SONICWALL INC - 10-Q Quarterly Report

	September 30, 2002			December 31, 2001
	(Unaudited)
ASSETS
Current Assets:
Cash and cash equivalents	$	159,399		$	60,908
Short term investments		74,599			166,271
Accounts receivable, net		13,853			15,642
Inventories, net		6,436			5,489
Deferred income taxes		13,743			20,364
Prepaid expenses and other current assets		2,765			3,384

Total current assets		270,795			272,058
Property and Equipment, net		6,104			6,616
Goodwill		186,191			189,312
Purchased Intangibles, net		33,727			48,014
Other Assets		394			351

	$	497,211		$	516,351

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Accounts payable	$	6,642		$	7,400
Accrued restructuring		1,685			—
Accrued compensation and related benefits		4,363			3,854
Other accrued liabilities		6,161			11,263
Deferred revenue		14,948			15,122
Income taxes payable		3,937			9,934

Total current liabilities		37,736			47,573
Deferred Tax Liability		13,169			17,625

Total liabilities		50,905			65,198


Shareholders’ Equity:
Common stock		463,995			466,857
Deferred stock compensation		(605	)		(2,881	)
Accumulated other comprehensive income		127			194
Accumulated deficit		(17,211	)		(13,017	)

Total shareholders’ equity		446,306			451,153

	$	497,211		$	516,351

	Three Months Ended September 30,						Nine Months Ended September 30,
	2002			2001			2002			2001
Revenue:
Product	$	19,349		$	21,362		$	60,723		$	62,426
License and service		5,062			6,399			19,534			16,466

Total revenue		24,411			27,761			80,257			78,892

Cost of revenue:
Product, excluding amortization of stock-based compensation of $9, $10, $35 and $46, respectively		6,198			6,081			19,603			17,856
License and service		1,210			423			3,196			955

Total cost of revenue		7,408			6,504			22,799			18,811

Gross margin		17,003			21,257			57,458			60,081

Operating expenses:
Research and development, excluding amortization of stock-based compensation of $62, $252, $246 and $552, respectively		4,185			5,103			13,728			15,576
Sales and marketing, excluding amortization of stock-based compensation of $218, $291, $746 and $1,344, respectively		10,363			7,973			33,314			22,352
General and administrative, excluding amortization of stock-based compensation of $39, $75, $133 and $538, respectively		3,183			2,472			8,499			6,764
Amortization of goodwill and intangibles		2,578			10,919			7,734			31,858
Restructuring charges		—			—			3,969			—
Stock-based compensation		328			628			1,160			2,480

Total operating expenses		20,637			27,095			68,404			79,030

Loss from operations		(3,634	)		(5,838	)		(10,946	)		(18,949	)
Interest income and other expense, net		1,334			2,072			4,714			7,592

Loss before income taxes		(2,300	)		(3,766	)		(6,232	)		(11,357	)
Benefit from (provision for) income taxes		775			(1,438	)		2,038			(4,746	)

Net loss	$	(1,525	)	$	(5,204	)	$	(4,194	)	$	(16,103	)

Net loss per share:
Basic and Diluted	$	(0.02	)	$	(0.08	)	$	(0.06	)	$	(0.25	)

Shares used in computing net loss per share:
Basic and Diluted		67,289			65,232			67,052			63,851

	Nine Months Ended September 30,
	2002			2001
Cash flows from operating activities:
Net loss	$	(4,194	)	$	(16,103	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		10,086			32,778
Provision for (recovery of) doubtful accounts		(105	)		609
Amortization of stock-based compensation		1,160			2,480
Tax benefit from exercise of stock options		—			1,597
Non-cash restructuring charges		1,109			—
Changes in operating assets and liabilities, net of effects of businesses acquired:
Accounts receivable		3,100			(4,436	)
Inventories		(1,185	)		(1,184	)
Deferred income taxes		(2,865	)		3,528
Prepaid expenses and other current assets		2,030			(1,022	)
Other assets		(43	)		(246	)
Accounts payable		(820	)		(4,263	)
Accrued restructuring		1,685			—
Accrued compensation and related benefits		509			(941	)
Other accrued liabilities		(753	)		1,751
Deferred revenue		271			2,713
Income taxes payable		765			(534	)

Net cash provided by operating activities		10,750			16,727

Cash flows from investing activities:
Purchase of property and equipment		(3,229	)		(2,871	)
Sale (purchase) of short term investments		90,124			(76,686	)
Acquisitions, net of cash acquired		(2,451	)		(11,966	)

Net cash provided by (used in) investing activities		84,444			(91,523	)

Cash flows from financing activities:
Proceeds from exercise of stock options and warrants		3,297			11,656

Net cash provided by financing activities		3,297			11,656

Net increase (decrease) in cash and cash equivalents		98,491			(63,140	)
Cash and cash equivalents at beginning of period		60,908			140,287

Cash and cash equivalents at end of period	$	159,399		$	77,147

Supplemental disclosure of non-cash investing and financing activities:
Deferred stock compensation, net of cancellations	$	(1,178	)	$	710
Income tax benefit from stock option exercises	$	—		$	8,872
Common stock issued for acquired businesses	$	—		$	13,296
Adjustments to goodwill recorded for acquired businesses	$	(8,186	)	$	3,604
Unrealized loss on short-term investments, net of taxes	$	(67	)	$	486

The accompanying condensed consolidated financial statements have been prepared by SonicWALL, Inc. (the “Company”), are unaudited and reflect all adjustments which are normal, recurring and, in the opinion of management, necessary for a fair presentation of the financial position and the results of operations of the Company for the interim periods. The statements have been prepared in accordance with the regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all information and footnotes required by generally accepted accounting principles. The results of operations for the nine months ended September 30, 2002 are not necessarily indicative of the operating results to be expected for the full fiscal year or future operating periods. The information included in this report should be read in conjunction with the audited consolidated financial statements and notes thereto for the fiscal year ended December 31, 2001, the critical accounting policies, and the risk factors as set forth in the Company’s Annual Report on Form 10-K. These publicly available documents are available on the SEC’s website at http://www.sec.gov. You may also read and copy any document we file at the SEC’s public reference room in Washington, D.C., New York, NY and Chicago, IL. Please call the SEC at 1-800-SEC-0330 for further information on the public reference rooms.

The consolidated financial statements include those of the Company and its wholly-owned subsidiaries Sonic Systems International, Inc., a Delaware corporation, Phobos Corporation, a Utah corporation, SonicWALL Switzerland, SonicWALL Norway and SonicWALL B.V., a subsidiary in the Netherlands. Sonic Systems International, Inc. is intended to be a sales office but to date has not had any significant transactions. All intercompany accounts and transactions have been eliminated in consolidation.

	Three Months Ended September 30,						Nine Months Ended September 30,
	(In thousands, except per share amounts)
	2002			2001			2002			2001
Numerator:
Net loss	$	(1,525	)	$	(5,204	)	$	(4,194	)	$	(16,103	)

Denominator:
Weighted average common shares outstanding		67,291			65,504			67,084			64,161
Weighted average unvested common shares subject to repurchase		(2	)		(272	)		(32	)		(310	)

Denominator for basic and diluted calculation		67,289			65,232			67,052			63,851

Basic and Diluted net loss per share	$	(0.02	)	$	(0.08	)	$	(0.06	)	$	(0.25	)

Common stock equivalents of 664,000 and 4,176,000 for the three-month periods ended September 30, 2002 and 2001, respectively, consisting of options, warrants and restricted stock, and common stock equivalents of 1,949,000 and 4,537,000 for the nine-month periods ended September 30, 2002 and 2001, respectively, consisting of options, warrants and restricted stock were not included in the computation of diluted net loss per share because their effect would be anti-dilutive.

Comprehensive income (loss) includes unrealized gains and losses on investment securities that have been reflected as a component of shareholders’ equity and have not affected net income (loss). The amount of income tax expense or benefit allocated to unrealized gains or losses on investment securities is equivalent to the effective tax rate in each of the respective periods. Comprehensive income (loss) is comprised, net of tax, as follows (in thousands):

During the second quarter of 2002, the Company’s management approved and initiated a restructuring plan designed to reduce its cost structure and integrate certain company functions. Accordingly, the Company recognized a restructuring charge of approximately $4.0 million during the second quarter of 2002. The restructuring charge consists of workforce reduction costs across all geographic regions and functions and excess facilities consolidation costs related to lease commitments for space no longer needed to support ongoing operations and fixed asset impairments. The estimated facility costs were based on the Company’s contractual obligations, net of assumed sublease income, based on current comparable rates for leases in their respective markets. Should facilities operating lease rental rates continue to decrease in these markets or should it take longer than expected to find a suitable tenant to sublease these facilities, the actual loss could exceed this estimate. Future cash outlays are anticipated through December 2005, unless the Company negotiates to exit the leases at an earlier date. Asset impairments consist primarily of leasehold improvements, computer equipment and related software, and furniture and fixtures. The restructuring plan will result in the elimination of approximately 78 positions worldwide, 77 of which were eliminated as of September 30, 2002.

On December 6, 2001, a securities class action complaint was filed in the U.S. District Court for the Southern District of New York against the Company, three of its officers and directors, and certain of the underwriters in the Company’s initial public offering in November 1999 and its follow-on offering in March 2000. Similar complaints were filed in the same court against numerous public companies that conducted initial public offerings (“IPOs”) of their common stock since the mid-1990s. All of these lawsuits were consolidated for pretrial purposes before Judge Shira Scheindlin. On April 19, 2002, plaintiffs filed an amended complaint. The amended complaint alleges claims under the Securities Act of 1933 and the Securities Exchange Act of 1934, and seeks damages or rescission for misrepresentations or omissions in the prospectuses relating to, among other things, the alleged receipt of excessive and undisclosed commissions by the underwriters in connection with the allocation of shares of common stock in the Company’s public offerings. On July 15, 2002, the issuers filed an omnibus motion to dismiss for failure to comply with applicable pleading standards. On October 8, 2002, the Court entered an Order of Dismissal as to all of the individual defendants in the SonicWALL IPO litigation, without prejudice. While the Company believes that the claims against it and its officers and directors are without merit and intends to vigorously defend against these allegations, the litigation could result in substantial costs and divert the Company’s attention and resources, which could have a material adverse effect on the Company’s business, operating results, liquidity and financial condition.

				September 30, 2002							December 31, 2001
				September 30, 2002							December 31, 2001

	Amortization Period	Gross Carrying Amount		Accumulated Amortization			Net		Gross Carrying Amount		Accumulated Amortization			Net
Existing technology	52–72 months	$	26,970	$	(8,345	)	$	18,625	$	26,970	$	(4,938	)	$	22,032
Non-compete agreements	36 months		7,019		(4,377	)		2,642		7,019		(2,622	)		4,397
Customer base	36–72 months		18,140		(5,771	)		12,369		18,140		(3,328	)		14,812
Acquired workforce	36–54 months		—		—			—		7,871		(1,319	)		6,552
Other	2–52 months		400		(309	)		91		400		(179	)		221

Total intangibles		$	52,529	$	(18,802	)	$	33,727	$	60,400	$	(12,386	)	$	48,014

The carrying amount of goodwill was $186.2 million and $189.3 million at September 30, 2002 and December 31, 2001, respectively. The decrease of approximately $3.1 million resulted primarily from three adjustments. First, goodwill was increased by the reclassification of acquired workforce to goodwill of $6.6 million, offset by the corresponding reduction in the deferred tax liability of $1.7 million. Second, goodwill was decreased by $5.0 million for the 317,244 shares of the Company’s common stock received back from Phobos in connection with the escrow settlement. Third, the finalization of purchase price for the other minor acquisitions completed during the course of 2001 reduced goodwill by $2.5 million.

	Three months ended September 30,						Nine months ended September 30,
	2002			2001			2002			2001
Net loss, as reported	$	(1,525	)	$	(5,204	)	$	(4,194	)	$	(16,103	)
Adjustment for amortization of goodwill and acquired workforce, net of tax		—			8,232			—			24,173

Adjusted net income (loss)	$	(1,525	)	$	3,028		$	(4,194	)	$	8,070

Net income (loss) per share:
Basic and diluted net loss per share, as reported	$	(0.02	)	$	(0.08	)	$	(0.06	)	$	(0.25	)
Adjustment to net loss per share for amortization of goodwill and acquired workforce, net of tax:
Basic	$	—		$	0.13		$	—		$	0.38
Diluted	$	—		$	0.12		$	—		$	0.37
Adjusted net income (loss) per share:
Basic	$	(0.02	)	$	0.05		$	(0.06	)	$	0.13
Diluted	$	(0.02	)	$	0.04		$	(0.06	)	$	0.12
Shares used in computing adjusted net income (loss) per share:
Basic		67,289			65,232			67,052			63,851
Diluted		67,289			69,408			67,052			68,388

In August 2001, the FASB issued Statement of Financial Accounting Standards No. 143 (“SFAS No. 143”), Accounting for Asset Retirement Obligations. SFAS No. 143 addresses financial accounting requirements for retirement obligations associated with retirement of tangible long-lived assets and for the associated asset retirement costs. SFAS No. 143 requires a company to record the fair value of an asset retirement obligation in the period in which it is incurred. When the retirement obligation is initially recorded, the Company also records a corresponding increase to the carrying amount of the related tangible long-lived asset and depreciates that cost over the useful life of the tangible long-lived asset. The retirement obligation is increased at the end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the initial fair value measurement. Upon settlement of the retirement obligation, the Company either settles the retirement obligation for its recorded amount or incurs a gain or loss upon settlement. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002, with earlier application encouraged. Accordingly, SFAS No. 143 will be effective for the Company beginning January 1, 2003. The Company is currently in the process of evaluating the impact, if any, SFAS No. 143 will have on its financial position and results of operations.

In May 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statement Nos. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS No. 145 eliminates Statement No. 4 (and Statement 64, as it amends Statement No. 4), which requires gains and losses from extinguishments of debt to be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect. As a result, the criteria in APB Opinion No. 30 will now be used to classify those gains and losses. SFAS No. 145 amends FASB Statement No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions are accounted for in the same manner as sale-leaseback transactions. This amendment is consistent with the FASB’s goal of requiring similar accounting for transactions that have similar economic effects. In addition, SFAS No. 145 makes technical corrections to existing pronouncements. While those corrections are not substantive in nature, in some instances, they may change accounting practice. This statement is effective for fiscal years beginning after May 2002 for the provisions related to the rescission of Statements Nos. 4 and 64, and for all transactions entered into beginning May 2002 for the provision related to the amendment of Statement No. 13 although early adoption is permitted. The Company does not expect the adoption of SFAS No. 145 to have a material impact on its financial position, cash flows or results of operations.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred and states that an entity’s commitment to exit plan, by itself, does not create a present obligation that meets the definition of a liability. SFAS No. 146 also establishes that fair value is the objective for initial measurement of the liability. The provisions of SFAS No. 146 are effective for exit or disposal activities initiated after December 31, 2002. The Company does not expect the adoption of SFAS No. 146 to have a material impact upon the Company’s financial position, cash flows or results of operations.

This Form 10-Q contains forward-looking statements which relate to future events or our future financial performance. In many cases you can identify forward-looking statements by terminology such as “may”, “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “intend” or “continue,” or the negative of such terms and other comparable terminology. In addition, forward-looking statements in this document include, but are not limited to, those regarding: expansion of our enterprise market share; product revenues and percentage of revenues derived from our different products; increased market opportunity for upgrade and subscription products; expanded subscription revenue; revenue trends from license and service revenues; revenue trends resulting from the increased bundling and VPN functionality in our firewall products; expenditures for research and development, sales and marketing, and general and administrative functions; and our belief that existing cash, cash equivalents and short-term investments will be sufficient to meet our cash requirements for at least the next twelve months. These statements are only predictions, and they are subject to risks and uncertainties. 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 set forth herein under the heading “Risk Factors” and also under the heading “Risk Factors” in our Form 10-K filed with the Securities and Exchange Commission. References to “we,” “our,” and “us” refer to SonicWALL, Inc. and its subsidiaries.

SonicWALL designs, develops, manufactures and sells Internet security infrastructure products designed to provide secure Internet access to broadband customers, enable secure Internet-based connectivity for distributed organizations and process secure transactions for enterprises and service providers. We believe our access security appliances provide high performance, robust, reliable, easy-to-use and affordable Internet firewall security and virtual private networking (“VPN”) functionalities. We also sell value-added security applications for our access security appliances including content filtering and vulnerability assessment services, digital certificates and anti-virus protection on an annual subscription basis. Our transaction security products provide high performance SSL acceleration and offloading to enable service providers and enterprises to deploy e-commerce and web-based applications without degrading web server performance. We sell our products primarily to customers in the small to medium enterprise, e-commerce, service provider, branch office and telecommuter markets. As of September 30, 2002, we have sold more than 310,000 of our Internet security appliances worldwide.

From inception through 1996, we derived substantially all of our revenue from the development and marketing of networking products for Apple Macintosh computers. These products enabled Apple Macintosh computers to connect to computer networks using Ethernet communications standards. The Ethernet standard was developed in the 1970s by Xerox Corporation and is the most widely used technology to facilitate communication between computers on local area networks. The Ethernet standard is defined by the Institute of Electrical and Electronics Engineers and specifies the speed and other characteristics of a computer network. In 1998, we made a strategic business decision to concentrate our resources in the Internet security market. As a result, we stopped shipments of our Ethernet product line during December 1999. In October 1997, we introduced our first Internet security appliance, the SonicWALL DMZ, and began volume shipments in 1998. We have since focused all our development, marketing and sales efforts on the Internet security appliance market, and we have progressively introduced a broad line of Internet security products and services from 1998 through 2002.

Our SonicWALL product line provides our customers with comprehensive integrated security including firewall, VPN, anti-virus, content filtering and SSL encryption and decryption functionality, giving users affordable Internet security and secure Internet transactions. SonicWALL delivers appliance solutions that we believe are high performance, easy to install and cost-effective. With current suggested retail prices ranging from $495 to $9,995, our products are designed to enable customers to reduce purchase costs and avoid hiring costly information technology personnel for Internet security. By using an embedded single purpose operating system and a solid state hardware design without moving parts, our products maximize reliability and uptime. The SonicWALL access security products can be used in networks ranging in size from 1 to 10,000 users and are fully compatible with VPN technology from more expensive enterprise security solutions offered by, among others, Check Point Software, Nortel Networks and Cisco.

To date, a significant portion of our revenue has been dependent on large purchase orders from a limited number of distributors. These purchase orders typically have short lead times and are subject to delay or cancellation without penalty. We anticipate that our operating results for a given period will continue to depend on a small number of customers. If we experience a decline in revenue from any of our significant distributors in a given quarter, our revenue for that quarter, or following quarters, will be adversely affected. This could adversely affect our business, prospects, results of operations and financial condition. Furthermore, if any of our significant customers experience financial difficulties, our sales to these customers may be reduced, and we may have difficulty collecting accounts receivable from these customers. Any delay in large customer orders or customer financial difficulties could have a material adverse effect on our business, prospects, results of operations and financial condition.

On November 14, 2000, we acquired Phobos Corporation (“Phobos”) for $216.5 million in a transaction accounted for as a purchase. Phobos designed, developed and sold scaleable SSL solutions for Internet service providers, application service providers, e-commerce companies and web hosting and enterprise network operations centers. Under the terms of the merger, 0.615 shares of our common stock were exchanged for each share of outstanding Phobos common stock at November 14, 2000, the closing date of the merger. In connection with the merger, we issued 9,906,000 shares of our common stock, and options and warrants to purchase 2,294,000 shares of our common stock. The total purchase price was based upon the average fair value of our common stock for five trading days surrounding the date the acquisition was announced. In addition, we paid $30 million in cash to the shareholders of Phobos based upon their pro-rata ownership percentage in Phobos. The merger agreement also provided for up to an additional $20 million in cash to be payable upon achievement of certain quarterly revenue targets during 2001, of which $4 million was earned and recorded as additional goodwill. Payments in the amount of $3 million and $1 million were made in 2001 and 2002, respectively. During the quarter ended June 30, 2002, we received 317,244 shares of our common stock back from Phobos in connection with the escrow settlement, which resulted in a reduction of goodwill of $5.0 million.

On March 8, 2001, we acquired Ignyte Technology, Inc. (“Ignyte”) in a transaction accounted for as a purchase. Ignyte provided in-depth consulting, design and support for enterprise networking customers, as well as management of their Internet security needs. As of the acquisition date we recorded the fair value of Ignyte’s assets and liabilities. The total purchase price of $10.2 million was based upon the average fair value of our common stock for five trading days surrounding the date the acquisition was announced. The purchase price consisted of 735,000 shares of our common stock issued for common stock and options of Ignyte and valued at approximately $8,975,000, $685,000 in cash consideration and $600,000 in closing costs.

On October 25, 2001, we acquired substantially all of the assets and certain liabilities of RedCreek Communications, Inc. (“RedCreek”) in a transaction accounted for as a purchase. RedCreek developed and sold standards-based Internet security products for corporate data communications networks that enable the secure transmission of data between offices over the Internet. As a result of this acquisition, we expect to expand our enterprise market share. At the closing of the acquisition, we paid $12.5 million in cash, assumed certain current accounts payable and other liabilities of RedCreek, and forgave repayment of bridge loan amounts payable by RedCreek to us that were used by RedCreek to fund its operating expenses from the date the purchase agreement was signed until the closing of the acquisition. We also assumed RedCreek’s 2001 stock option plan and 206,500 options valued at $2,205,000 issued thereunder. In the event RedCreek products achieve certain quarterly sales targets during 2001 to 2003, we are obligated to pay additional purchase consideration of up to $4.5 million in cash, which payments would be recorded, if and when payable, as adjustments to goodwill. As of September 30, 2002, no additional payments have been made.

During the second quarter of 2002, we initiated a restructuring plan designed to reduce our cost structure and integrate certain company functions. Accordingly, we recognized a restructuring charge of approximately $4 million during the second quarter of 2002. The restructuring plan consists of workforce reductions across all geographic regions and functions and excess facilities consolidations related to lease commitments for space no longer needed to support ongoing operations and fixed asset impairments. The estimated facility costs were based on our contractual obligations, net of assumed sublease income, based on current comparable rates for leases in their respective markets. Should facilities operating lease rental rates continue to decrease in these markets or should it take longer than expected to find a suitable tenant to sublease these facilities, the actual loss could exceed this estimate. Future cash outlays are anticipated through December 2005, unless we negotiate to exit the leases at an earlier date. Asset impairments consist primarily of leasehold improvements, computer equipment and related software, and furniture and fixtures. The restructuring plan will result in the elimination of approximately 78 positions worldwide, 77 of which were eliminated as of September 30, 2002.

	Three Months Ended September 30,				Nine Months Ended September 30,
	2002		2001		2002		2001
Revenue:
Product	79.3	%	76.9	%	75.7	%	79.1	%
License and service	20.7		23.1		24.3		20.9

Total revenue	100.0		100.0		100.0		100.0

Cost of revenue:
Product	25.4		21.9		24.4		22.6
License and service	4.9		1.5		4.0		1.2

Total cost of revenue	30.3		23.4		28.4		23.8

Gross margin	69.7		76.6		71.6		76.2

Operating expenses:
Research and development	17.1		18.4		17.1		19.7
Sales and marketing	42.5		28.7		41.5		28.3
General and administrative	13.0		8.9		10.6		8.6
Amortization of goodwill and intangibles	10.6		39.3		9.6		40.4
Restructuring charges	—		—		4.9		—
Stock-based compensation	1.3		2.3		1.5		3.2

Total operating expenses	84.5		97.6		85.2		100.2

Loss from operations	(14.8	)	(21.0	)	(13.6	)	(24.0	)
Interest income and other expense, net	5.4		7.5		5.9		9.6

Loss before income taxes	(9.4	)	(13.5	)	(7.7	)	(14.4	)
Benefit from (provision for) income taxes	3.2		(5.2	)	2.5		(6.0	)

Net loss	(6.2	)%	(18.7	)%	(5.2	)%	(20.4	)%

Product revenue. Revenue from sales of our products decreased to $19.3 million in the three months ended September 30, 2002 from $21.4 million in the three months ended September 30, 2001. Revenue from sales of our products decreased to $60.7 million in the nine months ended September 30, 2002 from $62.4 million in the nine months ended September 30, 2001. Our Small to Medium Enterprise (“SME”) products, including our TELE, SOHO, XPRS and PRO product lines, represented approximately 86% and 88% of product revenues in the three and nine months ended September 30, 2002, respectively, compared to 86% and 89% of product revenues in the three and nine months ended September 30, 2001, respectively. Our transaction security and large network access security products, including our SSL and GX product lines and VPN products acquired from RedCreek, represented approximately 13% and 10% of product revenues in the three and nine months ended September 30, 2002 compared to 7% and 6% in the three and nine months ended September 30, 2001. In the three and nine months ended September 30, 2002, we generated approximately 1% and 2%, respectively, of product revenues from certain legacy products of acquired entities that have generally been brought to end of life within the first year of combined operations. These revenues have been generated from network infrastructure products that are not part of our long-term product strategy. In the three and nine months ended September 30, 2001, legacy product revenues represented 7% and 5%, respectively, of product revenues.

We anticipate going forward a majority of our product revenues to be generated from the SME access security market. We will continue to reach this market through our distribution and OEM channels. We have established an enterprise sales team to address the needs of large enterprises. In addition to selling our GX and Global Management products into central sites of these large networks, we believe that successful penetration of these accounts is a means of furthering our penetration of the SME market, as the perimeter of these large networks are the branch office and telecommuter opportunities of the SME market. Our enterprise sales team and an OEM partner are also selling our transaction security products into large enterprises; however this market is in an early stage of development and we do not expect transaction security revenues to represent more than 10% of total product revenues in 2002.

License and service revenue. Revenue from licenses and services decreased to $5.1 million in the three months ended September 30, 2002 from $6.4 million in the three months ended September 30, 2001. Revenue from licenses and services increased to $19.5 million in the nine months ended September 30, 2002 from $16.5 million in the nine months ended September 30, 2001. License and service revenue is comprised primarily of licenses and services such as VPN upgrades, node upgrades, anti-virus protection and content filtering services that are sold into the installed base of access security appliances. In addition, we generate license and service revenues from extended service contracts, licensing of our Global Management software, licensing of our VPN ASIC, licensing of our firewall software, and professional services related to training, consulting and engineering services. Our installed base has grown from approximately 190,000 units at September 30, 2001 to approximately 310,000 units at September 30, 2002, and the increasing size of our installed base has been a primary contributor to the growth of our integrated license and service products. This growth has resulted from initial sales with new units as well as renewals of subscriptions for products such as content filtering and anti-virus.

We expect the market opportunity for our upgrade and subscription products sold to our installed base to increase as our installed base grows. We are dedicating increased sales and marketing resources to sell into our installed base, and we are also focusing resources on marketing renewals for existing subscriptions. In addition, in December 2001, we introduced new service offerings across our product lines to provide our customers primarily maintenance releases of our firmware and technical support. We believe these products will help expand our subscription revenues. Revenues from the licensing of our software and ASIC technology are more difficult to predict. Unlike our upgrade and subscription products marketed to our installed base, we do not have dedicated sales and marketing resources to pursue licensing transactions for our technology, but rather we pursue these opportunities as they arise.

Historically, a significant component of our license and services revenues has been VPN upgrades, which have been offered to our customers as a separately licensed product after their initial purchase of an appliance. We continue to offer VPN upgrades to our customers that purchase products without bundled VPN functionality. However, there has been a trend in our market to offer VPN functionality as a bundled feature in a firewall product, and in response to this trend we have offered our customers the opportunity to purchase our products with bundled VPN functionality. Products sold with bundled VPN generate a higher average selling price than the same product without bundled VPN functionality. The result of this trend has been a decline in our VPN upgrade license revenues, and an increase in our product revenues due in part to the higher average selling prices realized from bundled VPN products. In the three and nine months ended September 30, 2002, VPN upgrades represented approximately 12% of license and service revenues compared to 29% of license and service revenues for the same periods of the prior year. We expect this trend to continue as more of our customers choose to purchase VPN functionality through our bundled offerings.

Cost of revenue; gross margin. Cost of product revenue includes all costs associated with the production of our products, including cost of materials, manufacturing and assembly costs paid to contract manufacturers and related overhead costs associated with our manufacturing operations personnel. Additionally, warranty costs and inventory provisions or write-downs are included in cost of product revenue. Cost of product revenue increased slightly to $6.2 million in the three months ended September 30, 2002 from $6.1 million in the three months ended September 30, 2001, and increased to $19.6 million in the nine months ended September 30, 2002 from $17.9 million in the nine months ended September 30, 2001.

Cost of service revenue includes all costs associated with the delivery of our license and service products, including cost of packaging and materials, royalty payments, technical support costs under service contracts, cost of training revenues and other costs of services such as co-location costs for our content filtering subscriptions. Cost of service revenue increased to $1.2 million in the three months ended September 30, 2002 from $0.4 million in the three months ended September 30, 2001, and increased to $3.2 million in the nine months ended September 30, 2002 from $1.0 million in the nine months ended September 30, 2001. These increases relate primarily to increases in technical support costs and training costs.

Gross margin decreased to 69.7% for the three months ended September 30, 2002 from 76.6% in the three months ended September 30, 2001. Gross margin decreased to 71.6% for the nine months ended September 30, 2002 from 76.2% in the nine months ended September 30, 2001. The primary reasons for this decrease were lower sales in higher margin license and service revenues such as VPN upgrades and node upgrades, lower gross margins from service contracts due to higher technical support

costs, and a shift in product mix from our higher margin Pro products to our lower margin SOHO and TELE products. Our gross margin has been and will continue to be affected by a variety of factors, including among others competition; the mix and average selling prices of products; new product introductions and enhancements; fluctuations in manufacturing volumes; the cost of components and manufacturing labor; and the costs of providing technical support services under our service contracts. We must manage each of these factors effectively in order to maintain our gross margins levels.

Research and development. Research and development expenses primarily consist of personnel costs, contract consultants, outside testing services and equipment and supplies associated with enhancing existing products and developing new products. Research and development expenses decreased by 18% to $4.2 million in the three months ended September 30, 2002 from $5.1 million in the three months ended September 30, 2001. These expenses represented 17.1% and 18.4%, respectively, of revenue for such periods. Research and development expenses decreased by 12% to $13.7 million in the nine months ended September 30, 2002 from $15.6 million in the nine months ended September 30, 2001. These expenses represented 17.1% and 19.7%, respectively, of revenue for such periods. These decreases were primarily attributable to reductions in headcount, lower spending on project materials and reduction in non-recurring engineering costs and fees paid to outside consultants. These decreases are partially offset by the October 2001 purchase of RedCreek which increased research and development costs related to additional personnel and increased product development and integration efforts. We believe that significant investments in research and development will be required to remain competitive.

Sales and marketing. Sales and marketing expenses primarily consist of personnel costs, including commissions, costs associated with the development of our business and corporate identification, costs related to customer support, travel, tradeshows, promotional and advertising costs. Sales and marketing expenses increased 30% to $10.4 million in the three months ended September 30, 2002 from $8.0 million in the three months ended September 30, 2001. These expenses were 42.5% and 28.7% of net sales for such periods, respectively. Sales and marketing expenses increased 49% to $33.3 million in the nine months ended September 30, 2002 from $22.4 million in the nine months ended September 30, 2001. These expenses were 41.5% and 28.3% of net sales for such periods, respectively. The increase in absolute dollars was primarily related to the continued worldwide expansion of our sales and marketing organization, including growth in the domestic and international sales force, particularly in Europe, increased customer service expenses related to a larger installed base and increased travel expenses. The addition of RedCreek in October 2001 increased our worldwide organization with enterprise sales and marketing personnel. We expect to continue to increase our sales and marketing expenses in an effort to expand domestic and international markets, introduce new products and establish and expand new distribution channels and OEM relationships.

General and administrative. General and administrative expenses were $3.2 million for the three months ended September 30, 2002, as compared to $2.5 million for the three months ended September 30, 2001. These expenses represented 13% and 8.9% of total revenue for such periods, respectively. General and administrative expenses were $8.5 million for the nine months ended September 30, 2002, as compared to $6.8 million for the nine months ended September 30, 2001. These expenses represented 10.6% and 8.6% of total revenue for such periods, respectively. The increase in absolute dollars was primarily related to increased personnel costs, including employment termination costs, and increased legal and other professional service fees. We believe that general and administrative expenses will increase in absolute dollars and remain relatively stable as a percentage of total revenue as we continue to build our infrastructure.

Amortization of goodwill and intangibles. Amortization of goodwill and intangibles represents the excess of the aggregate purchase price over the fair market value of the net tangible assets acquired by us. Intangible assets, including existing technology, are being amortized over the estimated useful lives of three to six year periods. In accordance with SFAS No. 142 “Goodwill and Other Intangible Assets,” goodwill and intangibles related to acquired workforce are no longer being amortized effective January 1, 2002. Amortization of intangibles was $2.6 million for the three months ended September 30, 2002 compared to $10.9 million for the three months ended September 30, 2001. Amortization for the three months ended September 30, 2002 primarily consisted of $2.4 million, $87,000 and $38,000 relating to the amortization of intangibles associated with the acquisitions of Phobos, RedCreek, and Ignyte, respectively. Amortization of intangibles was $7.7 million for the nine months ended September 30, 2002 compared to $31.9 million for the nine months ended September 30, 2001. Amortization for the nine months ended September 30, 2002 primarily consisted of $7.1 million, $260,000 and $115,000 relating to the amortization of intangibles associated with the acquisitions of Phobos, RedCreek and Ignyte, respectively.

Restructuring charges. During the second quarter of 2002, we implemented a restructuring plan designed to reduce our cost structure and integrate certain company functions. Accordingly, we recognized a restructuring charge of approximately $4.0 million during the second quarter of 2002. The restructuring plan consists of workforce reductions across all geographic regions and functions and excess facilities consolidations related to lease commitments for space no longer needed to support ongoing operations and fixed asset impairments. The restructuring plan will result in the elimination of approximately 78 positions worldwide, 77 of which were eliminated as of September 30, 2002.

Interest income and other expense, net. Interest income and other expense, net consists primarily of interest income on our cash, cash equivalents and short-term investments, and was $1.3 million for the three months ended September 30, 2002 compared to $2.1 million in the three months September 30, 2001. The fluctuations in the short-term interest rates directly influence the interest income recognized by us. Interest income and other expense, net was $4.7 million for the nine months ended September 30, 2002 compared to $7.6 million for the nine months ended September 30, 2001. Interest rates for the nine-month period ended September 30, 2002 decreased over the corresponding period of the prior fiscal year, resulting in lower interest income.

Benefit from (provision for) income taxes. The benefit from income taxes in the three months ended September 30, 2002 was $0.8 million as compared to a provision of $1.4 million in the three months ended September 30, 2001. The benefit from income taxes in the nine months ended September 30, 2002 was $2.0 million as compared to a provision of $4.7 million in the nine months ended September 30, 2001. In both periods, the provision or benefit for income taxes is based on an estimated effective rate for each of the respective calendar years. Our effective tax rate differs from the statutory federal and state tax rates for the three and nine months of fiscal 2002 and 2001 due principally to the effect of amortization of stock-based compensation, goodwill and intangibles, which are permanent, non-deductible book/tax differences.

Our annual operating results have in the past varied and may in the future vary significantly depending on a number of factors including the level of competition; the size and timing of significant orders; product mix; market acceptance of new products and product enhancements; new product announcements or introductions by us or our competitors; deferrals of customer orders in anticipation of new products or product enhancement; changes in pricing by us or our competitors; our ability to develop, introduce and market new products and product enhancements on a timely basis; hardware component costs; supply constraints; our success in expanding our sales and marketing programs; technological changes in the Internet security market; the mix of sales among our sales channels; levels of expenditure on research and development; changes in our strategy; personnel changes; our ability to successfully expand domestic and international operations; general economic trends and other factors.

For the nine months ended September 30, 2002, our cash, cash equivalents and short-term investments increased by $6.8 million to $234 million as compared to an increase of $14.0 million to $233.6 million for the nine month period ended September 30, 2001. Our working capital increased for the nine months ended September 30, 2002 by $8.6 million to $233.1 million as compared to an increase of $20.6 million to $243.6 million for the nine months ended September 30, 2001. For the nine months ended September 30, 2002, we generated cash from operating activities totaling $10.8 million compared to $16.7 million in the same period of the prior year.

For the nine months ended September 30, 2002, we generated cash from investing activities totaling $84.4 million, principally as a result of the net sale of $90.1 million of short-term investments offset by $3.2 million used to purchase property and equipment and $2.5 million used for the repayment of liabilities assumed upon the acquisition of other businesses. Net cash used in investing activities for the nine months ended September 30, 2001 was principally as a result of the net purchase of approximately $76.7 million of short-term investments and $2.9 million of property and equipment. In addition, $12.0 million was used for the repayment of liabilities assumed upon the acquisitions of other businesses.

We believe our existing cash, cash equivalents and short-term investments will be sufficient to meet our cash requirements at least through the next twelve months. However, we may be required, or could elect, to seek additional funding prior to that time. Our future capital requirements will depend on many factors, including our rate of revenue growth, the timing and extent of spending to support product development efforts and expansion of sales and marketing, the timing of introductions of new products and enhancements to existing products, and market acceptance of our products. We cannot assure you that additional equity or debt financing will be available on acceptable terms or at all. Our sources of liquidity beyond twelve months, in management’s opinion, will be our then current cash balances, funds from operations and whatever long-term credit facilities we can arrange. We have no other agreements or arrangements with third parties to provide us with sources of liquidity and capital resources beyond twelve months.

In August 2001, the FASB issued Statement of Financial Accounting Standards No. 143 (“SFAS No. 143”), Accounting for Asset Retirement Obligations. SFAS No. 143 addresses financial accounting requirements for retirement obligations associated with retirement of tangible long-lived assets and for the associated asset retirement costs. SFAS No. 143 requires a company to record the fair value of an asset retirement obligation in the period in which it is incurred. When the retirement obligation is initially recorded, we also record a corresponding increase to the carrying amount of the related tangible long-lived asset and depreciate that cost over the useful life of the tangible long-lived asset. The retirement obligation is increased at the end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the initial fair value measurement. Upon settlement of the retirement obligation, we either settle the retirement obligation for its recorded amount or incur a gain or loss upon settlement. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002, with earlier application encouraged. Accordingly, SFAS No. 143 will be effective for us beginning January 1, 2003. We are currently in the process of evaluating the impact, if any, SFAS No. 143 will have on our financial position and results of operations.

In May 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statement Nos. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS No. 145 eliminates Statement No. 4 (and Statement 64, as it amends Statement No. 4), which requires gains and losses from extinguishments of debt to be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect. As a result, the criteria in APB Opinion No. 30 will now be used to classify those gains and losses. SFAS No. 145 amends FASB Statement No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions are accounted for in the same manner as sale-leaseback transactions. This amendment is consistent with the FASB’s goal of requiring similar accounting for transactions that have similar economic effects. In addition, SFAS No. 145 makes technical corrections to existing pronouncements. While those corrections are not substantive in nature, in some instances, they may change accounting practice. This statement is effective for fiscal years beginning after May 2002 for the provisions related to the rescission of Statements Nos. 4 and 64, and for all transactions entered into beginning May 2002 for the provision related to the amendment of Statement No. 13 although early adoption is permitted. We do not expect the adoption of SFAS No. 145 to have a material impact on our financial position, cash flows or results of operations.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred and states that an entity’s commitment to exit plan, by itself, does not create a present obligation that meets the definition of a liability. SFAS No. 146 also establishes that fair value is the objective for initial measurement of the liability. The provisions of SFAS No. 146 are effective for exit or disposal activities initiated after December 31, 2002. We do not expect the adoption of SFAS No. 146 to have a material impact upon our financial position, cash flows or results of operations.

You should carefully review the following risks associated with owning our common stock. Our business, operating results or financial condition could be materially adversely affected by any of the following risks. You should also refer to the other information set forth in this report and incorporated by reference herein, including our financial statements and the related notes. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

Overall weakness in the general economy and volatility in the demand for Internet security products are two of the many factors underlying our inability to predict our revenue for a given period. We base our spending levels for product development, sales and marketing, and other operating expenses largely on our expected future revenue. A large proportion of our expenses are fixed for a particular quarter or year, and therefore, we may be unable to decrease our spending in time to compensate for any unexpected quarterly or annual shortfall in revenue. As a result, any shortfall in revenue could adversely affect our operating results. For example, in the quarter ended September 30, 2002, we experienced a shortfall in revenues from our mid-tier market, and as a result, our revenues and net income were less than originally expected and our stock price declined.

To date, sales to two distributors have accounted for a significant portion of our revenue. In 2001, approximately 88% of our sales were to distributors and resellers, and Ingram Micro and Tech Data accounted for approximately 27% and 19% of our revenue, respectively. In 2000, approximately 84% of our sales were to distributors, and Ingram Micro and Tech Data accounted for approximately 32% and 20% of our revenue, respectively. In addition, in 2000 and 2001 and in the nine months ended September 30, 2002, our top 10 customers accounted for 70% or more of total revenues. Although we have limited one-year agreements with Ingram Micro and Tech Data and certain other large distributors, these contracts are subject to termination at any time, and we do not know if these customers will continue to place orders for our products. We cannot assure you that any of these customers will continue to place orders with us, that orders by these customers will continue at the levels of previous periods or that we will be able to obtain large orders from new customers. If any of the foregoing should occur, our revenues will likely decline and our business will be adversely affected.

The average selling prices for our products may decline as a result of competitive pricing pressures, a change in our product mix, promotional programs and customers who negotiate price reductions in exchange for longer-term purchase commitments. For example, in the first quarter of 2002, we experienced pricing issues relating to our PRO product line due to rebates and incentives offered to our customers as well as a shift in mix between certain product lines. Together, these two factors reduced our overall average selling prices, and our product revenue for the first quarter of 2002 declined. In addition, competition has increased over the past year, and we expect competition to further increase in the future, thereby leading to increased pricing pressures. Furthermore, we anticipate that the average selling prices and gross margins for our products will decrease over product life cycles. We cannot assure you that we will be successful in developing and introducing on a timely basis new products with enhanced features, or that these products, if introduced, will enable us to maintain our average selling prices and gross margins at current levels.

The market for Internet security products is worldwide and highly competitive, competition has increased over the past year, and we expect competition to further intensify in the future. There are few substantial barriers to entry, and additional competition from existing competitors and new market entrants will likely occur in the future. Current and potential competitors in our markets include, but are not limited to the following, all of which sell worldwide or have a presence in most of the major markets for such products:

Competitors to date have generally targeted the security needs of small, medium and large enterprises with firewall, VPN and SSL products that range in price from approximately $300 to more than $15,000. We may experience increased competitive pressure on some of our products, resulting in both lower prices and gross margins. Many of our current or potential competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical, marketing and other resources than we do. In addition, our competitors may bundle products competitive to ours with other products that they may sell to our current or potential customers. These customers may accept these bundled products rather than separately purchasing our products. If any of the foregoing were to occur, our business could be adversely affected.

To succeed, we must continually introduce new products and change and improve our products in response to rapid technological developments and changes in operating systems, broadband Internet access, application and networking software, computer and communications hardware, programming tools, computer language technology and other security threats. Product development for Internet security appliances requires substantial engineering time and testing, and releasing new products and services prematurely may result in quality problems, and delays may result in loss of customer confidence and market share. In addition to developing new products, we have purchased a number of companies over the last few years and have integrated their products into our product line. We may be unable to develop new products and services or achieve and maintain market acceptance of them once they have come to market. In the past, we have on occasion experienced delays in the scheduled introduction of new and enhanced products and services, and we may experience delays in the future. For example, we did not achieve our expected level of penetration of large enterprise networks in the first quarter of 2002, and as a result, our revenues were less than originally expected and our stock price declined. Furthermore, when we do introduce new or enhanced products and services, we may be unable to manage the transition from the older products and services to minimize disruption in customer ordering patterns avoid excessive inventories of older products and deliver enough new products and services to meet customer demand.

products in our distributors’ inventory are subject to price protection, which represented approximately 7.1% of our revenue for the year ended December 31, 2001. We have incurred less than $100,000 of credits under our price protection policies in the past three fiscal years. Future credits for price protection will depend on the percentage of our price reductions for the products in inventory and our ability to manage the level of our major distributors’ inventory. If future price protection adjustments are higher than expected, our future results of operations could be materially adversely affected.

International revenue represented 31% of total revenue in 2001, 32% of total revenue in 2000, and 34% of total revenue in 1999. For the year ended December 31, 2001, revenue from Japan represented 10% of our total revenue, and revenue from all other international regions collectively represented approximately 21% of our total revenue. Our risks of doing business abroad include our ability to maintain distribution relationships on favorable terms, and if we are unable to do so, revenue may decrease from our international operations. Because our sales are denominated in U.S. dollars, the weakness of a foreign country’s currency against the dollar could increase the price of our products in such country and reduce our product unit sales by making our products more expensive in the local currency. We are subject to the risks of conducting business internationally, including potential foreign government regulation of our technology, general geopolitical risks associated with political and economic instability, changes in diplomatic and trade relationships, and foreign countries’ laws affecting the Internet generally.

Our products incorporate certain components or technologies that are available from single or limited sources of supply. Specifically, our products rely upon microprocessors from Motorola, Toshiba, IBM and Intel, security ASICs from Hi Fn and Broadcom and incorporate software products from third-party vendors. We do not have long-term supply arrangements with any vendor, and any disruption in the supply of these products or technologies may adversely affect our ability to obtain necessary components or technology for our products. If this were to happen, our product shipments may be delayed or lost, resulting in a decline in sales and a loss of revenue. In addition, our products utilize components that have in the past been subject to market shortages and price fluctuations. If we experience price increases in our product components, we will experience declines in our gross margin.

We outsource all of our hardware manufacturing and assembly primarily to one third-party manufacturer and assembly house, Flash Electronics, Inc. Flash Electronics manufactures our products in both the U.S. and China. We do not have a long-term manufacturing contract with this vendor, and our operations could be disrupted if we have to switch to a replacement vendor or if our hardware supply is interrupted for an extended period. In addition, we provide forecasts of our demand to Flash Electronics up to six months prior to scheduled delivery of products to our customers. If we overestimate our requirements, Flash Electronics may have excess inventory, which would increase our costs. If we underestimate our requirements, Flash Electronics 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. If any of the foregoing occur, we could lose customer orders and revenue could decline.

We compete for employees in California’s Silicon Valley, one of the most difficult employer environments in the United States. Our future success will depend largely on the efforts and abilities of our current senior management and our ability to attract and retain additional key personnel. In August of 2002, our Chief Executive Officer, Cosmo Santullo, resigned. At this time Bill Roach, Senior Vice President of Partners, Alliances and Strategic Accounts, was appointed to the role of interim CEO. Future departures of key employees may be disruptive to our business and may adversely affect our operations. We do not maintain life insurance for any of our key personnel.

We have entered into arrangements with original equipment manufacturers (“OEMs”) to sell our products, and these OEMs sell our technologies under their brand name. Our OEM revenues represented approximately 12% and 15% of total revenues in 2001 and 2000, respectively. Some of our OEM partners compete in the same markets in which we and those OEMs sell our jointly-produced products, and recently those OEM partners have developed their own products that will compete against the jointly-produced products. This increased competition could result in decreased sales of our product to our OEM customers, less revenues, lower prices and/or reduced gross margins. If any of the foregoing occur, our business may suffer.

In October 2001, we acquired RedCreek Communications and have begun integrating the RedCreek technologies and product features into our SonicWALL line of products. In particular, the RedCreek technologies are designed to address to needs of larger enterprise networking customers, and consequently, we anticipate that we will expand our market share in the enterprise market. Our experience in the larger enterprise market is relatively new, however, as sales of our small to medium enterprise products comprise a large majority of our revenues. If we fail to effectively integrate the RedCreek technologies into our products, or if potential customers do not purchase our products designed for larger enterprises in the expected volumes, our revenues would be below our expectations and our results of operations would suffer.

Sales of our products depend on the increased use and widespread adoption of broadband access services, such as cable, DSL, Integrated Services Digital Network, or ISDN, Frame Relay and T-1. These broadband access services typically are more expensive in terms of required equipment and ongoing access charges than are Internet dial-up access providers. Our business, prospects, results of operations and financial condition would be adversely affected if the use of broadband access services does not increase as anticipated or if our customers’ access to broadband services is limited. Critical issues concerning use of broadband access services are unresolved and will likely affect the use of broadband access services. These issues include security, reliability, bandwidth, congestion, cost, ease of access and quality of service. Even if these are resolved, if the market for products that provide broadband access to the Internet fails to develop, or develops at a slower pace than we anticipate, our business would be materially adversely affected.

We currently rely on a combination of patent, trademark, copyright, and trade secret laws, confidentiality provisions and other contractual provisions to protect our proprietary rights. Despite our efforts to protect our proprietary rights, unauthorized parties may misappropriate or infringe on our patents, trade secrets, copyrights, trademarks, service marks and similar proprietary rights. As of September 30, 2002, we have filed 14 United States patent applications, and we plan to aggressively pursue additional patent protection. Our pending patent applications may not result in the issuance of any patents. Even if we obtain such patents, that will not guarantee that our patent rights will be valuable, create a competitive barrier, or will be free from infringement. Furthermore, if any patent is issued, it might be invalidated or circumvented or otherwise fail to provide us any meaningful protection. We face additional risk when conducting business in countries that have poorly developed or inadequately enforced intellectual property laws. In any event, competitors may independently develop similar or superior technologies or duplicate the technologies we have developed, which could substantially limit the value of our intellectual property.

infringement claims will be more frequent for Internet participants as the number of products, services and competitors grows and the functionality of products and services overlaps. Any litigation, regardless of its success, would probably be costly and require significant time and attention of our key management and technical personnel. An adverse result in litigation could also force us to: stop or delay selling, incorporating or using products that incorporate the challenged intellectual property; pay damages; enter into licensing or royalty agreements, which may be unavailable on acceptable terms; or redesign products or services that incorporate infringing technology. If any of the above occur, our revenues could decline and our business could suffer.

Our products and services provide and monitor Internet security. If a third party were able to circumvent our security measures, such a person or entity could misappropriate the confidential information or other property of end users using our products and services or interrupt their operations. If that happens, affected end users or others may sue us for product liability, tort or breach of warranty claims. Although we attempt to reduce the risk of losses from claims through contractual warranty disclaimers and liability limitations, these provisions 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. Although we currently maintain business liability insurance, this coverage may be inadequate or may be unavailable in the future on acceptable terms, if at all. Our business liability insurance has no specific provisions for potential liability for Internet security breaches.

Because we provide Internet security, we may become a greater target for attacks by computer hackers. We will not succeed unless the marketplace is confident that we provide effective Internet security protection. Networks protected by our products may be vulnerable to electronic break-ins. 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. Although we have not experienced any act of sabotage or unauthorized access by a third party of our internal network to date, if an actual or perceived breach of Internet security occurs in our internal systems or those of our end-user customers, regardless of whether we cause the breach, it could adversely affect the market perception of our products and services. This could cause us to lose current and potential customers, resellers, distributors or other business partners.

Our exposure to market risk for changes in interest rates relates primarily to our cash, cash equivalents and short-term investments. In accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” we classified our short-term investments as available-for-sale. Consequently, investments are recorded on the balance sheet at the fair value with unrealized gains and losses reported as a separate component of accumulated other comprehensive income (loss), net of tax. As of September 30, 2002, our cash, cash equivalents and short-term investments included money-markets securities, corporate bonds, municipal bonds and commercial paper which are subject to no interest rate risk when held to maturity, but may increase or decrease in value if interest rates changes prior to maturity.

We consider our exposure to foreign currency exchange rate fluctuations to be minimal. We invoice substantially all of our foreign customers from the United States in U.S. dollars and substantially all revenue is collected in U.S. dollars. For the year ended December 31, 2001, we earned approximately 31% of our revenue from international markets, which in the future may be denominated in various currencies. As a result, our operating results may become subject to significant fluctuations based upon changes in the exchange rates of some currencies in relation to the U.S. dollar and diverging economic conditions in foreign markets. Although we will continue to monitor our exposure to currency fluctuations, we cannot assure you that exchange rate fluctuations will not affect adversely our financial results in the future. In addition, we have minimal cash balances denominated

Our chief executive officer and our chief financial officer, after evaluating our “disclosure controls and procedures” (as defined in Securities Exchange Act of 1934 (the “Exchange Act”) Rules 13a-14 (c) and 15d-14 (c) as of the date within 90 days before filing date of the Quarterly Report on Form 10-Q (the “Evaluation Date”) have concluded that as of the Evaluation Date, our disclosure controls and procedures are effective. Subsequent to the Evaluation Date, there were no significant changes in our internal controls or in other factors that could significantly affect our disclosure controls and procedures, nor were there any significant deficiencies or material weaknesses in our internal controls. As a result, no corrective actions were required or undertaken.

On December 6, 2001, a securities class action complaint was filed in the U.S. District Court for the Southern District of New York against us, three of our officers and directors, and certain of the underwriters in our initial public offering in November 1999 and our follow-on offering in March 2000. Similar complaints were filed in the same court against numerous public companies that conducted initial public offerings (“IPOs”) of their common stock since the mid-1990s. All of these lawsuits were consolidated for pretrial purposes before Judge Shira Scheindlin. On April 19, 2002, plaintiffs filed an amended complaint. The amended complaint alleges claims under the Securities Act of 1933 and the Securities Exchange Act of 1934, and seeks damages or rescission for misrepresentations or omissions in the prospectuses relating to, among other things, the alleged receipt of excessive and undisclosed commissions by the underwriters in connection with the allocation of shares of common stock in our public offerings. On July 15, 2002, the issuers filed an omnibus motion to dismiss for failure to comply with applicable pleading standards. On October 8, 2002, the Court entered an Order of Dismissal as to all of the individual defendants in the SonicWALL IPO litigation, without prejudice. While we believe that the claims against us and our officers and directors are without merit and intend to vigorously defend against these allegations, the litigation could result in substantial costs and divert our attention and resources, which could have a material adverse effect on our business, operating results, liquidity and financial condition.

California		77-0270079
(State or other jurisdiction of incorporation)		(I.R.S. Employer Identification No.)

		Page
PART I. FINANCIAL INFORMATION		3

ITEM 1.	Financial Statements	3

ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11

ITEM 3.	Quantitative and Qualitative Disclosures About Market Risk	21

ITEM 4.	Controls and Procedures	22

PART II. OTHER INFORMATION		22

ITEM 1.	Legal Proceedings	22

ITEM 2.	Changes in Securities and Use of Proceeds	22

ITEM 3.	Defaults Upon Senior Securities	22

ITEM 4.	Submission of Matters to a Vote of Security Holders	22

ITEM 5.	Other Information	22

ITEM 6.	Exhibits and Reports on Form 8-K	22

SIGNATURES		23

		Condensed Consolidated Balance Sheets as of September 30, 2002 (unaudited) and December 31, 2001		4

		Condensed Consolidated Statements of Operations for the three and nine-month periods ended September 30, 2002 and 2001 (unaudited)		5

		Condensed Consolidated Statements of Cash Flows for the nine-month periods ended September 30, 2002 and 2001 (unaudited)		6

		Notes to Condensed Consolidated Financial Statements		7

	September 30, 2002		December 31, 2001
Raw materials	$	1,456	$	2,677
Finished goods		4,980		2,812

	$	6,436	$	5,489

	Total Charges June 30, 2002		Payments			Non-Cash Charges			Accrual June 30, 2002		Payments			Accrual September 30, 2002
Employee severance benefits	$	858	$	(758	)	$	—		$	100	$	(61	)	$	39
Facility costs		1,944		(65	)		—			1,879		(233	)		1,646
Asset impairments		1,167		(58	)		(1,109	)		—		—			—

	$	3,969	$	(881	)	$	(1,109	)	$	1,979	$	(294	)	$	1,685

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Fiscal Year
2002 (fourth quarter)		$ 2,553
2003		9,876
2004		7,632
2005		7,356
2006		6,310

Total		$33,727

	Total Charges June 30, 2002		Payments			Non-Cash Charges			Accrual June 30, 2002		Payments			Accrual September 30, 2002
Employee severance benefits	$	858	$	(758	)	$	—		$	100	$	(61	)	$	39
Facility costs		1,944		(65	)		—			1,879		(233	)		1,646
Asset impairments		1,167		(58	)		(1,109	)		—		—			—

	$	3,969	$	(881	)	$	(1,109	)	$	1,979	$	(294	)	$	1,685

Number		Description
99.1		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SONICWALL, INC.

By:		/s/ MICHAEL J. SHERIDAN

		Michael J. Sheridan, Senior Vice President of Strategy and Chief Financial Officer and Secretary (Principal Financial Officer, and Chief Accounting Officer and Authorized Signer)