or are perceived to sell, substantial amounts of our common stock in the public market, the market price of our common stock could decline. As
of March 31, 2002, there were 73,730,785 shares of common stock outstanding. Of these shares, only shares of common stock sold in our initial public offering are freely tradable, without restriction, in the public market. After the lockup agreements
pertaining to our initial public offering expire on June 9, 2002, which is 180 days from the date of the prospectus for our initial public offering, an additional 56,103,383 shares will be eligible for sale in the public market, 35,864,016 of which
are held by directors, executive officers and other affiliates, and are subject to volume limitations under Rule 144 of the Securities Act and various vesting agreements. In addition, shares subject to outstanding options and warrants and shares
reserved for future issuance under our stock option and purchase plans will become eligible for sale in the public market to the extent permitted by the provisions of various vesting agreements, the lock-up agreements and Rules 144 and 701 under the
Securities Act. Goldman Sachs & Co., the lead managers of our initial public offering, may also, in its sole discretion, permit our officers, directors and current stockholders to sell shares prior to the expiration of the lock-up agreements.




24




---

##### Table of Contents




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





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





ITEM 3.    
Qualitative and Quantitative Disclosure about Market Risk





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





As of March 31, 2002, our investment portfolio
consisted of money market funds, corporate-backed debt obligations, municipal bonds and U.S. government discount notes, generally due within one year. We place investments with high quality issuers and limit the amount of credit exposure to any one
issuer. These securities are subject to interest rate risks. Based on our portfolio content and our ability to hold investments to maturity, we believe that, if a significant change in interest rates were to occur, it would not have a material
effect on our financial condition, although there can be no assurance of this.




25




---

##### Table of Contents




PART IIOTHER INFORMATION





Item 1.    
Legal Proceedings





None.





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





Item
2.    
Changes in Securities and Use of Proceeds





(d) The Securities and Exchange Commission declared the Companys first
registration statement, filed on Form S-1 under the Securities Act of 1933 (File No. 333-71048), relating to the Companys initial public offering of its common stock, effective on December 11, 2001. The Company is furnishing the following
information with respect to the use of proceeds from its initial public offering of common stock, $0.001 par value per share, in December 2001:





Gross proceeds from the Companys IPO

$
184,000,000Offering expenses:Underwriting fees


12,880,000Other offering expenses


2,481,000Total offering expenses


15,361,000Net proceeds from the Companys IPO

$
168,639,000





To date, the Company has not used any of the net proceeds of the IPO.





Item 3.    
Defaults upon Senior Securities





None.





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





None.





Item 5.    
Other Information





None.





Item 6.    
Exhibits and Reports on Form 8-K





(a)    Exhibits





The following exhibit is filed herewith:





3.01  Restated Bylaws of the Registrant, effective
December 17, 2001





(b)    Reports on Form 8-K





No reports on Form 8-K were filed by the Company during the three months ended March 31, 2002.




26




---

##### Table of Contents




SIGNATURE





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





/s/    REMO E. CANESSARemo E. Canessa, Chief Financial Officer and Corporate Secretary (Principal Financial Officer)





Dated: May 13, 2002




27