<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
June 30, 2000
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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)
316 Occidental Avenue South, Suite 200
--------------------------------------
Seattle WA 98104
----------------
(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___
---
24,089,310 shares of WatchGuard common stock were outstanding
as of August 2, 2000.
Page 1
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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 June 30, 2000 and December 31, 1999................................................ 3
- Statements of Operations for the three and six months ended June 30, 2000 and 1999...................... 4
- Statements of Cash Flows for the six months ended June 30, 2000 and 1999................................ 5
- Notes to Financial Statements........................................................................... 6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS....................... 9
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.................................................. 16
PART II. OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS................................................................... 17
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS......................................................... 17
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K............................................................................ 17
SIGNATURES............................................................................................................ 18
</TABLE>
Page 2
<PAGE>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
WATCHGUARD TECHNOLOGIES, INC.
BALANCE SHEETS
--------------
(in thousands, except share and per share data)
<TABLE>
<CAPTION>
June 30, December 31,
2000 1999
------------------- --------------------
(unaudited)
ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 5,606 $ 1,903
Securities available for sale 108,023 24,498
Trade accounts receivable, net 8,701 3,772
Inventories 5,339 2,013
Prepaid expenses and other receivables 2,952 1,275
----------------- -----------------
Total current assets 130,621 33,461
Equipment and furniture, net 2,130 1,927
Goodwill, intangibles and other assets 5,216 5,923
----------------- -----------------
Total assets $ 137,967 $ 41,311
================= =================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 5,017 $ 2,088
Accrued expenses 1,649 1,394
Accrued payroll expenses 1,536 968
Deferred revenue 7,716 4,233
Equipment term loan -- 383
----------------- -----------------
Total current liabilities 15,918 9,066
Stockholders' equity:
Preferred stock, par value $0.001 per share, 10,000,000 shares -- --
authorized; 0 shares issued and outstanding at June 30, 2000
and December 31, 1999
Common stock, par value $0.001 per share, 80,000,000 shares 24 19
authorized; 23,770,096 and 19,511,752 shares issued and outstanding
at June 30, 2000 and December 31, 1999, respectively
Additional paid-in capital 156,299 63,694
Stock-based compensation (988) (1,452)
Accumulated other comprehensive loss (273) (77)
Accumulated deficit (33,013) (29,939
----------------- -----------------
Total stockholders' equity 122,049 32,245
----------------- -----------------
Total liabilities and stockholders' equity $ 137,967 $ 41,311
================= =================
</TABLE>
_____________________________
The accompanying notes are an integral part of these financial statements.
Page 3
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
-----------------------------
STATEMENTS OF OPERATIONS
------------------------
(in thousands, except per share data)
(unaudited)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
----------------------------------- -----------------------------------
2000 1999 2000 1999
--------------- ---------------- ---------------- --------------
<S> <C> <C> <C> <C>
Revenues:
Product $ 12,000 $ 3,831 $ 20,494 $ 7,218
Service 1,740 806 3,048 1,357
-------------- -------------- -------------- --------------
Total revenues 13,740 4,637 23,542 8,575
Cost of revenues 4,898 1,846 8,421 3,481
-------------- -------------- -------------- --------------
Gross margin 8,842 2,791 15,121 5,094
Operating expenses:
Sales and marketing 5,967 3,242 11,526 6,083
Research and development 3,262 1,614 5,782 3,040
General and administrative 1,249 862 2,404 1,774
Stock-based compensation 228 258 464 511
Amortization of goodwill and other intangibles 368 - 736 -
-------------- -------------- -------------- --------------
Total operating expenses 11,074 5,976 20,912 11,408
-------------- -------------- -------------- --------------
Loss from operations (2,232) (3,185) (5,791) (6,314)
Interest income 1,855 6 2,766 15
Interest expense (1) (269) (49) (362)
-------------- -------------- -------------- --------------
Net loss $ (378) $ (3,448) $ (3,074) $ (6,661)
============== ============== ============== ==============
Basic and diluted net loss per share $ (0.02) $ (2.36) $ (0.14) $ (4.65)
============== ============== ============== ==============
Shares used in computation of basic and diluted
net loss per share 23,160 1,459 22,223 1,433
============== ============== ============== ==============
</TABLE>
______________________________
The accompanying notes are an integral part of these financial statements.
Page 4
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
STATEMENTS OF CASH FLOWS
------------------------
(in thousands)
(unaudited)
<TABLE>
<CAPTION>
Six Months Ended
June 30,
--------------------------------------
2000 1999
---------------- ----------------
<S> <C> <C>
OPERATING ACTIVITIES:
Net loss $ (3,074) $ (6,661)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation 588 266
Amortization of goodwill and intangibles 736 14
Amortization of stock-based compensation 464 512
Provision for sales returns and allowances 879 730
Provision for bad debt expense 190 74
Noncash interest expense -- 168
Changes in operating assets and liabilities:
(Increase) in trade accounts receivable (5,998) (788)
(Increase) in inventories (3,326) (197)
(Increase) in prepaid expenses and other receivables (1,677) (882)
(Increase) decrease in goodwill, intangibles and other assets (7) 17
Increase in accounts payable 2,929 1,740
Increase in accrued expenses 255 80
Increase in accrued payroll expenses 568 76
Increase in deferred revenue 3,483 1,003
-------------- -------------
NET CASH USED IN OPERATING ACTIVITIES (3,990) (3,848)
INVESTING ACTIVITIES:
Purchase of equipment and furniture (788) (823)
Purchase of intangible assets (25) --
Proceeds from sales and maturities of marketable securities 17,618 --
Purchases of marketable securities (101,339) --
-------------- ---------------
NET CASH USED IN INVESTING ACTIVITIES (84,534) (823)
FINANCING ACTIVITIES:
Borrowings on line of credit and notes payable -- 6,600
Issuance of warrants -- 195
Principal repayments on line of credit and notes payable (383) (1,634)
Proceeds from the sale of common stock, net of expenses 90,427 --
Proceeds from the sale of common stock in connection with the
employee stock purchase plan 512 --
Proceeds from exercise of common stock options and warrants 1,671 12
-------------- ---------------
NET CASH PROVIDED BY FINANCING ACTIVITIES 92,227 5,173
-------------- ---------------
NET INCREASE IN CASH AND CASH EQUIVALENTS 3,703 502
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 1,903 1,712
-------------- ---------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 5,606 $ 2,214
============== ===============
</TABLE>
_____________________
The accompanying notes are an integral part of these financial statements.
Page 5
<PAGE>
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 six-month periods ended June 30, 2000 are not necessarily indicative
of the results that may be expected for future quarters or 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, as amended, as filed with
the Securities and Exchange Commission.
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, distributors and, beginning in late 1998, from sales of its
products to Internet service providers (ISPs), which utilize the 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.
6
<PAGE>
In December 1999, SEC Staff Accounting Bulletin No. 101 (SAB 101),
"Revenue Recognition in Financial Statements," was issued. This pronouncement
summarizes certain of the SEC staff's views in applying generally accepted
accounting principles to revenue recognition. SAB 101 is required to be adopted
no later than the fourth quarter of this year, with restatement for previous
quarters retroactive to the first quarter of 2000. WatchGuard has reviewed the
requirements of the new 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 Loss
WatchGuard's investments are considered available-for-sale and are
stated at fair value on the balance sheet, with unrealized gains and losses
included as a component of stockholders' equity. During the second quarters of
2000 and 1999, there were no material realized gains or losses on securities
available-for-sale. WatchGuard's investment guidelines state that the maximum
life of any one security shall be 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 June 30, Six Months Ended June 30,
----------------------------------- -----------------------------------
2000 1999 2000 1999
---------------- --------------- ---------------- ---------------
<S> <C> <C> <C> <C>
Net loss $ (378) $ (3,448) $ (3,074) $ (6,661)
Unrealized gain (loss) on investments 38 -- (196) --
---------------- --------------- ---------------- ---------------
Comprehensive loss $ (340) $ (3,448) $ (3,270) $ (6,661)
================ =============== ================ ===============
</TABLE>
Reclassifications
Certain prior-period items have been reclassified to conform to the
current-period presentation.
NOTE 3 - BALANCE SHEET ACCOUNT DETAIL
Accounts Receivable
<TABLE>
<CAPTION>
Accounts receivable consisted of the following (in thousands): June 30, December 31,
2000 1999
----------------- ------------------
<S> <C> <C>
Trade accounts receivable $ 9,817 $ 4,499
Reserve for returns (765) (550)
Allowance for uncollectible accounts (351) (177)
------------------ ------------------
Total net accounts receivable $ 8,701 $ 3,772
================== ==================
</TABLE>
Inventories
<TABLE>
<CAPTION>
Inventories consisted of the following (in thousands): June 30, December 31,
2000 1999
------------------ ------------------
<S> <C> <C>
Finished goods $ 4,239 $ 1,093
Components 1,100 920
------------------ ------------------
$ 5,339 $ 2,013
================== ==================
</TABLE>
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):
7
<PAGE>
<TABLE>
Three Months Ended June 30, Six Months Ended June 30,
---------------------------------- ------------------------------------
2000 1999 2000 1999
---------------- --------------- ---------------- ---------------
<S> <C> <C> <C> <C>
United States $ 5,964 $ 2,203 $ 10,497 $ 4,304
Rest of World 7,776 2,434 13,045 4,271
---------------- --------------- ---------------- ---------------
Total $ 13,740 $4,637 $ 23,542 $ 8,575
================ =============== ================ ===============
</TABLE>
NOTE 5 - SUBSEQUENT EVENT
In July 2000, WatchGuard adopted the 2000 Stock Option Plan ("the
Plan"), which provides for the granting of nonqualified stock options to
employees, consultants, agents, advisors and independent contractors. The new
stock option plan supplements the WatchGuard 1996 Stock Incentive Compensation
Plan, which remains effective. WatchGuard has authorized 3,000,000 shares of
common stock for grants under the new Plan. Options under the Plan generally are
granted at fair market value on the date of grant. The shares of common stock
covered by the option generally vest at the rate of 25% on the first anniversary
of the date of grant and 2.08% every month thereafter, with all shares becoming
fully vested on the fourth anniversary of the date of grant. Stock options under
the Plan have a term of ten years unless otherwise provided by the plan
administrator.
8
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis provides information which 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 forward-looking statements that involve
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. You should not
unduly rely on these forward-looking statements, which apply only as of the date
of this report. Our actual results could differ materially from those
anticipated in the forward-looking statements for many reasons, including the
risks described in the section entitled "Factors Affecting Our Operating
Results, Our Business and Our Stock Price" in our Annual Report on Form 10-K, as
amended, for the year ended December 31, 1999.
Overview
WatchGuard is a leading provider of Internet security solutions that
protect enterprises or 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. 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 security 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. During the first quarter of 2000
we issued an additional 1,780,000 shares of common stock in another 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.
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.
9
<PAGE>
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 Six Months Ended
June 30, June 30,
----------------------------------- -----------------------------------
2000 1999 2000 1999
--------------- ---------------- ---------------- ---------------
<S> <C> <C> <C> <C>
Revenues:
Product 87.3 % 82.6 % 87.1 % 84.2 %
Service 12.7 17.4 12.9 15.8
--------------- ---------------- ---------------- ---------------
Total revenues 100.0 100.0 100.0 100.0
Cost of revenues 35.6 39.8 35.8 40.6
--------------- ---------------- ---------------- ---------------
Gross margin 64.4 60.2 64.2 59.4
Operating expenses:
Sales and marketing 43.4 69.9 49.0 70.9
Research and development 23.7 34.8 24.6 35.5
General and administrative 9.1 18.6 10.2 20.7
Stock-based compensation 1.7 5.6 2.0 6.0
Amortization of goodwill and other intangibles 2.7 -- 3.1 --
--------------- ---------------- ---------------- ---------------
Total operating expenses 80.6 128.9 88.9 133.1
--------------- ---------------- ---------------- ---------------
Loss from operations (16.2) (68.7) (24.6) (73.6)
Interest income (expense), net 13.5 (5.7) 11.5 (4.0)
--------------- ---------------- ---------------- ---------------
Net loss (2.8)% (74.4) % (13.1)% (77.7)%
=============== ================ ================ ===============
</TABLE>
Three Months Ended June 30, 2000 and 1999
Revenues
Total revenues, which consist of product revenues and service revenues,
increased from $4.6 million in the three months ended June 30, 1999 to $13.7
million in the three months ended June 30, 2000, an increase of 198%. In the
three months ended June 30, 1999, no one customer accounted for more than 10% of
total revenues. However, in the three months ended June 30, 2000, two
distributors accounted for $1.6 million each in revenues, or approximately 12%
each of 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 52% of total revenues in the three months ended June
30, 1999 and 57% in the three months ended June 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 $3.8 million in the three months ended June 30, 1999 to $12.0 million in
the three months ended June 30, 2000, an increase of 213%. As a percentage of
total revenues, product revenues increased from 83% in the three months ended
June 30, 1999 to 87% in the three months ended June 30, 2000. We do not believe
that the historical percentage growth rates of product revenues will be
sustainable as our revenue base increases. Historically, we have generated the
majority of our revenues from our product sales, which, until the introduction
of LiveSecurity for MSS in late 1998, consisted primarily of the sale of our
LiveSecurity System for the enterprise. Product revenues from LiveSecurity for
MSS are growing and are expected to be a more significant component of our
revenues in the future.
10
<PAGE>
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
$806,000 in the three months ended June 30, 1999 to $1.7 million in the three
months ended June 30, 2000, an increase of 116%. As a percentage of total
revenues, service revenues decreased from 17% in the three months ended June 30,
1999 to 13% in the three months ended June 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 $7.7 million at June 30,
2000, an increase of 82%. 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.
Revenues from our LiveSecurity for MSS from ISPs have been increasing in
amount during each quarter since we introduced the product. Total revenues for
the LiveSecurity System for the enterprise increased from $3.9 million in the
three months ended June 30, 1999 to $11.7 million in the three months ended June
30, 2000, an increase of 200%, while total revenues from LiveSecurity for MSS
from ISPs increased from $700,000 in the three months ended June 30, 1999 to
$2.0 million in the three months ended June 30, 2000, an increase of 186%. As a
percentage of total revenues, LiveSecurity for MSS revenues remained stable at
15% for the second quarter of 1999 and 2000. The increase in LiveSecurity for
MSS revenues is attributable to the growing number of enterprises seeking
security protection through their ISPs and an increase in the number of ISPs
with which we contract to offer the LiveSecurity for MSS service.
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 $330,000, or 7% of total
revenues, in the three months ended June 30, 1999 and $670,000, or 5% of total
revenues, in the three months ended June 30, 2000. The provision, as a
percentage of total revenues, in the three months ended June 30, 2000 as
compared to the provision for both the three months ended June 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 $1.8 million in the three months ended June 30, 1999 to $4.9 million in the
three months ended June 30, 2000. As a percentage of total revenues, cost of
revenues were 40% in the three months ended June 30, 1999 and 36% in the three
months ended June 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 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 and 2) an increase in personnel-related costs of our service
organization. While we expect to continue to streamline manufacturing and gain
cost savings over time, increased revenues originating from the higher initial
production costs of our SOHO products may negatively impact gross margins in the
short term. Therefore, we do not expect our gross margins to improve
significantly during the third quarter of 2000. Over time, as volume levels
increase, we expect the unit costs to manufacture both the Firebox II and the
SOHO products to decrease. However, 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. For the longer term, as revenues from LiveSecurity service
subscriptions increase and become a greater percentage of total revenues, we
expect our gross margin to increase.
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 $3.2 million in the three months ended June 30, 1999 to $6.0
million in the three months ended June 30, 2000, an increase of 84%. As a
percentage of total revenues, sales and marketing expenses decreased from 70% in
the three months ended June 30, 1999 to 43% in the three months ended June 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:
Page 11
<PAGE>
. an increase in salaries, commissions, recruiting and related expenses
from $1.5 million to $2.6 million;
. an increase in variable marketing costs from $881,000 to $1.9 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 $692,000 to $930,000.
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, but we expect to see a gradual reduction in sales and
marketing 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 $1.6 million in the three
months ended June 30, 1999 to $3.3 million in the three months ended June 30,
2000, an increase of 102%. As a percentage of total revenues, research and
development expenses decreased from 35% in the three months ended June 30, 1999
to 24% in the three months ended June 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 the
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 $1.1 million to $2.0
million;
. an increase in costs associated with security appliance prototypes
from $80,000 to $365,000, reflecting increased expenses for our new
SOHO product line and enhancement of our traditional Firebox security
appliance; and
. an increase in consulting and contract labor costs from $167,000 to
$448,000.
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 to our
employees on Internet security. 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
$862,000 in the three months ended June 30, 1999 to $1.2 million in the three
months ended June 30, 2000, an increase of 45%. As a percentage of total
revenues, general and administrative expenses decreased from 19% in the three
months ended June 30, 1999 to 9% in the three months ended June 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 for
financial reporting purposes of our common stock during the periods in which the
options were granted, and for the value of common stock issued in connection
with an employment agreement associated with the acquisition of BeadleNet.
Deferred compensation is amortized over the vesting periods of the options.
Total amortization of compensation expense was $258,000 in the three months
ended June 30, 1999 and $228,000 in the three months ended June 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 in the three months ended June 30,
1999 was $93,000, $126,000 and $39,000, respectively, and was $48,000, $160,000,
and $20,000, respectively, for the three months ended June 30, 2000.
Interest Income (Expense)
Interest expense of $269,000 in the three months ended June 30, 1999
resulted from borrowings on our bank line of credit, notes payable and our
equipment term loan, and was slightly offset by $6,000 of interest income
generated from our investment of proceeds from the sale of preferred stock in
prior periods. Interest income of $1.9 million in the three months
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ended June 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 public offering in February 2000.
Six Months Ended June 30, 2000 and 1999
Revenues
Total revenues increased from $8.6 million in the six months ended June 30,
1999 to $23.5 million in the six months ended June 30, 1999, an increase of
175%. In the six months ended June 30, 1999, no one customer accounted for more
than 10% of total revenues. However, in the six months ended June 30, 2000,
revenues from one of our distributors were $2.6 million, or approximately 11% of
total revenues, while revenues from another distributor were $2.5 million, or
11% 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 six months ended June 30,
1999 and 55% in the six months ended June 30, 2000.
Product revenues increased from $7.2 million in the six months ended June
30, 1999 to $20.5 million in the six months ended June 30, 2000, an increase of
184%. As a percentage of total revenues, product revenues increased from 84% in
the six months ended June 30, 1999 to 87% in the six months ended June 30, 2000.
Total revenues for the LiveSecurity System for the enterprise increased
from $7.5 million in the six months ended June 30, 1999 to $19.9 million in the
six months ended June 30, 2000, an increase of 166%, while total revenues from
LiveSecurity for MSS from ISP's increased from $1.1 million in the six months
ended June 30, 1999 to $3.6 million in the six months ended June 30, 2000, an
increase of 230%. As a percentage of total revenues, LiveSecurity for MSS
revenues were 13% in the period ended June 30, 1999 and 15% in the period ended
June 30, 2000.
Service revenues increased from $1.4 million in the six months ended June
30, 1999 to $3.0 million in the six months ended June 30, 2000, an increase of
125%. As a percentage of total revenues, service revenues decreased from 16% in
the six months ended June 30, 1999 to 13% in the six months ended June 30, 2000,
which reflects the significant growth in product revenues.
The provision for sales returns and allowances was $730,000, or 9% of total
revenues, in the six months ended June 30, 1999 and $879,000, or 4% of total
revenues, in the six months ended June 30, 2000. The provision, as a percentage
of total revenues, in the six months ended June 30, 2000 as compared to the six
months ended June 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
Cost of revenues increased from $3.5 million in the six months ended June
30, 1999 to $8.4 million in the six months ended June 30, 2000, an increase of
142%. As a percentage of total revenues, cost of revenues decreased from 41% in
the six months ended June 30, 1999 to 36% in the six months ended June 30, 2000.
The dollar increases in cost of revenues were primarily due to increases in
sales volume. 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 $6.1
million in the six months ended June 30, 1999 to $11.5 million in the six months
ended June 30, 2000, an increase of 89%. As a percentage of total revenues,
sales and marketing expenses decreased from 71% in the six months ended June 30,
1999 to 49% in the six months ended June 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 payroll and related expenses from $2.9 million to $4.7
million;
. an increase in variable marketing costs from $1.4 million to $4.2
million; and
. an increase in travel and related expenses from $1.2 million to $1.6
million.
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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
$3.0 million in the six months ended June 30, 1999 to $5.8 million in the six
months ended June 30, 2000, an increase of 90%. As a percentage of total
revenues, research and development expenses decreased from 36% in the six months
ended June 30, 1999 to 25% in the six months ended June 30, 2000. The dollar
increase in research and development expenses reflects the growth of our
research and development organization to expand our enterprise product line and
our efforts in researching and evaluating 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 $2.0 million to $3.7
million and
* an increase in prototype engineering costs from $183,000 to $580,000.
General and Administrative. General and administrative expenses increased
from $1.8 million in the six months ended June 30, 1999 to $2.4 million in the
six months ended June 30, 2000, an increase of 36%. As a percentage of total
revenues, general and administrative expenses decreased from 21% in the six
months ended June 30, 1999 to 10% in the six months ended June 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
decreased from $511,000 in the six months ended June 30, 1999 to $464,000 in the
six months ended June 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 in the six
months ended June 30, 1999 was $188,000, $248,000 and $75,000, respectively, and
was $100,000, $323,000, and $41,000, respectively, in the six months ended June
30, 2000.
Interest Income (Expense)
Interest expense of $362,000 in the six months ended June 30, 1999 resulted
from borrowings on our bank line of credit, notes payable and our equipment term
loan, and was offset by $15,000 of interest income generated from our investment
of proceeds from the sale of preferred stock in prior periods. Interest income
of $2.8 million in the six months ended June 30, 2000 resulted from the
investment of proceeds from our public offerings, and was offset by $49,000 of
interest expense resulting from borrowings on our term loan with a bank, which
has since been paid in full.
Liquidity and Capital Resources
Since our inception, we have financed our operations through private
placements of convertible preferred stock, through the proceeds from our initial
public offering in July 1999 and most recently, 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.
We have a working capital revolving line of credit with a bank, secured by
our accounts receivable. The line of credit was renegotiated in March 2000 and
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 June 30, 2000, we
had no borrowings on this line of credit, which expires in February 2001 and
bears interest at the prime rate plus 0.5% per year. At June 30, 2000, our
borrowing base was $5.0 million, reduced by a $1.5 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 is expected to commence no later than 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.
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We have provided the landlord with an unconditional letter of credit in the
amount of $1.5 million, which will be increased to $3.0 million upon
commencement of the lease.
As of June 30, 2000, we had $113.6 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 June 30, 2000 was $114.7 million.
Operating activities. Our operating activities resulted in net cash
outflows of $3.8 million in the six months ended June 30, 1999 and $4.0 million
in the six months ended June 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 $1.8 million for the
six months ended June 30, 1999 and $2.9 million for the six months ended June
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 $1.0 million for the six months ended June
30, 1999, and cash used from working capital components for operating activities
was $3.8 million for the six months ended June 30, 2000. For the six months
ended June 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 $8.7
million at June 30, 2000, reflecting the increase in revenues from
$6.5 million in the three months ended December 31, 1999 to $13.7
million in the three months ended June 30, 2000. We implemented
enhanced credit and collection processes during 1999 that contributed
to improved collection periods. Days sales outstanding, or DSOs, were
68 days, 52 days and 57 days for the quarters ended June 30, 1999,
December 31, 1999 and June 30, 2000, respectively. The DSO ratio for
the second quarter of 2000 has increased slightly from the fourth
quarter of 1999 and is the result of changes in our customer sales mix
during the second 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
second quarter of 2000 was greater than in prior quarters. Based upon
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 $351,000 at June 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 $765,000 at June 30, 2000, and reflects 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 $5.3
million at June 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 new SOHO
product line. In addition, inventory levels at those customers where
revenue is recognized 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 that
have long lead times.
(c) Prepaid expenses and other receivables increased from $1.3 million at
December 31, 1999 to $3.0 million at June 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 payroll-related expenses
increased from $4.4 million at December 31, 1999 to $8.2 million at
June 30, 2000, related to purchases of inventory and inventory
components, and increased spending levels within the sales and
marketing areas.
(e) Deferred revenue increased from $4.2 million at December 31, 1999 to
$7.7 million at June 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 $823,000 in
the six months ended June 30, 1999 and $84.5 million in the six months ended
June 30, 2000, and reflect short-term investing activity and capital
expenditures for computing equipment and furniture.
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Financing activities. Cash provided by financing activities totaled $5.2
million in the six months ended June 30, 1999 and $92.2 million in the six
months ended June 30, 2000. These activities primarily relate to borrowings on
our line of credit and from bridge financing during 1999 and proceeds from our
public offering 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, the underlying assumed
levels of spending for the potential acquisition of or investment in
complementary businesses or technologies might prove to be inaccurate, and 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.
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 the average maturity of our investments equal
to 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 second 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 4. Submission of Matters to a Vote of Security Holders
We held an annual meeting of our stockholders on June 8, 2000. Of the
22,855,912 shares outstanding as of April 24, 2000, the record date of the
annual meeting, 21,698,406 shares, or 94.94% of the total number of shares
eligible to vote at the annual meeting were registered in person or by proxy.
One matter, the election of directors, was submitted to our stockholders
for approval at the annual meeting. Stuart J. Ellman was elected as a Class 1
director, Andrew W. Verhalen and Charles P. Waite, Jr. were elected as Class 2
directors, and Christopher G. Slatt and Steven N. Moore were elected as Class 3
directors, each receiving greater than 99.9% of the votes at the annual meeting.
No other matters were submitted to a vote of our shareholders in the
quarter ended June 30, 2000.
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).
10.1 WatchGuard 2000 Stock Option Plan (incorporated by reference to
Exhibit 99.1 to WatchGuard's Registration Statement on Form S-8
(file number 333-43562), filed August 11, 2000).
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 June 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.
August 14, 2000 WATCHGUARD TECHNOLOGIES, INC.
By: /s/Steven N. Moore
------------------
Steven N. Moore
Executive Vice President
of Finance, Chief Financial
Officer, Secretary and
Treasurer (Principal Financial
and Accounting Officer)
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