<PAGE>
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15 (d)
of the Securities Exchange Act of 1934
For the quarterly period ended Commission File Number 000-26819
September 30, 2000
------------------------------
WATCHGUARD TECHNOLOGIES, INC.
------------------------------------------------------
(Exact Name of Registrant as Specified in Its Charter)
Delaware 91-1712427
------------------------------- ------------------------------------
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
505 Fifth Ave. South, Suite 500
-------------------------------
Seattle WA 98104-3892
---------------------
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code: (206) 521-8340
--------------
Not Applicable
----------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report.)
Indicate by check mark whether the Registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to the
filing requirements for the past 90 days. Yes X No
--- ---
25,943,265 shares of WatchGuard common stock were outstanding
as of November 6, 2000.
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WATCHGUARD TECHNOLOGIES, INC.
TABLE OF CONTENTS FOR FORM 10-Q
<TABLE>
<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
- Balance Sheets as of September 30, 2000 and December 31, 1999................................... 3
- Statements of Operations for the three and nine months ended September 30, 2000 and 1999........ 4
- Statements of Cash Flows for the nine months ended September 30, 2000 and 1999.................. 5
- Notes to Financial Statements................................................................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........... 10
Item 3. Quantitative and Qualitative Disclosures About Market Risk...................................... 28
PART II. OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds....................................................... 29
Item 6. Exhibits and Reports on Form 8-K................................................................ 29
</TABLE>
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
WATCHGUARD TECHNOLOGIES, INC.
BALANCE SHEETS
--------------
(In thousands, except share and per share data)
<TABLE>
<CAPTION>
September 30, December 31,
2000 1999
--------------------- --------------------
(unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 26,612 $ 1,903
Securities available for sale 89,856 24,498
Trade accounts receivable, net 11,772 3,772
Inventories 5,488 2,013
Prepaid expenses and other receivables 2,609 1,275
---------------- ---------------
Total current assets 136,337 33,461
Equipment and furniture, net 5,324 1,927
Goodwill, intangibles and other assets 5,241 5,923
---------------- ---------------
Total assets $146,902 $ 41,311
================ ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 6,033 $ 2,088
Accrued expenses 1,801 1,394
Accrued payroll-related expenses 1,962 968
Deferred revenue 9,869 4,233
Equipment term loan - 383
---------------- ---------------
Total current liabilities 19,665 9,066
Stockholders' equity:
Preferred stock, par value $0.001 per share, 10,000,000 shares
authorized; no shares issued and outstanding at September 30, 2000
and December 31, 1999 - -
Common stock, par value $0.001 per share, 80,000,000 shares
authorized; 24,508,656 and 19,511,752 shares issued and
outstanding at September 30, 2000 and December 31, 1999, respectively 25 19
Additional paid-in capital 159,730 63,694
Stock-based compensation (795) (1,452)
Accumulated other comprehensive loss (44) (77)
Accumulated deficit (31,679) (29,939)
---------------- ---------------
Total stockholders' equity 127,237 32,245
---------------- ---------------
Total liabilities and stockholders' equity $146,902 $ 41,311
================ ===============
</TABLE>
The accompanying notes are an integral part of these financial statements.
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WATCHGUARD TECHNOLOGIES, INC.
------------------------------
STATEMENTS OF OPERATIONS
------------------------
(In thousands, except per share data)
(unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- ----------------------------
2000 1999 2000 1999
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Revenues:
Product $14,782 $ 4,614 $35,276 $11,832
Service 2,453 907 5,501 2,264
----------- ----------- ----------- -----------
Total revenues 17,235 5,521 40,777 14,096
Cost of revenues 6,187 2,085 14,608 5,566
----------- ----------- ----------- -----------
Gross margin 11,048 3,436 26,169 8,530
Operating expenses:
Sales and marketing 5,849 3,612 17,375 9,695
Research and development 3,413 1,700 9,195 4,740
General and administrative 1,703 842 4,107 2,616
Stock-based compensation 193 186 657 697
Amortization of goodwill
and other intangibles 368 - 1,104 -
----------- ----------- ----------- -----------
Total operating expenses 11,526 6,340 32,438 17,748
----------- ----------- ----------- -----------
Loss from operations (478) (2,904) (6,269) (9,218)
Interest income 1,813 253 4,579 268
Interest expense (1) (135) (50) (497)
----------- ----------- ----------- -----------
Net income (loss) $ 1,334 $(2,786) $(1,740) $(9,447)
=========== =========== =========== ===========
Net income (loss) per share:
Basic $0.06 $(0.21) $(0.08) $(1.76)
=========== =========== =========== ===========
Diluted $0.05 $(0.21) $(0.08) $(1.76)
=========== =========== =========== ===========
Shares used in computation of
net income (loss) per share:
Basic 24,147 13,135 22,882 5,379
=========== =========== =========== ===========
Diluted 27,809 13,135 22,882 5,379
=========== =========== =========== ===========
</TABLE>
The accompanying notes are an integral part of these financial statements.
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WATCHGUARD TECHNOLOGIES, INC.
STATEMENTS OF CASH FLOWS
------------------------
(in thousands)
(unaudited)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
-------------------------------
2000 1999
------------- ------------
<S> <C> <C>
OPERATING ACTIVITIES:
Net loss $ (1,740) $ (9,447)
Adjustments to reconcile net loss to
net cash used in operating activities:
Depreciation 945 430
Loss on disposal of furniture 39 --
Amortization of goodwill and intangibles 1,104 --
Amortization of stock-based compensation 657 697
Provision for sales returns and allowances 1,241 915
Provision for bad debt expense 351 79
Noncash interest expense -- 195
Changes in operating assets and liabilities:
(Increase) in trade accounts receivable (9,592) (1,066)
(Increase) decrease in inventories (3,475) 250
(Increase) in prepaid expenses and other receivables (1,334) (118)
(Increase) in goodwill, intangibles and other assets (401) (15)
Increase (decrease) in accounts payable 3,945 (437)
Increase in accrued expenses 407 174
Increase in accrued payroll-related expenses 994 131
Increase in deferred revenue 5,636 1,591
---------- ---------
NET CASH USED IN OPERATING ACTIVITIES (1,223) (6,621)
INVESTING ACTIVITIES:
Purchase of equipment and furniture (4,472) (993)
Cash received on disposal of furniture 95 --
Purchase of intangible assets (25) --
Proceeds from sales and maturities of marketable securities 55,129 --
Purchases of marketable securities (120,454) --
---------- ---------
NET CASH USED IN INVESTING ACTIVITIES (69,727) (993)
FINANCING ACTIVITIES:
Borrowings on line of credit and notes payable -- 7,280
Issuance of warrants -- 195
Principal repayments on line of credit and notes payable (383) (10,122)
Proceeds from the sale of common stock, net of expenses 90,427 40,810
Proceeds from the sale of common stock through the
employee stock purchase plan 1,139 --
Proceeds from exercise of common stock options and warrants 4,476 207
---------- ---------
NET CASH PROVIDED BY FINANCING ACTIVITIES 95,659 38,370
---------- ---------
NET INCREASE IN CASH AND CASH EQUIVALENTS 24,709 30,756
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 1,903 1,712
---------- ---------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 26,612 $ 32,468
========== =========
</TABLE>
The accompanying notes are an integral part of these financial statements.
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WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS
NOTE 1 - DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION
Description of Business
WatchGuard Technologies, Inc. is in the business of developing and
marketing Internet security solutions that incorporate a security appliance,
security and management software and an Internet-based broadcast service
designed to keep its products current.
Interim Financial Information
The accompanying unaudited financial statements of WatchGuard, which
include the December 31, 1999 balance sheet that was derived from audited
financial statements, have been prepared in accordance with generally accepted
accounting principles for interim financial information and with the
instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they
do not include all of the information and footnotes required by generally
accepted accounting principles for complete financial statements. In the
opinion of management, this information includes all adjustments, consisting of
normal recurring accruals, necessary for a fair presentation. Operating results
for the three- and nine-month periods ended September 30, 2000 are not
necessarily indicative of the results that may be expected for future quarters
or for the year ended December 31, 2000. The financial statements should be
read in conjunction with the financial statements and notes thereto for the year
ended December 31, 1999 included in WatchGuard's Annual Report on Form 10-K/A,
as filed with the Securities and Exchange Commission on May 1, 2000.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Revenue Recognition
Statement of Position (SOP) 97-2, "Software Revenue Recognition," was
issued in October 1997 by the American Institute of Certified Public Accountants
(AICPA) and was amended by SOP 98-4. In December 1998, the AICPA issued SOP 98-
9, which amends SOP 97-2 and 98-4 and is effective for transactions entered into
after March 15, 1999. WatchGuard adopted SOP 97-2, as amended by SOP 98-9,
effective January 1, 1998. Based upon its interpretation of SOP 97-2 and SOP
98-9, WatchGuard believes its current revenue recognition policies and practices
are consistent with the SOPs.
WatchGuard generates revenues through sales of its Internet security
products, including related software licenses, Internet security appliances and
subscriptions for its LiveSecurity broadcast service, which includes threat
responses, information alerts, expert editorials, user support flashes, software
updates and maintenance. Software license revenues are generated from licensing
the rights to use WatchGuard's products directly to end-users, from sublicense
fees from resellers and distributors and from sales of its products to Internet
service providers (ISPs), which utilize WatchGuard's LiveSecurity product to
provide managed security services to the ISPs' customers. Revenues from
LiveSecurity subscriptions are recognized ratably over the term of the contract,
typically one year.
Revenues from software license agreements are generally recognized upon
delivery of software if persuasive evidence of an arrangement exists, collection
is probable, the fee is fixed and determinable and vendor-specific objective
evidence exists to allocate the total fee to elements of the arrangement.
Payment terms do not extend beyond a year. A limited number of WatchGuard's
distributors have the right to delay payment until the product is sold to the
end-user. Revenues from these few arrangements are not recognized until sale to
the end-user occurs. WatchGuard provides unspecified upgrades on a when-and-if-
available basis. These upgrades are considered post-contract customer support
(PCS) and are recognized as revenues ratably over the term of the PCS
arrangement. Vendor-specific objective evidence is typically based on the price
charged when an element is sold separately or, in the case of an element not
sold separately, on the price established by authorized management, if it is
probable that the price, once established, will not change before market
introduction. WatchGuard uses the residual method, as defined in SOP 98-9, to
allocate revenue to delivered elements once it has established vendor-specific
objective evidence for all undelivered elements. Under the residual method, any
discount in the arrangement is allocated to the delivered element. WatchGuard
provides for return rights and pricing protection rights for some of its
customers. The return rights included in these customer agreements are
generally limited to a percentage of purchases by these customers for the
previous quarter. The pricing protection rights in these agreements are
generally limited to 60 to 90 days after notification of a price change.
Revenues are reduced by the provision for estimated returns and allowances at
the time the sale is made. The reserves are reviewed and revised as needed.
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In December 1999, the SEC issued Staff Accounting Bulletin No. 101 (SAB
101), "Revenue Recognition in Financial Statements". This pronouncement
summarizes certain of the SEC staff's views in applying generally accepted
accounting principles to revenue recognition. WatchGuard has reviewed the
requirements of this standard and believes that its current revenue recognition
policies are in compliance with SAB 101. However, WatchGuard will continue to
review new interpretations of this standard as they become available and will
make those or any adjustments to internal policy it deems appropriate.
Comprehensive Income (Loss)
WatchGuard's investments consist of corporate and government debt
securities, are considered available-for-sale, and are stated at fair value,
with unrealized gains and losses included as a component of stockholders'
equity. During the third quarters of 2000 and 1999, there were no material
realized gains or losses on securities available-for-sale. All such investments
mature within two years, with the weighted average life of the investment
portfolio being one year. The following table sets forth the components of
comprehensive loss (in thousands):
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ------------------------
2000 1999 2000 1999
------- --------- --------- ---------
<S> <C> <C> <C> <C>
Net income (loss) $1,334 $(2,786) $(1,740) $(9,447)
Unrealized gain on investments 229 -- 33 --
------- --------- --------- ---------
Comprehensive income (loss) $1,563 $(2,786) $(1,707) $(9,447)
======= ========= ========= =========
</TABLE>
Reclassifications
Certain prior-period items have been reclassified to conform to the
current-period presentation.
NOTE 3 - BALANCE SHEET ACCOUNT DETAIL
<TABLE>
<CAPTION>
Accounts Receivable
Accounts receivable consisted of the following (in thousands): September 30, December 31,
2000 1999
------------- ------------
<S> <C> <C>
Trade accounts receivable $13,042 $4,499
Reserve for returns (835) (550)
Allowance for uncollectible accounts (435) (177)
-------- -------
Total net accounts receivable $11,772 $3,772
======== =======
<CAPTION>
Inventories
Inventories consisted of the following (in thousands): September 30, December 31,
2000 1999
------------- ------------
<S> <C> <C>
Finished goods $3,327 $1,093
Components 2,161 920
-------- -------
$5,488 $2,013
======== =======
</TABLE>
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NOTE 4 - INTERNATIONAL REVENUES
WatchGuard licenses and markets its Internet security products and services
throughout the world and operates in a single industry segment. While certain
expenses for sales and marketing activities are incurred in various geographical
regions, substantially all of WatchGuard's assets are located, and the majority
of its operating expenses are incurred, at its corporate headquarters. Revenue
information by geographic region is as follows (in thousands):
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------- ----------------------
<S> <C> <C> <C> <C>
2000 1999 2000 1999
-------- ------- -------- --------
United States $ 8,058 $2,680 $18,555 $ 6,983
Rest of World 9,177 2,841 22,222 7,113
-------- ------- -------- --------
Total $17,235 $5,521 $40,777 $14,096
======== ======= ======== ========
</TABLE>
NOTE 5 - NET INCOME (LOSS) PER SHARE
Basic and diluted net income (loss) per common share is calculated by
dividing net income (loss) by the weighted average number of shares of common
stock outstanding. Common stock equivalents, including stock options and
warrants, are excluded from the computation of diluted net loss per share as
their effect is antidilutive.
The components of calculating net income (loss) per share are set forth in
the following table (in thousands, except per share data):
<TABLE>
<CAPTION>
Three Months Nine Months
Ended September 30, Ended September 30,
--------------------- ---------------------
<S> <C> <C> <C> <C>
2000 1999 2000 1999
-------- -------- -------- --------
Net income (loss) $ 1,334 $(2,786) $(1,740) $(9,447)
======== ======== ======== ========
Weighted average number of shares:
For basic earnings per share 24,147 13,135 22,882 5,379
Effect of dilutive securities:
Employee stock options and warrants 3,662 -- -- --
-------- -------- -------- --------
Weighted average number of shares:
For diluted earnings per share 27,809 13,135 22,882 5,379
======== ======== ======== ========
Net income (loss) per share:
Basic $ 0.06 $ (0.21) $ (0.08) $ (1.76)
======== ======== ======== ========
Diluted $ 0.05 $ (0.21) $ (0.08) $ (1.76)
======== ======== ======== ========
</TABLE>
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NOTE 6 - ACQUISITION OF BUSINESS
On October 4, 2000, WatchGuard acquired Qiave Technologies Corporation, a
provider of digital information security products for internetworked Windows NT
(TM) and Windows 2000 (TM) computing environments. Pursuant to the Agreement and
Plan of Merger among WatchGuard, Qiave, Logan Acquisition Corporation, a
Delaware corporation and wholly owned subsidiary of WatchGuard, and certain key
stockholders of Qiave, Logan Acquisition Corporation merged with and into Qiave,
with Qiave as the surviving corporation. The merger will be accounted for as a
purchase.
Under the terms and conditions of the merger agreement, WatchGuard issued
to Qiave stockholders 1,292,997 shares of WatchGuard common stock valued at
approximately $66,000,000, based on the average closing price of WatchGuard
common stock prior to the consummation of the merger. In addition, all
outstanding options to purchase shares of Qiave common stock outstanding at the
effective time of the merger were assumed by WatchGuard and converted into
options to purchase an aggregate of 100,856 shares of WatchGuard common stock,
at a weighted average exercise price of $0.46 per share.
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Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion and analysis provides information that we believe
is relevant to an assessment and understanding of WatchGuard's results of
operations and financial condition. The discussion should be read in
conjunction with the financial statements and the notes to the financial
statements. References to "we," "our" and "us" in this quarterly report refer
to WatchGuard Technologies, Inc.
Special Note Regarding Forward-Looking Information
This quarterly report contains and incorporates by reference forward-
looking statements that involve assumptions, risks and uncertainties. These
forward-looking statements include statements about our plans, objectives,
expectations, intentions, future financial performance and other statements that
are not historical facts. We use words such as anticipates, believes, expects,
future and intends, and similar expressions, to identify forward-looking
statements, but the absence of these words does not mean that the statement is
not forward-looking. Our actual results could differ materially from those
anticipated in the forward-looking statements for many reasons, including the
risks described in the section below entitled "Factors Affecting Our Operating
Results, Our Business and Our Stock Price." You should not unduly rely on these
forward-looking statements, which apply only as of the date of this report.
Overview
WatchGuard is a leading provider of Internet security solutions that
protect enterprises and telecommuters using the Internet for electronic commerce
and communications. Our core market is small- to medium-sized enterprises
(SMEs), and we have recently expanded our marketing focus to include larger
enterprises as well as small offices and home offices (SOHOs) and telecommuters,
particularly those using the broadband Internet connections. Our innovative
subscription-based LiveSecurity solution broadcasts threat responses, software
updates, information alerts, expert editorials, support flashes and virus alerts
over the Internet, enabling enterprises to keep their security systems current
with minimal effort.
Since our inception, we have invested heavily in the development of our
products and services, as follows:
. In September 1996, we introduced our initial Internet security appliance
and began selling our products both domestically and internationally.
. In 1997, we significantly expanded our worldwide sales and marketing
efforts, and in 1998 we launched our managed security offering for
Internet service providers (ISPs) and introduced our second-generation
security appliances, which added significant functionality to our
existing product lines.
. We have continued to recruit and hire additional employees in marketing,
development, technical support and finance and have invested in our
operational infrastructure to support our growth.
. In February 1999, we launched the broadcast portion of our LiveSecurity
products.
. In July 1999, we completed our initial public offering of our common
stock.
. In October 1999, we acquired BeadleNet, LLC, a developer of Internet
security solutions for SOHOs, and formed our new broadband Internet
security division.
. In February 2000, we issued an additional 1,780,000 shares of common
stock in a follow-on public offering.
. In January 2000, we announced the introduction of our security solutions
for SOHOs and telecommuters, which we began shipping in the first
quarter of 2000.
. In October 2000, we acquired Qiave Technologies Corporation, a developer
of digital information security systems, which enhanced our ability to
protect Web and application servers from hackers targeting public
content residing behind an enterprise's firewall.
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Sources of Revenues and Revenue Recognition Policy
We generate revenues through:
. sales of products and service subscriptions through our indirect
distribution partners at a discount from list price;
. sales of products and service subscriptions directly and, from time to
time, indirectly through our distributors, to our ISP customers at
volume pricing rates; and
. from time to time, sales of service subscription renewals directly to
our enterprise customers at list price.
Product revenues include perpetual software license fees and sales of our
security appliance. Service revenues include fees for access to our
LiveSecurity broadcast service for product updates, security threat responses,
general security information and technical support. Service revenues also
include annual fees for our LiveSecurity for MSS, which gives our ISP customers
access to the LiveSecurity broadcast service and the ability to manage and
update a specific number of their customers' security appliances. To date,
service subscription renewals directly from our enterprise customers have not
been material.
We recognize revenues only when a contract or agreement has been executed,
delivery has occurred, the fee is fixed and determinable and we believe
collection is probable. We generally recognize product revenues upon shipment
and service subscription revenues ratably on a monthly basis, generally over a
one-year period.
Results of Operations
The following table provides financial data for the periods indicated as a
percentage of total revenues:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------- --------------------
2000 1999 2000 1999
------ ------ ------ ------
<S> <C> <C> <C> <C>
Revenues:
Product 85.8% 83.6 % 86.5 % 83.9 %
Service 14.2 16.4 13.5 16.1
------ ------ ------ ------
Total revenues 100.0 100.0 100.0 100.0
Cost of revenues 35.9 37.8 35.8 39.5
------ ------ ------ ------
Gross margin 64.1 62.2 64.2 60.5
Operating expenses:
Sales and marketing 33.9 65.4 42.6 68.8
Research and development 19.8 30.8 22.5 33.6
General and administrative 9.9 15.3 10.1 18.6
Stock-based compensation 1.1 3.4 1.6 4.9
Amortization of goodwill and other intangibles 2.1 -- 2.7 --
------ ------ ------ ------
Total operating expenses 66.9 114.8 79.5 125.9
------ ------ ------ ------
Loss from operations (2.8) (52.6) (15.4) (65.4)
Interest income (expense), net 10.5 2.1 11.1 (1.6)
------ ------ ------ ------
Net income (loss) 7.7 % (50.5)% (4.3)% (67.0)%
====== ====== ====== ======
</TABLE>
Three Months Ended September 30, 2000 and 1999
Revenues
Total revenues, which consist of product revenues and service revenues,
increased from $5.5 million in the three months ended September 30, 1999 to
$17.2 million in the three months ended September 30, 2000, an increase of 212%.
In the three months ended September 30, 1999, no one customer accounted for more
than 10% of total revenues. However, in the three months ended September 30,
2000, one distributor, Ingram Micro, Inc., accounted for $2.5 million in
revenues, or approximately 14% of
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total quarterly revenues. The increase in total revenues was primarily due to
increases in sales volume caused by increased distribution in the European,
Asia/Pacific and North American markets. Total international revenues
represented approximately 51% of total revenues in the three months ended
September 30, 1999 and 53% in the three months ended September 30, 2000.
Product revenues include (1) the perpetual software license fees for our
security management system and the sale of our security appliance as part of the
LiveSecurity System, including our new SOHO product line, and (2) the sale of
our NOC (network operations center) Security Suite software license and our
security appliance as part of LiveSecurity for MSS. Product revenues increased
from $4.6 million in the three months ended September 30, 1999 to $14.8 million
in the three months ended September 30, 2000, an increase of 220%. As a
percentage of total revenues, product revenues increased from 84% in the three
months ended September 30, 1999 to 86% in the three months ended September 30,
2000. Historically, we have generated the majority of our revenues from our
product sales. We do not believe that the historical percentage growth rates of
product revenues will be sustainable as our revenue base increases.
Service revenues include the annual fee for our LiveSecurity broadcast
service and annual client licenses for MSS, which are sold as a part of the
LiveSecurity System and LiveSecurity for MSS. Service revenues increased from
$907,000 in the three months ended September 30, 1999 to $2.5 million in the
three months ended September 30, 2000, an increase of 170%. As a percentage of
total revenues, service revenues decreased from 16% in the three months ended
September 30, 1999 to 14% in the three months ended September 30, 2000, which
reflects the significant growth in product revenues. Our deferred service
revenue balance increased from $4.2 million at December 31, 1999 to $9.9 million
at September 30, 2000, an increase of 133%, which reflects an increase in
product revenues and an increase in our renewals of LiveSecurity subscriptions.
As renewals of our service subscriptions and annual client licenses for the
LiveSecurity System and LiveSecurity for MSS increase, we expect service
revenues as a percentage of total revenues to increase.
We established a returns and allowances reserve in 1998 to address the
return rights and pricing protection rights of some of our customers, primarily
related to anticipated returns originating from the introduction of a new
version of our security appliance, the Firebox II, during the last half of 1998.
The provision for sales returns and allowances was $185,000, or 3% of total
revenues, in the three months ended September 30, 1999 and $362,000, or 2% of
total revenues, in the three months ended September 30, 2000. The provision, as
a percentage of total revenues, in the three months ended September 30, 2000 as
compared to the provision for both the three months ended September 30, 1999 and
for all of 1999, reflects a reduction in the expected returns and pricing
protection allowances based on actual results over the last several quarters,
and no recent introduction of replacement products or major changes in our
product and service pricing.
Cost of Revenues and Gross Margin
Cost of revenues consists of product and service costs, which include the
costs of manufacturing our security appliance, product packaging, third-party
product licensing fees and our technical support organization, including costs
associated with our LiveSecurity broadcast service. Cost of revenues increased
from $2.1 million in the three months ended September 30, 1999 to $6.2 million
in the three months ended September 30, 2000. As a percentage of total revenues,
cost of revenues decreased from 38% in the three months ended September 30, 1999
to 36% in the three months ended September 30, 2000.
The dollar increases in cost of revenues were primarily due to increases in
sales volume and increased service costs associated with our larger customer
base. While we have experienced an overall improvement in our gross margin
percentage, the decrease in cost of revenues as a percentage of total revenues
reflects (1) a decrease in the cost of manufacturing our Firebox II security
appliance during the past year, (2) additional manufacturing and rework costs
associated with a change in the motherboard for our security appliance that is
anticipated to reduce future costs of our SOHO products and (3) an increase in
personnel-related costs of our service organization. While we expect to continue
to streamline manufacturing and gain cost savings over time, the extent that the
higher initial production costs of our SOHO products offset increased revenues
from these products may negatively impact gross margins in the short term.
Therefore, we do not expect our gross margins to improve significantly during
the fourth quarter of 2000. Although we expect the unit costs to manufacture
both the Firebox II and the SOHO products to decrease over time as volume levels
increase, we cannot predict if or when this reduction will occur. We expect
service costs to increase in total dollar amount as our user base expands. In
the longer term, as revenues from LiveSecurity service subscriptions increase
and become a greater percentage of total revenues, we expect our gross margins
to increase.
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Operating Expenses
Sales and Marketing. Sales and marketing expenses include salaries,
commissions and related expenses and certain variable marketing expenses,
including distributor promotional costs, public relations costs, marketing
collateral and trade show expenses. Overall, sales and marketing expenses
increased from $3.6 million in the three months ended September 30, 1999 to $5.8
million in the three months ended September 30, 2000, an increase of 62%. As a
percentage of total revenues, sales and marketing expenses decreased from 65% in
the three months ended September 30, 1999 to 34% in the three months ended
September 30, 2000. The dollar increase in sales and marketing expenses was
primarily due to recruiting, training and supporting our domestic and
international resellers and distributors and, to a lesser extent, to
establishing brand recognition of our products and services. Specifically, major
components of the increase included:
. an increase in salaries, commissions, recruiting and related expenses
from $1.8 million to $2.9 million;
. an increase in variable marketing costs from $764,000 to $1.6 million,
reflecting increased advertising to achieve market awareness and the
cost of channel programs for increased channel distribution efforts; and
. an increase in travel and related expenses from $604,000 to $764,000.
The decrease in sales and marketing expenses as a percentage of total
revenues reflects both increased productivity of and efficiencies in managing
our indirect channel network and realization of our previous investments to
expand distribution, capture market share and establish brand recognition of our
products. We will continue to invest in sales and marketing programs designed to
increase distribution. Because we expect our various expenses to increase at a
slower rate than revenues, we expect to see a gradual reduction in sales and
marketing expenses, and all other expenses, over time as a percentage of total
revenues.
Research and Development. Research and development expenses consist of
salaries, computing equipment and software tools, nonrecurring costs associated
with our security appliance prototypes and payment of designers and contractors.
Research and development expenses increased from $1.7 million in the three
months ended September 30, 1999 to $3.4 million in the three months ended
September 30, 2000, an increase of 101%. As a percentage of total revenues,
research and development expenses decreased from 31% in the three months ended
September 30, 1999 to 20% in the three months ended September 30, 2000. The
dollar increase in research and development expenses reflects the growth of our
research and development organization to expand and enhance our enterprise
product line, including our SOHO products, development and enhancement of our
LiveSecurity for MSS products and our efforts to respond to new and emerging
security threats through our LiveSecurity broadcast service. Specifically, major
components of the change included:
. an increase in payroll and related expenses from $1.3 million to $2.1
million; and
. an increase in costs associated with security appliance prototypes from
$44,000 to $500,000, reflecting increased expenses for our new SOHO
products and enhancement of our traditional Firebox.
We will continue to increase our research and development expenses in total
dollar amounts to enhance and expand our current product offerings, develop new
products and enhance our rapid response team and advisory council, which analyze
new security vulnerabilities and threats and provide continuing education on
Internet security to our employees. We expect that research and development
expenses will continue to increase in total dollar amounts but will decrease as
a percentage of total revenues.
General and Administrative. General and administrative expenses include
costs of executive, human resource, finance and administrative support
functions, provision for uncollectible accounts and legal and accounting
professional services. General and administrative expenses increased from
$842,000 in the three months ended September 30, 1999 to $1.7 million in the
three months ended September 30, 2000, an increase of 102%. As a percentage of
total revenues, general and administrative expenses decreased from 15% in the
three months ended September 30, 1999 to 10% in the three months ended September
30, 2000. The dollar increase in general and administrative expenses reflects
the expansion of our infrastructure to manage the growth of our operations and
our changes as a public company. We expect that these expenses will continue to
increase in total dollar amounts but will decrease as a percentage of total
revenues.
Deferred Compensation. Deferred compensation is recorded as the difference
between the exercise price of options we granted and the fair value of our
common stock on the date in which the options were granted, and for the value of
common stock issued in connection with an employment agreement associated with
our October 1999 acquisition of BeadleNet. Deferred compensation is amortized
over the vesting periods of the options. Total amortization of deferred
compensation expense was $186,000 in the three months ended September 30, 1999
and $193,000 in the three months ended
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September 30, 2000. The allocation of the stock-based compensation expense
associated with the functional operating expense categories of sales and
marketing, research and development, and general and administrative was $67,000,
$91,000 and $28,000 in the three months ended September 30, 1999, respectively,
and $36,000, $143,000, and $14,000, respectively, in the three months ended
September 30, 2000.
Interest Income (Expense)
Interest income of $1.8 million in the three months ended September 30,
2000 was generated from our investment of proceeds from the sale of common stock
in our initial public offering in July 1999 and the sale of stock in our follow-
on public offering in February 2000. Interest expense of $135,000 in the three
months ended September 30, 1999 resulted from borrowings on our bank line of
credit, notes payable and our equipment term loan, and was offset by $253,000 of
interest income generated from our investment of proceeds from the sale of
common stock in our initial public offering in July 1999.
Nine Months Ended September 30, 2000 and 1999
Revenues
Total revenues increased from $14.1 million in the nine months ended
September 30, 1999 to $40.8 million in the nine months ended September 30, 1999,
an increase of 189%. In the nine months ended September 30, 1999, no one
customer accounted for more than 10% of total revenues. However, in the nine
months ended September 30, 2000, revenues from one of our distributors, Ingram
Micro, Inc., were $5.1 million, or approximately 12% of total revenues, while
revenues from another distributor, Tech Data Corporation, were $4.2 million, or
10% of total revenues. The increase in total revenues was primarily due to
increases in sales volume caused by increased distribution in the European,
Asia/Pacific and North American markets. Total international revenues
represented approximately 50% of total revenues in the nine months ended
September 30, 1999 and 54% in the nine months ended September 30, 2000.
Product revenues increased from $11.8 million in the nine months ended
September 30, 1999 to $35.3 million in the nine months ended September 30, 2000,
an increase of 198%. As a percentage of total revenues, product revenues
increased from 84% in the nine months ended September 30, 1999 to 87% in the
nine months ended September 30, 2000.
Service revenues increased from $2.3 million in the nine months ended
September 30, 1999 to $5.5 million in the nine months ended September 30, 2000,
an increase of 143%. As a percentage of total revenues, service revenues
decreased from 16% in the nine months ended September 30, 1999 to 14% in the
nine months ended September 30, 2000, which reflects the significant growth in
product revenues.
The provision for sales returns and allowances was $915,000, or 6% of total
revenues, in the nine months ended September 30, 1999 and $1.2 million, or 3% of
total revenues, in the nine months ended September 30, 2000. The decrease in the
provision, as a percentage of total revenues, in the nine months ended September
30, 2000 as compared to the nine months ended September 30, 1999, reflects a
reduction in the expected returns and pricing protection allowances based on
actual results over the last several quarters, and no recent introduction of
replacement products or major changes in our product and service pricing.
Cost of Revenues and Gross Margin
Cost of revenues increased from $5.6 million in the nine months ended
September 30, 1999 to $14.6 million in the nine months ended September 30, 2000,
an increase of 162%. As a percentage of total revenues, cost of revenues
decreased from 40% in the nine months ended September 30, 1999 to 36% in the
nine months ended September 30, 2000. The dollar increases in cost of revenues
were primarily due to increases in sales volume and increased service costs
associated with our larger customer base. The decrease in cost of revenues as a
percentage of total revenues primarily reflects a decrease in the cost of
manufacturing our Firebox II security appliance during the past year.
Operating Expenses
Sales and Marketing. Sales and marketing expenses increased from $9.7
million in the nine months ended September 30, 1999 to $17.4 million in the nine
months ended September 30, 2000, an increase of 79%. As a percentage of total
revenues, sales and marketing expenses decreased from 69% in the nine months
ended September 30, 1999 to 43% in the nine months ended September 30, 2000. The
dollar increase in sales and marketing expenses was primarily due to
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recruiting, training and supporting our domestic and international resellers and
distributors and, to a lesser extent, to establishing brand recognition of our
products and services. Specifically, major components of the increase included:
. an increase in salaries, commissions, recruiting and related expenses
from $4.7 million to $7.5 million;
. an increase in variable marketing costs from $2.4 million to $5.8
million; and
. an increase in travel and related expenses from $1.8 million to $2.4
million.
The decrease in sales and marketing expenses as a percentage of total
revenues reflects both increased productivity of and efficiencies in managing
our indirect channel network and realization of our previous investments to
expand distribution, capture market share and establish brand recognition of our
products.
Research and Development. Research and development expenses increased
from $4.7 million in the nine months ended September 30, 1999 to $9.2 million in
the nine months ended September 30, 2000, an increase of 94%. As a percentage
of total revenues, research and development expenses decreased from 34% in the
nine months ended September 30, 1999 to 23% in the nine months ended September
30, 2000. The dollar increase in research and development expenses reflects the
growth of our research and development organization to expand and enhance our
enterprise and MSS for ISPs product lines and our research and evaluation of new
and emerging security threats for our LiveSecurity broadcast service.
Specifically, major components of the increase included:
. an increase in payroll and related expenses from $3.4 million to $5.9
million; and
. an increase in security appliance prototype engineering costs from
$227,000 to $1.1 million.
General and Administrative. General and administrative expenses increased
from $2.6 million in the nine months ended September 30, 1999 to $4.1 million in
the nine months ended September 30, 2000, an increase of 57%. As a percentage of
total revenues, general and administrative expenses decreased from 19% in the
nine months ended September 30, 1999 to 10% in the nine months ended September
30, 2000. The dollar increase in general and administrative expenses reflects
the expansion of our infrastructure to manage the growth of our operations, and
primarily relates to an increase in payroll and related expenses.
Deferred Compensation. Amortization of deferred compensation expense was
$697,000 in the nine months ended September 30, 1999 and $657,000 in the nine
months ended September 30, 2000. The allocation of the stock-based compensation
expense associated with the functional operating expense categories of sales and
marketing, research and development, and general and administrative was
$255,000, $339,000 and $103,000, respectively, in the nine months ended
September 30, 1999 and $136,000, $465,000, and $56,000, respectively, in the
nine months ended September 30, 2000.
Interest Income (Expense)
Interest income of $4.6 million in the nine months ended September 30, 2000
resulted from the investment of proceeds from our public offerings, and was
offset by $50,000 of interest expense resulting from borrowings on our term loan
with a bank, which has since been paid in full. Interest expense of $497,000 in
the nine months ended September 30, 1999 resulted from borrowings on our bank
line of credit, notes payable and our equipment term loan, and was offset by
$268,000 of interest income generated from interest income generated from our
investment of proceeds from the sale of common stock in our initial public
offering in July 1999.
Liquidity and Capital Resources
Since our inception, we have financed our operations through private
placements of convertible preferred stock and through the proceeds from our
initial public offering in July 1999 and our follow-on public offering in
February 2000. To date, net proceeds from private placements of preferred stock
and our two public offerings have totaled approximately $144.0 million. We have
also financed our operations through equipment financing, traditional accounts
receivable financing arrangements, bridge financing arrangements and convertible
notes. More recently, and to a lesser extent, we have also used net proceeds
received from our employee stock purchase plan and employee stock option
exercises to help fund operating capital.
We have a working capital revolving line of credit with a bank, secured by
our accounts receivable. The line of credit provides for borrowings not greater
than $5.0 million or the amount of the borrowing base. For purposes of this
loan, the borrowing base is the sum of 80% of the net amount of our eligible
domestic accounts receivable and 50% of the net amount of our eligible foreign
accounts receivable. As of September 30, 2000, we had no borrowings on this line
of credit,
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which expires in February 2001 and bears interest at the prime rate plus 0.5%
per year. At September 30, 2000, our borrowing limit of $5.0 million was reduced
by a $3.0 million unconditional letter of credit we issued to our landlord in
conjunction with our new facilities lease. In February 2000, we repaid our two
term-loan facilities with the same bank, which had a combined balance of
$383,000 as of December 31, 1999.
In March 2000, we signed a 10-year facilities lease agreement that provides
for approximately 90,000 square feet of office space, out of approximately
290,000 available square feet, for a new corporate headquarters location in
Seattle, Washington, with an option to extend the lease for an additional five-
year term. We intend to sublease a portion of the new space for the 12 to 18
months following the commencement of the lease, depending on our space
requirements. This lease commenced in September 2000 and includes base rent of
approximately $175,000 per month during the first year of the lease, increasing
to $241,000 per month during the final year of the lease. We are also
responsible for our pro-rata share of the building operating costs, which are
estimated to be $60,000 per month during the first year of the lease.
As of September 30, 2000, we had $116.5 million in cash, cash equivalents
and securities available for sale, invested primarily in high-quality money
market accounts and marketable securities. We believe that the market risk
arising from our holdings of these financial instruments is not material. Our
working capital as of September 30, 2000 was $116.7 million.
Operating activities. Our operating activities resulted in net cash
outflows of $6.6 million in the nine months ended September 30, 1999 and $1.2
million in the nine months ended September 30, 2000. The operating cash outflows
in 1999 and 2000 resulted primarily from significant investments in sales and
marketing and research and development, all of which led to operating losses.
Cash used in operating activities was net of noncash charges totaling $2.3
million in the nine months ended September 30, 1999 and $4.3 million in the nine
months ended September 30, 2000. These noncash charges were primarily associated
with depreciation of capital assets, amortization of goodwill, provisions for
bad debts and sales returns and allowances, and compensation charges resulting
from the issuance of stock options and warrants. Cash provided from working
capital components impacting operating activities was $510,000 in the nine
months ended September 30, 1999, and cash used from working capital components
for operating activities was $3.4 million in the nine months ended September 30,
2000. In the nine months ended September 30, 2000, there were large fluctuations
within some major working capital components, as described below:
(a) Receivables increased from $3.8 million at December 31, 1999 to $11.8
million at September 30, 2000, reflecting the increase in revenues
from $6.5 million in the three months ended December 31, 1999 to $17.2
million in the three months ended September 30, 2000. Days sales
outstanding (DSOs) were 54 days, 52 days and 61 days for the quarters
ended September 30, 1999, December 31, 1999 and September 30, 2000,
respectively. The DSO ratio for the third quarter of 2000 has
increased from the fourth quarter of 1999 as a result of changes in
our customer sales mix during the third quarter. Our largest domestic
customers and international customers receive longer payment terms and
the sales volume from our international and large domestic customers
in the third quarter of 2000 was greater than in prior quarters. Based
on sales mix and the resulting timing differences arising from varying
payment terms in our customer agreements, we expect our DSOs to
generally range from 55 days to 70 days. Reserves for uncollectable
accounts were $177,000 at December 31, 1999 and $435,000 at September
30, 2000, reflecting an increased accounts receivable balance related
to increased sales. Our returns and allowance reserve was $550,000 at
December 31, 1999 and $835,000 at September 30, 2000, reflecting our
estimate of returns and allowances associated with the return rights
and price protection rights of some of our customers. The reserve may
fluctuate from time to time depending upon the timing of product
introductions and pricing program changes.
(b) Inventories increased from $2.0 million at December 31, 1999 to $5.5
million at September 30, 2000. The increase reflects build-up of
inventory levels as a result of continued anticipated increases in
product shipments, as well as inventory purchases related to our SOHO
product line. In addition, inventory levels for those customers for
whom we recognize revenue on a sell-through basis has increased due to
the significant revenue growth with those customers. Also contributing
to the increase was the purchase of component parts on allocation or
purchases of parts with long lead times.
(c) Prepaid expenses and other receivables increased from $1.3 million at
December 31, 1999 to $2.6 million at September 30, 2000, primarily due
to an increase in the interest receivable originating from the
investment of proceeds from our public offerings.
(d) Accounts payable, accrued expenses and accrued payroll-related
expenses increased from $4.4 million at December 31, 1999 to $9.8
million at September 30, 2000, related to increased purchases of
inventory and inventory components and increased spending levels in
sales and marketing.
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(e) Deferred revenue increased from $4.2 million at December 31, 1999 to
$9.9 million at September 30, 2000, reflecting the significant
increase in new product revenues and renewals of our LiveSecurity
subscription services.
Investing activities. Cash used in investing activities totaled $993,000
in the nine months ended September 30, 1999 and $69.7 million in the nine months
ended September 30, 2000, reflecting short-term investing activity and capital
expenditures. During the nine month period ended September 30, 2000, this
activity included capital expenditures for furniture and leasehold improvements
in our new corporate headquarters.
Financing activities. Cash provided by financing activities totaled $38.4
million in the nine months ended September 30, 1999 and $95.7 million in the
nine months ended September 30, 2000. These activities primarily relate to
borrowings on our line of credit and through bridge financing during 1999 and
proceeds from public offerings in the third quarter of 1999 and in the first
quarter of 2000.
We believe that existing cash and cash equivalents balances and our lines
of credit will be sufficient to meet our anticipated cash needs for working
capital, capital expenditures and potential acquisitions or technology
investments for at least the next 12 months. However, if the underlying assumed
levels of spending for the potential acquisition of or investment in
complementary businesses or technologies prove to be inaccurate, we may need to
seek additional funding before that time through public or private financings or
other arrangements.
Year 2000 Compliance
We believe that we have successfully rendered our products, internal
management and other administrative systems and external information systems
year 2000 compliant. In addition, we have surveyed the vendors of the third-
party technologies we incorporate into our products and services and applied
updates or arrangements to correct potential year 2000 compliance problems.
Since January 1, 2000, we have experienced no disruptions in our business
operations as a result of year 2000 compliance problems or otherwise, and we
have received no reports of any year 2000 compliance problems with our products
and services. We are continuing to monitor third-party vendors of incorporated
technologies for additional recommended year 2000 upgrades, which we will apply
as soon as they become available. To date, the total cost of our efforts to
address year 2000 compliance has not been material.
Nonetheless, some problems related to year 2000 risks may not yet have
appeared. Year 2000 issues could include problems with our own products and
services or with third-party products or technology that we use or with which
our products exchange data. Any problems that are not identified and corrected
successfully and completely could adversely affect our business. We expect that
the cost to fix any year 2000 problems that may be identified, however, will
involve internal labor-hours and will not be material.
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Factors Affecting Our Operating Results, Our Business and Our Stock Price
In addition to the other information contained in this quarterly report,
you should carefully read and consider the following risk factors. If any of
these risks actually occur, our business, financial condition or operating
results could be adversely affected and the trading price of our common stock
could decline.
We have incurred losses in the past and may not achieve or sustain consistent
profitability, which could result in a decline in the value of our common stock.
Since inception through the second quarter of 2000, we incurred net losses
and experienced negative cash flows from operations in each quarter. As of
September 30, 2000, we had an accumulated deficit of approximately $31.7
million. Although we achieved profitability in the third quarter of 2000, we
expect to incur losses in future quarters as a result of expenses associated
with our October 2000 acquisition of Qiave Technologies Corporation. In
addition, although our revenues have increased each year since we began
operations, we do not believe that the historical percentage growth rate of our
revenues will be sustainable as our revenue base increases. Moreover, we
currently expect to increase our operating expenses significantly in connection
with
. expanding into new geographic markets;
. expanding into new product markets;
. continuing to develop our technology;
. hiring additional personnel;
. upgrading our information and internal control systems; and
. integrating acquisitions of businesses, products and technologies and
pursuing additional strategic acquisitions.
If we are unable to achieve or sustain profitability in future quarters,
the trading price of our common stock could decline.
Our operating results fluctuate and could fall below expectations of securities
analysts and investors, resulting in a decrease in our stock price.
Our quarterly and yearly operating results have varied widely in the past
and will probably continue to fluctuate. For this reason, we believe that
period-to-period comparisons of our operating results are not meaningful. In
addition, our limited operating history makes predicting our future performance
difficult. As a result of these factors, our operating results for a particular
quarter or year may fall below the expectations of securities analysts and
investors, which could result in a decrease in our stock price.
We base our spending levels for product development, sales and marketing
and other operating expenses largely on our expected future revenues. Because
our expenses are largely fixed for a particular quarter or year, we may be
unable to adjust our spending in time to compensate for
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any unexpected quarterly or annual shortfall in revenues. A failure to so adjust
our spending in time also could cause operating results to fall below the
expectations of securities analysts and investors, resulting in a decrease in
our stock price.
Because many potential customers remain unaware of the need for Internet
security or may perceive it as costly and difficult to implement, our products
and services may not achieve market acceptance.
We believe that many potential customers, particularly SMEs, SOHOs and
telecommuters, are not fully aware of the need for Internet security products
and services. Historically, only enterprises having substantial resources have
developed or purchased Internet security solutions. Also, there is a perception
that Internet security is costly and difficult to implement. We will therefore
not succeed unless the market understands the need for Internet security and we
can convince our potential customers of our ability to provide this security in
a cost-effective and administratively feasible manner. Although we have spent,
and will continue to spend, considerable resources educating potential customers
about the need for Internet security and the benefits of our products and
services, our efforts may be unsuccessful.
If potential customers do not accept our LiveSecurity products and services, our
business will not succeed.
We currently expect all future revenues to be generated through sales of
our LiveSecurity Internet security products and related services, particularly
subscription and license fees, and we cannot succeed if the market does not
accept these products and services. Our success depends on our ability and the
ability of our channel partners, which include value-added resellers,
distributors, ISPs and, in the future, original equipment manufacturers, or
OEMs, to obtain and retain LiveSecurity customers. Our LiveSecurity products and
services, however, are relatively new and unproven. The broadcast portion of our
LiveSecurity products has been available only since February 1999, our
LiveSecurity for MSS product has been available only since September 1998 and
our Firebox SOHO and Firebox telecommuter products have been available only
since February 2000. In addition, we have not yet launched under the WatchGuard
brand the products we acquired in the merger with Qiave in October 2000. To
receive our LiveSecurity broadcasts, enterprises will be required to pay an
annual subscription fee, either to us or, if they obtain LiveSecurity through
one of our channel partners, to the channel partner. We are not aware of any
other Internet security product that allows enterprises to keep their security
solution current by receiving broadcasts of software updates and related
information over the Internet. Enterprises may be unwilling to pay a
subscription fee to keep their Internet security up to date. Because our
broadcast service is relatively new, we cannot predict the rate at which our
customers will renew their annual subscriptions. In addition, most businesses
implementing security services have traditionally managed their own Internet
security rather than seeking the services of third-party service providers. As a
result, our products and services and the outsourcing of Internet security to
third parties may not achieve significant market acceptance.
The integration of Qiave and any future acquisitions may be costly, difficult
and disruptive.
In October 2000, we acquired Qiave Technologies Corporation, a privately
held provider of digital information security products. As part of our business
strategy, we may acquire other
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companies, products or technologies. The Qiave acquisition, and any future
acquisitions, will subject us to numerous operational and financial risks and
difficulties, including
. loss of key personnel;
. difficulties in assimilating the acquired company's technologies,
products and operations;
. disruption of our ongoing business and diversion of management
attention;
. assumption of known and unknown liabilities;
. higher-than-expected acquisition and integration costs and charges
against earnings;
. potentially dilutive issuances of equity securities; and
. the inability of our sales force, consultants and development staff to
adapt to the new product line.
We may be unable to successfully integrate Qiave or any future acquisition. In
addition, we may not gain any substantial benefit from the Qiave acquisition or
from any businesses, products or technologies that we acquire in the future,
notwithstanding the significant expenditure of time and financial, personnel and
other resources.
If our newly established relationships with OEMs are unsuccessful, our ability
to market and sell our products and services will be limited.
We have recently established relationships with several domestic and
international OEM partners to incorporate our LiveSecurity solution into their
products. If these OEM partners are unsuccessful in marketing and implementing
our LiveSecurity solution, we will be unable to generate the levels of revenue
we expect. Because our relationships with OEMs are new and unproven, we cannot
predict the degree to which they will succeed in marketing and selling our
products and services. The OEMs with which we have established relationships
have not had an opportunity to fully develop and implement product or service
offerings incorporating LiveSecurity. We cannot predict how long our current or
potential OEM partners will take to complete this development and
implementation. Until and unless this development and implementation is
achieved, our revenues from OEM partnerships will be limited. If our OEM
partners fail to provide adequate installation, deployment and support of our
products and services, end-users could choose not to purchase OEM products that
include our solution. Our OEM partners will offer our products and services in
combination with other products and services, some of which may be competitive
with our products and services. In addition, we may be unable to maintain our
existing relationships with OEM partners or establish new OEM relationships in
the future.
If our third-party channel partners fail to perform, our ability to sell our
products and services will be limited.
We sell most of our products and services through our channel partners, and
we expect our success to continue to depend in large part on their performance.
Our channel partners have the
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ability to sell products and services that are competitive with ours, to devote
more resources to those competitive products or to cease selling our products
and services altogether. Currently, two channel partners, Ingram Micro, Inc. and
Tech Data Corporation, together account for 23% of our total revenues. The loss
of one of these distributors, or a loss or reduction in sales to another
distributor or several channel partners, particularly to competitive products
offered by other companies, could adversely affect our revenues.
If we are unable to compete successfully in the highly competitive market for
Internet security products and services, our business will fail.
The market for Internet security products is intensely competitive and we
expect competition to intensify in the future. An increase in competitive
pressures in our market or our failure to compete effectively may result in
pricing reductions, reduced gross margins and loss of market share. Currently,
the dominant competitors in our industry are Cisco Systems, Inc., Check Point
Software Technologies Ltd. and NetScreen Technologies Inc. The introduction of
our SOHO and telecommuter products has increased our competition with SonicWALL
Inc., a developer of security appliances for SOHOs and home users. Other current
and potential competitors include hardware, software and operating system
vendors such as Axent Technologies, Inc., Lucent Technologies, Inc., Microsoft
Corporation, Network Associates, Inc., Nokia Corporation, Novell, Inc., Sun
Microsystems Inc. and a number of smaller companies. Many of our 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 current and potential competitors may establish
cooperative relationships among themselves or with third parties that may
further enhance their resources. As a result, they may be able to adapt more
quickly to new technologies and customer needs, devote greater resources to the
promotion or sale of their products and services, initiate or withstand
substantial price competition, take advantage of acquisition or other
opportunities more readily or develop and expand their product and service
offerings more quickly. In addition, our competitors may bundle products
competitive with 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.
Rapid changes in technology and industry standards could render our products and
services unmarketable or obsolete, and we may be unable to introduce new
products and services timely and successfully.
To succeed, we must continually change and improve our products in response
to rapid technological developments and changes in operating systems, Internet
access and communications, application and networking software, computer and
communications hardware, programming tools, computer language technology and
hacker techniques. We may be unable to successfully and timely develop these
new products and services or achieve and maintain market acceptance. The
development of new, technologically advanced products and services is a complex
and uncertain process requiring great innovation and the ability to anticipate
technological and market trends. Because Internet security technology is
complex, it can require long development and testing periods. Releasing new
products and services prematurely may result in quality problems, and releasing
them late may result in loss of customer confidence and market share. 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. When we do introduce new or enhanced products and services, we may be
unable to manage the transition from the older products and
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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.
Seasonality and concentration of revenues at the end of the quarter could cause
our revenues to fall below the expectations of securities analysts and
investors, resulting in a decrease in our stock price.
The growth rate of our domestic and international sales may be lower in the
summer months, when businesses often defer purchasing decisions. Also, as a
result of customer buying patterns and the efforts of our sales force to meet or
exceed quarterly and year-end quotas, historically we have earned a substantial
portion of a quarter's revenues during its last month. If expected revenues at
the end of any quarter are delayed, our revenues for that quarter could fall
below the expectations of securities analysts and investors, resulting in a
decrease in our stock price.
Product returns or retroactive price adjustments could exceed our allowances,
which could adversely affect our operating results.
We provide some of our channel partners with product return rights for
stock rotation. We also provide some of our channel partners with price
protection rights for inventories of our products held by those channel partners
if we lower our prices for those products. We may experience significant returns
and price adjustments for which we may not have adequate allowances. The short
life cycles of our products and the difficulty of predicting future sales
increase the risk that new product introductions or price reductions by us or
our competitors could result in significant product returns or price
adjustments. In September 1998, for example, when we introduced the Firebox II
security appliance, we experienced an increase in returns of previous products
and product versions. Provisions for returns and allowances for the years ended
December 31, 1997, 1998 and 1999, and the nine months ended September 30, 2000,
were $0, $1,655,000, $1,083,000 and $1,241,000, or 0%, 13%, 5% and 3% of total
gross revenues before returns and allowances.
We may be required to defend lawsuits or pay damages in connection with the
alleged or actual failure of our products and services.
Because our products and services provide and monitor Internet security and
may protect valuable information, we may face claims for product liability, tort
or breach of warranty relating to our products and services. Anyone who
circumvents our security measures 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 channel
partners may sue us. In addition, we may face liability for breaches caused by
faulty installation and implementation of our products by end-users or channel
partners. 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 software licenses to be unenforceable because the
licensee does not sign them. Defending a suit, 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.
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A breach of security could harm public perception of our products and services.
We will not succeed unless the marketplace is confident that we provide
effective Internet security protection. Even networks protected by our software
products may be vulnerable to electronic break-ins and computer viruses. If an
actual or perceived breach of Internet security occurs in an end-user's systems,
regardless of whether the breach is attributable to us, the market perception of
the efficacy of our products and services could be harmed. This could cause us
or our channel partners to lose current and potential customers or cause us to
lose potential channel partners. 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.
If we are unable to prevent attacks on our internal network system by computer
hackers, public perception of our products and services will be harmed.
Because we provide Internet security, we have become a greater target of
attacks by computer hackers. We have experienced attacks by computer hackers in
the past and expect attacks to continue. If attacks on our internal network
system are successful, public perception of our products and services will be
harmed.
Failure to address strain on our resources caused by our rapid growth will
result in our inability to effectively manage our business.
Our current systems, management and resources will be inadequate if we
continue to grow. Our business has grown rapidly in size and complexity. This
rapid expansion has placed significant strain on our administrative, operational
and financial resources and has resulted in ever-increasing responsibilities for
our management personnel. We will be unable to effectively manage our business
if we are unable to timely and successfully alleviate the strain on our
resources caused by our rapid growth.
We may be unable to adequately expand our operational systems to accommodate
growth, which could harm our ability to deliver our products and services.
Our operational systems have not been tested at the customer volumes that
may be required in the future. We may encounter performance difficulties when
operating with a substantially greater number of customers. In implementing our
LiveSecurity products and services, we have experienced periodic interruptions
affecting all or a portion of our systems, and we believe that interruptions
will continue to occur from time to time. These interruptions could harm our
ability to deliver our products and services. An inability to add software and
hardware or to develop and upgrade existing technology or operational systems to
handle increased traffic may cause unanticipated system disruptions, slower
response times and poor customer service, including problems filling customer
orders.
We may be unable to adequately protect our operational systems from damage,
failure or interruption, which could harm our reputation and our ability to
attract and retain customers.
Our operations, customer service, reputation and ability to attract and
retain customers depend on the uninterrupted operation of our operational
systems. Although we have off-site
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backup facilities and take other precautions to prevent damage, failure or
interruption of our systems, our precautions may be inadequate. Any damage,
failure or interruption of our computer or communications systems could lead to
service interruptions, delays, loss of data and inability to accept and fill
customer orders and provide customers with LiveSecurity updates.
We may be unable to deliver our products and services if we cannot continue to
license third-party technology that is important for the functionality of our
products.
Our success will depend in part on our continued ability to license
technology that is important for the functionality of our products. A
significant interruption in the supply of a third-party technology could delay
our development and sales until we can find, license and integrate equivalent
technology. This could damage our brand and result in loss of current and
potential customers. Although we believe that we could find other sources for
the technology we license, alternative technologies may be unavailable on
acceptable terms, if at all. We depend on our third-party licensors to deliver
reliable, high-quality products, develop new products on a timely and cost-
effective basis and respond to evolving technology and changes in industry
standards. We also depend on the continued compatibility of our third-party
software with future versions of our products.
We may be unable to deliver our products and services if component manufacturers
fail to supply component parts with acceptable quantity, quality and cost.
We obtain the component parts for our hardware from a variety of
manufacturers. While our component vendors have produced parts for us in
acceptable quantities and with acceptable quality and cost in the past, they may
be unable to do so in the future. Companies in the electronics industry
regularly experience lower-than-required component allocations, and the industry
is subject to frequent component shortfalls. Although we believe that we could
find additional or replacement sources for our hardware components, our
operations could be disrupted if we have to add or switch to a replacement
vendor or if our component supply is interrupted for an extended period. This
could result in loss of customer orders and revenue.
We may need additional capital and our ability to secure additional funding is
uncertain.
Our future revenues may be insufficient to support the expenses of our
operations and the expansion of our business. We may therefore need additional
equity or debt capital. We may seek additional funding through
. public or private equity financings, which could result in sufficient
dilution to stockholders;
. public or private debt financings; and
. capital lease transactions.
We believe that existing cash and cash equivalent balances will be
sufficient to meet our capital required for at least the next 12 months. Our
capital requirements will depend on several factors, however, including:
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. the rate of market acceptance of our products and services;
. our ability to expand our customer base;
. the growth of our sales and marketing capabilities; and
. the cost of any acquisitions we may complete.
Financing may be unavailable to us when needed or on acceptable terms.
We may be unable to adequately protect our proprietary rights, which may limit
our ability to compete effectively.
Despite our efforts to protect our proprietary rights, unauthorized parties
may misappropriate or infringe on our trade secrets, copyrights, trademarks,
service marks and similar proprietary rights. We face additional risk when
conducting business in countries that have poorly developed or inadequately
enforced intellectual property laws. While we are unable to determine the extent
to which piracy of our software products exists, we expect piracy to be a
continuing concern, particularly in international markets and as a result of the
growing use of the Internet.
If we fail to obtain and maintain patent protection for our technology, we
may be unable to compete effectively. We have 13 patents pending, but our patent
applications may not result in issued patents. Even if we secure a patent, the
patent may not provide meaningful protection. In addition, we rely on unpatented
proprietary technology. Because this technology does not benefit from the
protection of patents, we may be unable to meaningfully protect this proprietary
technology from unauthorized use or misappropriation by a third party. In
addition, our competitors may independently develop similar or superior
technologies or duplicate any unpatented technologies that we have developed,
which could significantly reduce the value of our proprietary technology or
threaten our market position.
Intellectual property claims and litigation could subject us to significant
liability for damages and invalidation of our proprietary rights.
In the future, we may have to resort to litigation to protect our
intellectual property rights, to protect our trade secrets or to determine the
validity and scope of the proprietary rights of others. Any litigation,
regardless of its success, would probably be costly and require significant time
and attention of our key management and technical personnel. 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.
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Although we have not been sued for intellectual property infringement, we
may face infringement claims from third parties in the future. The software
industry has seen frequent litigation over intellectual property rights, and we
expect that participants in the Internet security industry will be increasingly
subject to infringement claims as the number of products, services and
competitors grows and functionality of products and services overlaps.
Undetected product errors or defects could result in loss of revenues, delayed
market acceptance and claims against us.
Our products and services may contain undetected errors or defects,
especially when first released. Despite extensive testing, some errors are
discovered only after a product has been installed and used by customers. Any
errors discovered after commercial release could result in loss of revenues or
claims against us or our channel partners.
Governmental controls over the export or import of encryption technology could
cause us to lose sales.
Any additional governmental regulation of imports or exports or failure to
obtain required export approval of our encryption technologies could adversely
affect 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. Additional regulation of
encryption technology could delay or prevent the acceptance and use of
encryption products and public networks for secure communications. This, in
turn, could result in decreased 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 U.S. and international
Internet security markets.
If we do not retain our key employees, our ability to execute our business
strategy will be impaired.
Our future success will depend largely on the efforts and abilities of our
senior management and our key development, technical, operations, information
systems, customer support and sales and marketing personnel, and on our ability
to retain them. These employees are not obligated to continue their employment
with us and may leave us at any time.
If we do not expand our international operations and successfully overcome the
risks inherent in international business activities, the growth of our business
will be limited.
Our ability to grow will depend in part on the expansion of our
international sales and operations, which are expected to continue to account
for a significant portion of our revenues. Sales to customers outside of the
U.S. accounted for approximately 56% of our net revenues in 1997, 35% in 1998,
50% in 1999 and 54% in the nine months ended September 30, 2000. The failure of
our channel partners to sell our products internationally would limit our
ability to increase our revenues. In addition, our international sales are
subject to the risks inherent in international
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business activities, including
. cost of customizing products for foreign countries;
. export and import restrictions, such as those affecting encryption
commodities and software;
. difficulties in acquiring and authenticating customer information;
. reduced protection of intellectual property rights and increased
liability exposure; and
. regional economic and political conditions.
Our international sales currently are U.S. dollar-denominated. As a result,
an increase in the value of the U.S. dollar relative to foreign currencies could
make our products less competitive in international markets.
Our stock price is volatile.
The trading price of our common stock could be subject to fluctuations for
a number of reasons, including
. actual or anticipated variations in quarterly or annual operating
results;
. changes in analysts' earning projections or analysts' recommendations;
. our inability to successfully implement our business strategy;
. changes in business conditions affecting our customers, our
competitors and us; and
. changes in accounting standards that adversely affect our revenues and
earnings.
In recent years, moreover, the stock market in general and the market for
Internet-related technology companies in particular have experienced extreme
price and volume fluctuations, often unrelated to the operating performance of
the affected companies. Our common stock has experienced, and is likely to
continue to experience, these fluctuations in price, regardless of our
performance.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Risk. We do not hold derivative financial instruments or
derivative equity securities in our investment portfolio. Our cash equivalents
consist of high-quality securities, as specified in our investment policy
guidelines. Our policy limits the amount of credit exposure to any one issue or
issuer to a maximum of 20% of the total portfolio or $5 million per issuer, with
the exception of treasury securities and money market funds, which are exempt
from this size limitation. Our policy limits all investments to those that
mature in two years or less, with an average maturity of our investments of one
year or less. The securities are subject to interest-rate risk and will decrease
in value if interest rates increase. Due to the short-term nature of our
investments and our investment policies and procedures, however, we believe that
the risk associated with interest-rate fluctuations related to these securities
does not pose a material risk to WatchGuard.
Foreign Currency Risk. All of our sales and the majority of our expenses
are currently denominated in U.S. dollars. As a result, we have not experienced
significant foreign exchange gains and losses. While we conducted some
transactions in foreign currencies during the third quarter of 2000 and expect
to continue to do so in the future, we do not anticipate that foreign exchange
gains or losses will be material to WatchGuard. Although we have not engaged in
foreign currency hedging to date, we may do so in the future.
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PART II. OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds
(d) Use of Proceeds
On February 15, 2000, our registration statement on Form S-1 for our public
offering, file number 333-95049, became effective. The offering terminated as a
result of all of the shares offered being sold. After accounting for
approximately $5.3 million in underwriting discounts and commissions and
$600,000 in other expenses, we received proceeds of approximately $90.4 million.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
--------
3.1 Restated Certificate of Incorporation of WatchGuard Technologies,
Inc. (incorporated by reference to Exhibit 3.1 to WatchGuard's
Registration Statement on Form S-1 (file number 333-78813), filed
July 30, 1999).
3.2 Restated Bylaws of WatchGuard Technologies, Inc. (incorporated by
reference to Exhibit 3.2 to WatchGuard's Registration Statement on
Form S-1 (file number 333-78813), filed July 30, 1999).
27.1 Financial Data Schedule (filed only with the electronic submission
of Form 10-Q).
(b) Reports on Form 8-K
-------------------
No reports on Form 8-K were filed during the quarter ended September 30,
2000.
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SIGNATURES
----------
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
November 14, 2000 WATCHGUARD TECHNOLOGIES, INC.
By: /s/ Michael E. McConnell
--------------------------------------------
Michael E. McConnell
Chief Financial Officer
(Principal Financial and Accounting Officer)
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