<PAGE>
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q/A
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
March 31, 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
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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
----- -----
22,866,547 shares of WatchGuard common stock were outstanding as
of May 5, 2000.
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WATCHGUARD TECHNOLOGIES, INC.
TABLE OF CONTENTS FOR FORM 10-Q
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
<C> <S> <C>
- Balance Sheets as of March 31, 2000 and December 31, 1999....... 3
- Statements of Operations for the three months ended
March 31, 2000 and 1999........................................ 4
- Statements of Cash Flows for the three months ended
March 31, 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...... 14
PART II. OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds....................... 16
Item 6. Exhibits and Reports on Form 8-K................................ 16
</TABLE>
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
WATCHGUARD TECHNOLOGIES, INC.
BALANCE SHEETS
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(in thousands, except share and per share data)
<TABLE>
<CAPTION>
March 31, December 31,
2000 1999
---- ----
(unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 50,282 $ 1,903
Securities available for sale 63,135 24,498
Trade accounts receivable, net 6,356 3,772
Inventories 3,391 2,013
Prepaid expenses and other receivables 2,276 1,275
--------------------- ---------------------
Total current assets 125,440 33,461
Equipment and furniture, net 2,084 1,927
Goodwill, intangibles and other assets 5,568 5,923
--------------------- ---------------------
Total assets $133,092 $ 41,311
===================== =====================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 4,817 $ 2,088
Accrued expenses 1,674 2,362
Deferred revenue 5,492 4,233
Equipment term loan -- 383
--------------------- ---------------------
Total current liabilities 11,983 9,066
Stockholders' equity:
Preferred stock, par value $0.001 per share, 10,000,000 shares -- --
authorized; 0 shares issued and outstanding at March 31, 2000 and
December 31, 1999
Common stock, par value $0.001 per share, 80,000,000 shares 23 19
authorized; 22,718,643 and 19,511,752 shares issued and
outstanding at March 31, 2000 and December 31, 1999, respectively
Additional paid-in capital 155,250 63,694
Stock-based compensation (1,217) (1,452)
Accumulated other comprehensive loss (312) (77)
Accumulated deficit (32,635) (29,939)
--------------------- ---------------------
Total stockholders' equity 121,109 32,245
--------------------- ---------------------
Total liabilities and stockholders' equity $133,092 $ 41,311
===================== =====================
</TABLE>
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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
March 31,
----------------------------------------
2000 1999
----------------- -----------------
<S> <C> <C>
Revenues
Product $ 8,494 $ 3,387
Service 1,308 551
----------------- -----------------
Total revenues 9,802 3,938
Cost of revenues 3,523 1,635
----------------- -----------------
Gross margin 6,279 2,303
Operating expenses:
Sales and marketing 5,559 2,841
Research and development 2,521 1,426
General and administrative 1,154 912
Stock-based compensation 236 253
Amortization of goodwill and other intangibles 368 -
----------------- -----------------
Total operating expenses 9,838 5,432
----------------- -----------------
Loss from operations (3,559) (3,129)
Interest income (expense), net 863 (84)
----------------- -----------------
Net loss $(2,696) $(3,213)
================= =================
Basic and diluted net loss per share $ (0.13) $ (2.28)
================= =================
Shares used in the calculation of basic and diluted net loss per share 21,243 1,407
================= =================
</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>
Three Months Ended
March 31,
--------------------------------------------
2000 1999
------------------- -------------------
<S> <C> <C>
OPERATING ACTIVITIES
Net loss $ (2,696) $(3,213)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation 246 118
Amortization of goodwill and intangibles 368 --
Amortization of stock-based compensation 236 254
Provision for sales returns and allowances 209 400
Provision for bad debt expense 145 124
Noncash interest expense -- 29
Changes in operating assets and liabilities:
(Increase) in trade accounts receivable (2,938) (1,341)
(Increase) decrease in inventories (1,378) 435
(Increase) decrease in prepaid expenses and other receivables (1,001) 27
(Increase) decrease in goodwill, intangibles and other assets (13) 31
Increase in accounts payable and accrued expenses 2,041 429
Increase in deferred revenue 1,259 623
------------------- -------------------
NET CASH USED IN OPERATING ACTIVITIES (3,522) (2,084)
INVESTING ACTIVITIES
Purchase of equipment and furniture (403) (528)
Proceeds from maturities of marketable securities 2,000 --
Purchases of marketable securities (40,872) --
------------------- -------------------
NET CASH USED IN INVESTING ACTIVITIES (39,275) (528)
FINANCING ACTIVITIES
Borrowings on line of credit and notes payable -- 2,971
Issuance of warrants -- 155
Principal repayments on line of credit and notes payable (383) (188)
Proceeds from sale of common stock/employee stock purchase plan 512 --
Proceeds from sale of common stock, net of expenses 90,437 --
Proceeds from exercise of common stock options and warrants 610 8
------------------- -------------------
NET CASH PROVIDED BY FINANCING ACTIVITIES 91,176 2,946
------------------- -------------------
NET INCREASE IN CASH AND CASH EQUIVALENTS 48,379 334
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 1,903 1,712
------------------- -------------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 50,282 $ 2,046
=================== ===================
</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. ("WatchGuard") 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. WatchGuard was incorporated in
Washington on February 14, 1996 and maintains its headquarters in Seattle,
Washington. In May 1997, WatchGuard reincorporated in Delaware. In conjunction
with the reincorporation, WatchGuard changed its name from Seattle Software
Labs, Inc. to WatchGuard Technologies, Inc. in August 1997.
Interim Financial Information
The accompanying unaudited financial statements of WatchGuard Technologies,
Inc., 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-month period ended March 31, 2000 are not necessarily indicative of the
results that may be expected for future quarters or the year ending 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 ("SEC").
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 or 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
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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.
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 second quarter of 2000. WatchGuard has reviewed the
requirements of the new standard and believes its current revenue recognition
policies to be in compliance with SAB 101. However, WatchGuard will continue to
review new interpretations of this standard as they become available and will
make adjustments to internal policy if deemed appropriate.
Comprehensive Loss
Comprehensive loss is comprised of net loss and unrealized gains and losses
on marketable securities. Comprehensive loss was $2.9 million and $2.1
million for the three months ended March 31, 2000 and 1999, respectively.
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): March 31, December 31,
2000 1999
---------------- ----------------
<S> <C> <C>
Trade accounts receivable $7,242 $4,499
Reserve for returns and allowances (580) (550)
Allowance for uncollectible accounts (306) (177)
---------------- ----------------
Total net accounts receivable $6,356 $3,772
================ ================
</TABLE>
Inventories
<TABLE>
<CAPTION>
Inventories consisted of the following (in thousands): March31, December 31,
2000 1999
---------------- ----------------
<S> <C> <C>
Finished goods $1,294 $1,093
Components 2,097 920
---------------- ----------------
$3,391 $2,013
================ ================
</TABLE>
NOTE 4 - PUBLIC OFFERING
On February 15, 2000, WatchGuard issued 1,780,000 shares of its common
stock at a public offering price of $54.125 per share. The offering also
included an additional 2,314,000 shares of common stock sold by selling
stockholders, including those sold pursuant to the exercise of the underwriters
over-allotment option. The proceeds to WatchGuard from the offering were
approximately $90.4 million, net of $5.9 million in offering expenses,
underwriting discounts and commissions.
NOTE 5 - LOSS PER SHARE
Basic and diluted net loss per common share is calculated by dividing net
loss by the weighted average number of common shares outstanding. Other common
stock equivalents, including stock options and warrants, are excluded from the
computation as their effect is antidilutive.
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The components of calculating net loss per share are set forth in the
following table (in thousands, except per share data):
<TABLE>
<CAPTION>
Three Months
Ended March 31,
--------------------------------------------
2000 1999
------------------- -------------------
<S> <C> <C>
Net loss $(2,696) $(3,213)
=================== ===================
Weighted average number of shares:
For basic earnings per share 21,243 1,407
Effect of dilutive securities:
Employee stock options -- --
------------------- -------------------
Weighted average number of shares:
For diluted earnings per share 21,243 1,407
=================== ===================
Net loss per share:
Basic and diluted $ (0.13) $ (2.28)
=================== ===================
</TABLE>
Options to purchase 5,732,650 shares of common stock and warrants to
purchase 210,000 shares of common stock were outstanding as of March 31, 2000.
These options and warrants were excluded from the computation of actual and pro
forma diluted net loss per common share because their effect was antidilutive.
NOTE 6 - 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 March 31,
-------------------------------------------
<S> <C> <C>
2000 1999
------------------- -------------------
United States $4,533 $2,101
Rest of World 5,269 1,837
------------------- -------------------
Total $9,802 $3,938
=================== ===================
</TABLE>
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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 which management
believes 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 notes thereto. 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 certain 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 our filings with the SEC, including our Annual Report on
Form 10-K/A 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, or
SMEs, and we have recently expanded our marketing focus to include larger
enterprises as well as small offices and home offices, or 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 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 small office and
home offices, or 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 and completed another public offering. In addition, during
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 the
second quarter of 2000, we expect to introduce MSS solutions for SOHOs and
telecommuters.
Our revenues were $5.1 million in 1997, our first full year of operations.
Our revenues totaled $11.4 million in 1998, representing a 123% increase over
1997, and grew to $20.6 million in 1999, representing an 81% increase over 1998.
Product revenues, as a percentage of total revenues were 98% in 1997, 94% in
1998 and 84% in 1999. Service revenues, though small, are growing and are
expected to be a significant component of our revenues in the future as we
expand our LiveSecurity subscription-based broadcast service. Service revenues
as a percentage of total revenues were 2% in 1997, 6% in 1998 and 16% in 1999.
As a result of our investments in our worldwide sales and distribution channels,
development of new products and services, brand development and our operational
infrastructure, we have incurred net losses in each fiscal quarter. As of March
31, 2000, we had an accumulated deficit of $32.6 million. We anticipate
significant growth in our operating expenses as we continue to expand our
business. In the future, however, we expect our operating expenses to begin to
decline as a percentage of total revenues.
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
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* 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 allows 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 March 31,
-----------------------------------------
2000 1999
----------------- -----------------
<S> <C> <C>
Statement of Operations Data:
Revenues:
Product 86.7% 86.0 %
Service 13.3 14.0
----------------- -----------------
Total revenues 100.0 100.0
Cost of revenues 35.9 41.5
----------------- -----------------
Gross margin 64.1 58.5
Operating expenses:
Sales and marketing 56.7 72.1
Research and development 25.7 36.2
General and administrative 11.8 23.1
Stock-based compensation 2.4 6.4
Amortization of goodwill
and other intangibles 3.8 --
----------------- -----------------
Total operating expenses 100.4 137.9
----------------- -----------------
Loss from operations (36.3) (79.5)
Interest income (expense), net 8.8 (2.1)
----------------- -----------------
Net loss (27.5)% (81.6)%
================= =================
</TABLE>
Three Months Ended March 31, 2000 and 1999
Revenues
Total revenues, which consist of product revenues and service revenues,
increased from $3.9 million in the three months ended March 31, 1999 to $9.8
million in the three months ended March 31, 2000, an increase of 149%. During
these periods, no one customer accounted for 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 47% of total
revenues in the three months ended March 31, 1999 and 54% in the three months
ended March 31, 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, or network operations center, security suite software license and our
security appliance as part of LiveSecurity for MSS. Product revenues increased
from $3.4 million in the three months ended March 31, 1999 to $8.5 million in
the three
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months ended March 31, 2000, an increase of 151%. As a percentage of total
revenues, product revenues increased from 86% in the three months ended March
31, 1999 to 87% in the three months ended March 31, 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.
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
$551,000 in the three months ended March 31, 1999 to $1.3 million in the three
months ended March 31, 2000, an increase of 137%. As a percentage of total
revenues, service revenues decreased slightly from 14% in the three months ended
March 31, 1999 to 13% in the three months ended March 31, 2000, which reflects
the significant growth in product revenues. Our deferred service revenue balance
has increased from $4.2 million at December 31, 1999 to $5.5 million at March
31, 2000, an increase of 30%. 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 ISP's have increased in
amount during each quarter since we introduced the product. Total revenues for
the LiveSecurity System increased from $3.4 million for the three months ended
March 31, 1999 to $8.2 million for the three months ended March 31, 2000, an
increase of 137%, while total revenues from LiveSecurity for MSS from ISP's
increased from $551,000 for the three months ended March 31, 1999 to $1.6
million for the three months ended March 31, 2000, an increase of 190%. As a
percentage of total revenues, LiveSecurity for MSS revenues increased from 14%
for the first quarter of 1999 to 16% for the first quarter of 2000. The
increase in LiveSecurity for MSS revenues, both in dollars and as a percentage
of total 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 $400,000, or 10% of total
revenues, for the three months ended March 31, 1999 and $209,000, or 2% of total
revenues, for the three months ended March 31, 2000. The provision, as a
percentage of total revenues, for the three months ended March 31, 2000 as
compared to the provision for both the three months ended March 31, 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 $1.6 million in the three months ended March 31, 1999 to $3.5 million in
the three months ended March 31, 2000. As a percentage of total revenues, cost
of revenues were 42% in the three-month period ended March 31, 1999 and 36% in
the three-month period ended March 31, 2000.
The dollar increases in cost of revenues were primarily due to increases in
sales volume. The cost of revenues as a percentage of total revenues reflects a
1) 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, that was offset by the increased leverage of our service
costs against an increasing rate of service revenues. 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 during the second 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
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
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show expenses. Overall, sales and marketing expenses increased from $2.8 million
in the three months ended March 31, 1999 to $5.6 million in the three months
ended March 31, 2000, an increase of 96%. As a percentage of total revenues,
sales and marketing expenses decreased from 72% in the three months ended March
31, 1999 to 57% in the three months ended March 31, 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 variable marketing costs from $492,000 to $2.2 million,
reflecting increased advertising to achieve market awareness, and the
cost of channel programs for increased channel distribution efforts;
* an increase in salaries, commissions, recruiting and related expenses
from $1.5 million to $1.9 million; and
* an increase in travel and related expenses from $519,000 to $708,000.
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 $1.4 million in the three
months ended March 31, 1999 to $2.5 million in the three months ended March 31,
2000, an increase of 77%. As a percentage of total revenues, research and
development expenses decreased from 36% in the three months ended March 31, 1999
to 26% in the three months ended March 31, 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 product 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 $930,000 to $1.8
million; and
* an increase in costs associated with security appliance prototypes from
$104,000 to $215,000 for our new SOHO product line 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 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
$912,000 in the three months ended March 31, 1999 to $1.2 million in the three
months ended March 31, 2000, an increase of 27%. As a percentage of total
revenues, general and administrative expenses decreased from 23% in the three
months ended March 31, 1999 to 12% in the three months ended March 31, 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 $253,000 for the three months ended
March 31, 1999 and $236,000 for the three months ended March 31, 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 for the three months ended March 31,
2000 was $51,000, $164,000 and $21,000, respectively, and was $96,000, $121,000,
and $37,000, respectively, for the three months ended March 31, 1999.
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Interest Income (Expense)
Interest expense of $93,000 in the three months ended March 31, 1999
resulted from borrowings on our bank line of credit and our equipment term loan,
and was partially offset by $9,000 of interest income generated from our
investment of proceeds from the sale of preferred stock in prior periods.
Interest income of $911,000 in the three months ended March 31, 2000 was
generated from our investment of proceeds from the sale of common stock in our
initial public offering during July 1999 and the sale of stock in our public
offering in February 2000. Interest expense of $48,000 was recorded in the three
months ended March 31, 2000 resulted from costs related to our bank line of
credit and borrowings on our equipment term loan, which has since been paid in
full.
Liquidity and Capital Resources
Since our inception, we have financed our operations primarily through
private placements of convertible preferred stock, and most recently through the
proceeds from our initial public offering in July 1999 and our 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 March 31, 2000, we
had no borrowings on this line of credit, which expires in February 2001 and
bears interest at prime plus 0.5% per year. At March 31, 2000, our borrowing
base was $3.7 million. Our two term-loan facilities with the same bank, which
had a combined balance of $383,000 as of December 31, 1999, were repaid in
February 2000.
In March 2000, WatchGuard signed a 10-year facilities lease agreement that
provides for approximately 90,000 square feet, out of approximately 290,000
available square feet, of office space for a new corporate headquarters location
in Seattle, Washington, with an option to extend the lease for an additional 5-
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. WatchGuard is also responsible for its pro-rata share of the building
operating costs, which are estimated to be $60,000 per month during the first
year of the lease. WatchGuard has provided the landlord with an unconditional
letter of credit in the amount of $1.5 million, which will be increased to $3.0
million at the commencement of the lease.
As of March 31, 2000, we had $113.4 million in cash, cash equivalents and
short-term investments, 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 March 31, 2000 was $113.5 million.
Operating activities. Our operating activities resulted in net cash
outflows of $2.0 million for the three months ended March 31, 1999 and $3.5
million for the three months ended March 31, 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 $925,000
for the three months ended March 31, 1999 and $1.2 million for the three months
ended March 31, 2000. These noncash charges were primarily associated with
depreciation and amortization of capital assets, 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 $204,000 for the three months
ended March 31, 1999, and cash used from working capital components for
operating activities was $2.0 million for the three months ended March 31, 2000.
For the three months ended March 31, 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 $6.4
million at March 31, 2000, reflecting the growth in revenues from $6.5
million to $9.8 million for the three months ended December 31, 1999 and
March 31, 2000. We implemented enhanced credit and collection processes
during 1999 that contributed to improved collection periods. Days sales
outstanding, or DSOs, were 96 days, 52 days and 58 days for the quarters
ended March 31, 1999, December 31, 1999 and March 31, 2000, respectively.
The DSO ratio for the first quarter of 2000 has increased slightly from the
fourth quarter of 1999 and is a result of changes in our customer sales mix
during the first 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 first 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 DSO to generally range from 55 days to 70 days.
Reserves for uncollectible accounts were $177,000 at December 31,
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1999 and $306,000 at March 31, 2000, reflecting an increased accounts
receivable balance related to increased sales. Our returns and allowance
reserve was $550,000 at December 31, 1999 and $580,000 at March 31, 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 on the timing of product
introductions and pricing program changes.
(b) Inventories increased from $2.0 million at December 31, 1999 to $3.4
million at March 31, 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.
(c) Prepaid expenses and other receivables increased from $1.3 million at
December 31, 1999 to $2.3 million at March 31, 2000, primarily due to an
increase in the interest receivable originating from the investment of
proceeds from our public offering in February 2000.
(d) Accounts payable and accrued expenses increased from $4.4 million at
December 31, 1999 to $6.5 million at March 31, 2000, related to purchases
of inventory and inventory components, and increased spending levels within
the sales and marketing areas.
Investing activities. Cash used in investing activities totaled $528,000
for the three months ended March 31, 1999 and $39.3 million for the three months
ended March 31, 2000, and reflect short-term investing activity and capital
expenditures for computing equipment and furniture.
Financing activities. Cash provided by financing activities totaled $2.9
million for the three months ended March 31, 1999 and $91.2 million for the
three months ended March 31, 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 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 appear until
sometime after January 1, 2000. 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
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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 first 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 July 30, 1999, our registration statement on Form S-1, file number 333-
76587, became effective. The offering date was July 30, 1999. The offering
terminated as a result of all the shares offered being sold. The managing
underwriters were Dain Rauscher Wessels, Warburg Dillon Read LLC, SoundView
Technology Group and Wit Capital Corporation. The offering consisted of
3,879,570 shares of our common stock, including 3,500,000 shares of common stock
offered by WatchGuard and 379,570 shares of common stock offered by our selling
stockholders pursuant to the exercise of the underwriters' over-allotment
option. The aggregate price of shares offered and sold by us was $45.5 million,
and the aggregate price of the shares offered and sold by the selling
shareholders was $4.9 million. After accounting for approximately $3.2 million
in underwriting discounts and commissions and $1.5 million in other expenses, we
received proceeds of $40.8 million.
On February 15, 2000, our registration statement on Form S-1, file number
333-95049, became effective. The offering terminated as a result of all of the
shares offered being sold. The managing underwriters were Credit Suisse First
Boston, Dain Rauscher Wessels, SoundView Technology Group and Wit Capital
Corporation. The offering consisted of 3,560,000 shares of our common stock,
including 1,780,000 shares of common stock offered by WatchGuard and 1,780,000
shares of common stock offered by selling stockholders. The offering also
included 534,000 shares of common stock offered by our selling stockholders
pursuant to the exercise of the underwriters' over-allotment option. The
aggregate price of the shares offered and sold by us was $96.3 million, and the
aggregate price of the shares offered and sold by the selling shareholders was
$125.2 million, which includes the shares associated with the over-allotment
option. 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.
We are using the net proceeds raised in our public offerings for additional
working capital, repayment of short-term indebtedness and general corporate
purposes, including increased domestic and international sales and marketing
expenditures, increased research and development expenditures and capital
expenditures made in the ordinary course of business. We also intend to use
these proceeds for possible acquisitions of businesses, products and
technologies that are complementary to ours, such as our acquisition of the
assets of BeadleNet, LLC during October 1999. Although we have no current
agreements or understandings with respect to any such transactions, we do from
time to time evaluate such opportunities. Pending their use, the majority of
the net proceeds have been invested in investment-grade, interest-bearing
instruments, all of which are short-term.
We used $6.6 million of the net proceeds of the initial public offering to
repay all debt affiliated with Matrix IV Management Co., L.P., OVMC III, L.P.
and OVMC IV, LLC. Andrew W. Verhalen, a director of WatchGuard, serves as
general partner of Matrix IV Management Co., L.P. and Charles P. Waite, Jr., a
director of WatchGuard, serves as a general partner of OVMC III, L.P. and as a
managing member of OVMC IV, LLC.
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 Lease Agreement, dated as of March 1, 2000, between 505 Union Station
Ltd. and the registrant. (incorporated by reference to Exhibit 10.13
to WatchGuard's Annual Report on Form 10-K/A (file number 000-26819),
filed May 1, 2000).
10.2 Loan Modification Agreement, dated as of March 1, 2000, between
Silicon Valley Bank and the registrant (incorporated by reference to
Exhibit 10.13 to WatchGuard's Annual Report on Form 10-K/A (file
number 000-26819), filed May 1, 2000).
27.1 Financial Data Schedule (filed previously).
(b) Reports on Form 8-K
-------------------
No reports on Form 8-K were filed during the quarter ended March 31, 2000.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this amendment to report to be signed on its behalf
by the undersigned thereunto duly authorized.
July 27, 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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