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TUMBLEWEED COMMUNICATIONS CORP. INDEX

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 June 30, 2002

Commission File Number: 000-26223

TUMBLEWEED COMMUNICATIONS CORP.
(Exact name of registrant as specified in its charter)

700 SAGINAW DRIVE
REDWOOD CITY, CA 94063
(Address of principal executive offices, including zip code)

(650) 216-2000
(Registrant's telephone number, including area code)

        Indicate by check mark whether the registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes ý    No o

        The number of shares of common stock outstanding as of July 31, 2002 was 30,925,664.

SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS

        This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are subject to the "safe harbor" created by those sections. The forward-looking statements are based on our current expectations and projections about future events, including, but not limited to, implementing our business strategy; attracting and retaining customers; obtaining and expanding market acceptance of the products and services we offer; forecasts of Internet usage and the size and growth of relevant markets; rapid technological changes in its industry and relevant markets; our stock repurchase program; and competition in our market. Discussions containing such forward-looking statements may be found in "Management's Discussion and Analysis of Financial Condition and Results of Operations." In some cases, forward-looking statements can be identified by terminology such as "may," "will," "should," "could," "predicts," "potential," "continue," "expects," "anticipates," "future," "intends," "plans," "believes," "estimates," and similar expressions. These forward-looking statements involve certain risks and uncertainties that could cause actual results, levels of activity, performance, achievements and events to differ materially from those stated or implied by such forward-looking statements. The factors that could contribute to such differences include those discussed under the caption "Risks And Uncertainties That You Should Consider Before Investing In Tumbleweed" contained herein, as well as those discussed in our Form 10-K and other filings with the Securities and Exchange Commission. These forward-looking statements are made as of the date of this Quarterly Report on Form 10-Q. Tumbleweed disclaims any obligation to update these statements or to explain the reasons why actual results may differ. Tumbleweed reserves the right to update these statements for any reason including the occurrence of a material event. The risks and uncertainties under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations—Risks and Uncertainties That You Should Consider Before Investing in Tumbleweed" contained herein, among other things, should be considered in evaluating Tumbleweed's prospects and future financial performance.

TUMBLEWEED COMMUNICATIONS CORP.

INDEX

TRADEMARKS

        Our registered trademarks include Tumbleweed®, Tumbleweed Communications®, Secure Envelope®, Secure Inbox®, Tumbleweed IME Integrated Messaging Exchange®, WorldSecure® and Worldtalk®. Additional trademarks belonging to us include Tumbleweed Secure Guardian™, Tumbleweed Secure Policy Gateway™, Tumbleweed Secure Staging Server™, Tumbleweed Staging Server™, Tumbleweed Secure Mail™, Tumbleweed Secure Redirect™, Tumbleweed Secure Public Network™, Tumbleweed SPN™, Tumbleweed Secure Archive™, Tumbleweed Secure Web™, Tumbleweed Secure CRM™, Tumbleweed Secure Messenger™, Tumbleweed Secure Statements™, Tumbleweed My Copy™, Tumbleweed L2i™, Tumbleweed IME Developer™, Tumbleweed IME Personalize™, WorldSecure/Mail™ and Tumbleweed IME Alert™.

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PART I—FINANCIAL INFORMATION

ITEM 1—FINANCIAL STATEMENTS

TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(in thousands)

See accompanying Notes to Condensed Consolidated Financial Statements

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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES
Condensed Consolidated Statements of Operations
(in thousands, except per share data)
(unaudited)

(1)

Exclusive of non-cash stock-based compensation expense of $10 and $85 for the three months ended June 30, 2002, and 2001, respectively, and $87 and $164 for the six months ended June 30, 2002, and 2001, respectively.

(2)

Exclusive of non-cash stock-based compensation expense of $6 and $129 for the three months ended June 30, 2002, and 2001, respectively, and $29 and $503 for the six months ended June 30, 2002, and 2001, respectively.

(3)

Exclusive of non-cash stock-based compensation expense (credit) of $(395) and $355 for the three months ended June 30, 2002, and 2001, respectively, and $(264) and $1,104 for the six months ended June 30, 2002, and 2001, respectively.

(4)

Exclusive of non-cash stock-based compensation expense of $12 and $86 for the three months ended June 30, 2002, and 2001, respectively, and $43 and $554 for the six months ended June 30, 2002, and 2001, respectively.

(5)

Exclusive of non-cash stock-based compensation expense credit of $0 and $(336) for the six months ended June 30, 2002 and 2001, respectively.

See accompanying Notes to Condensed Consolidated Financial Statements

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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)

See accompanying Notes to Condensed Consolidated Financial Statements

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TUMBLEWEED COMMUNICATIONS CORP. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

(1)    Organization

        Tumbleweed Communications Corp. ("Tumbleweed" or "we") is a leading provider of secure messaging applications for businesses and government organizations using the Internet. Tumbleweed Secure Guardian is a leading enterprise-wide policy-based security framework that offers a wide range of solutions to both protect and extend enterprise networks, move business processes online and enable enterprises to communicate safely over the Internet. Tumbleweed solutions empower organizations to safely share and protect critical information, increase customer loyalty and privacy and reduce costs.

        We maintain our headquarters in Redwood City, California and have incorporated subsidiaries in Japan, Switzerland, the United Kingdom, Germany, the Netherlands, Sweden, France, Australia and Hong Kong. After June 30, 2002, we made a decision to transition from direct sales operations to indirect sales operations in Europe and Japan due to significant sustained declines in the operating results of those regions.

(2)    Basis of Presentation

        The consolidated condensed financial statements as of June 30, 2002 and for the three and six months ended June 30, 2002 and 2001 are unaudited and reflect all adjustments (consisting of normal recurring accruals except as otherwise indicated) which are, in the opinion of management, necessary for fair presentation of our financial position and operating results for the interim periods presented.

        The accompanying consolidated condensed financial statements include the accounts of Tumbleweed and our subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

(3)    Restructuring

        In January 2001, our Board of Directors approved a restructuring program intended to align our cost structures with our company-wide focus on customer service, sales and research and development. The restructuring involved consolidating our facilities in the United States and closing international sales office locations in Paris, France; Chatsworth, Australia; and Stockholm, Sweden. The restructuring program also realigned our professional services organization and reduced headcount in most areas of our business.

        Restructuring and related charges expensed during the six months ended June 30, 2001 was comprised of the following (in thousands):

        Employee separation for approximately 100 employees included severance pay and medical and other benefits. The restructuring charges were partially offset by a non-cash credit related to previously recorded stock-based compensation on unvested options held by terminated employees. During the quarter ended March 31, 2002, we made lease settlement payments of $2.3 million on facilities no longer required primarily due to the reduction in headcount. As of June 30, 2002, we had no remaining liabilities from the January 2001 restructuring.

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(4)    Goodwill Impairment

        During the three months ended March 31, 2001, we performed an impairment assessment of the identifiable intangibles and goodwill recorded in connection with the acquisition of Interface Systems, Inc. The assessment was performed primarily due to changes in the economy, the overall decline in the industry growth rate, and our lower actual and projected operating results including that of the business acquired from Interface. Our assessment was supported by the significant sustained decline in our stock price since the valuation date of the shares issued in the Interface acquisition. As a result of the assessment, we recorded a $51.0 million impairment charge to reduce goodwill and other intangible assets to their estimated fair value. The charge was based upon the estimated discounted cash flows over the remaining useful life of the goodwill and other intangible assets using a discount rate of 15%. The assumptions supporting the cash flows, including the discount rate, were determined using our best estimates as of March 31, 2001. The remaining intangible assets were amortized in full over their remaining useful life during 2001. The impairment consisted of the following charge (in thousands):

        Due to the significant sustained decline in the operating results of Tumbleweed Communications KK ("TKK"), our majority-owned subsidiary in Japan, After June 30, 2002, we performed an impairment assessment of the goodwill recorded in connection with our acquisition of TKK. As a result of the decline, we decided to transition from direct sales operations to indirect sales operations in Japan.

        We identified TKK as a reporting unit and assigned assets (including goodwill and intangible assets) and liabilities to this reporting unit for purposes of the impairment test. We compared the fair value of the reporting unit with its carrying amount and found that the fair value was less than the carrying amount. We then calculated the implied fair value of TKK's goodwill, determined by allocating TKK's fair value to all of its assets (recognized and unrecognized) and liabilities, both of which were measured as of June 30, 2002. This implied fair value of TKK's goodwill was determined to be less than its carrying amount and, therefore, we wrote off $5.7 million in goodwill, which was the remainder of the goodwill balance subsequent to the charge of $974,000 as a cumulative effect of the change in accounting principle. Both of these charges result from impairment assessments, as proscribed under Statement of Financial Accounting Standards ("SFAS") 142, Goodwill and Other Intangible Assets.

(5)    Net Loss Per Share

        Basic net loss per share is computed by dividing the net loss for the period by the weighted average number of common shares outstanding during the period. Diluted net loss per share is computed by dividing the net loss for the period by the weighted average number of common and potential common shares outstanding during the period if their effect is dilutive. Potential common shares comprise incremental common shares issuable upon the exercise of stock options and warrants. The potential common shares issuable under stock options and the potential warrants to purchase common shares have been excluded from the determination of diluted net loss per share for all periods because the effect of such shares would have been anti-dilutive.

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(6)    Comprehensive Loss

        Comprehensive loss includes our net loss as well as foreign currency translation adjustments, recorded net of tax. Comprehensive loss for the three month and six month periods ending June 30, 2002 and 2001, respectively, is as follows (in thousands):

(7)    Segment Information

        As defined by SFAS 131, Disclosure About Segments of an Enterprise and Related Information, our chief operating decision-makers are our Chief Executive Officer ("CEO") and our Chief Operating Officer ("COO"). Our CEO and COO review financial information presented on a consolidated basis accompanied by disaggregated information about revenue by geographic region for purposes of making operating decisions and assessing financial performance. The consolidated financial information reviewed by our CEO and COO is the information presented in the accompanying consolidated statement of operations. Therefore, we operate in a single operating segment, secure messaging applications for businesses using the Internet.

        Revenue information regarding operations in the different geographic regions is as follows (in thousands):

        Substantially all of our long-lived assets are located in the United States.

(8)    Contingencies

        On July 7, 2000, three complaints were filed by David H. Zimmer, Congressional Securities, Inc. and other plaintiffs against Interface Systems, Inc., a company we acquired in 2000, and various additional defendants, including Interface's prior president and chief executive officer, Robert A. Nero and Fiserv Correspondent Services, Inc., in the United States District Court for the Southern District of New York. The three cases contain substantially similar allegations of false and misleading representations by various defendants allegedly designed to inflate Interface's stock price. The complaints seek relief under the federal securities laws on behalf of purported classes of persons who purchased, held, or sold shares of Interface stock, and under various other causes of action. On July 27, 2001, the Court granted our motion to transfer the lawsuits to the United States District Court for the Eastern District of Michigan, which, on April 19, 2002, dismissed with prejudice plaintiffs' class

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allegations and federal securities law claims that purportedly arose under Section 10(b) of the Securities Exchange Act of 1934. Also on April 19, 2002, plaintiffs filed a Second Amended Consolidated Complaint that (i) consolidated the separate actions into one action; (ii) added certain new plaintiffs; (iii) withdrew Congressional Securities, Inc. ("CSI") as a plaintiff, and (iv) added claims for breach of fiduciary duty and negligent misrepresentation, which are the sole remaining claims in the case. On May 20, 2002, we filed a motion to dismiss these claims, which motion remains pending before the Court. The accompanying financial statements do not include any costs for damages, if any, that might result from this uncertainty. We believe this consolidated action is without merit and intend to vigorously defend against it and seek its dismissal.

(9)    Recent Accounting Pronouncements

        In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS 142, Goodwill and Other Intangible Assets. SFAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment.

        We adopted the provisions of SFAS 142 on January 1, 2002. In connection with SFAS 142's transitional goodwill impairment evaluation, we engaged a third-party independent valuation specialist to assess whether there was an indication that goodwill recorded in connection with our acquisition of TKK was impaired as of the date of adoption. To accomplish this, we determined the carrying value of our reporting units by assigning our assets and liabilities, including the existing goodwill and intangible assets, to our reporting units as of the date of adoption. As our TKK reporting unit's carrying amount exceeded its fair value, indicating that TKK's goodwill might be impaired, we performed the second step of the transitional impairment test. In the second step, we compared the implied fair value of TKK's goodwill, determined by allocating TKK's fair value to all of its assets (recognized and unrecognized) and liabilities to its carrying amount, both of which were measured as of the date of adoption. A transitional impairment loss of $974,000 was recognized as the cumulative effect of a change in accounting principle in our consolidated statement of operations.

        In June 2001, the FASB issued SFAS 143, Accounting for Asset Retirement Obligations, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The standard applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development, or normal use of the asset. SFAS 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. We are required to adopt the provisions of SFAS 143 as of January 1, 2003. We do not expect the adoption of SFAS 143 to have a material impact on our financial position or results of operations.

        In October 2001, the FASB issued SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS 144 supersedes SFAS 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, it retains many of the fundamental provisions of SFAS 121. SFAS 144 also supersedes the accounting and reporting provisions of APB Opinion 30 for the disposal of a segment of a business. By broadening the presentation of discontinued operations to include more disposal transactions, SFAS 144 enhances companies' ability to provide information that helps financial statement users to assess the effects of a disposal transaction on the ongoing operations

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of an entity. We adopted SFAS 144 as of January 1, 2002. The adoption of SFAS 144 did not have a material impact on our financial position or results of operations.

        In June 2002, the FASB issued SFAS 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses financial accounting and reporting for costs associated with an exit or disposal activity. SFAS 146 nullifies Emerging Issues Task Force ("EITF") Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS 146 requires that a liability be recognized for those costs only when the liability is incurred, that is, when it meets the definition of a liability in the FASB's conceptual framework. In contrast, under EITF Issue 94-3, a company recognized a liability for an exit cost when it committed to an exit plan. SFAS 146 also established fair value as the objective for initial measurement of liabilities related to exit or disposal activities. We are required to adopt the provisions of SFAS 146 as of January 1, 2003. We do not expect the adoption of SFAS 146 to have a material impact on our financial position or results of operations.

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ITEM 2—MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        The following discussion should be read in conjunction with the consolidated condensed financial statements and the accompanying notes. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those discussed below and those listed under "Risks and Uncertainties That You Should Consider Before Investing In Tumbleweed".

OVERVIEW

        We are a leading provider of secure messaging applications for businesses and government organizations using the Internet. Tumbleweed Secure Guardian is a leading enterprise-wide policy-based security framework that offers a wide range of solutions to both protect and extend enterprise networks, move business processes online, and enable enterprises to communicate safely over the Internet. Tumbleweed solutions empower organizations to safely share and protect critical information, increase customer loyalty and privacy and reduce costs.

        Secure Guardian provides centralized security for both incoming and outgoing communications and integrates various enterprise applications for safe delivery of all forms of enterprise content. Secure Guardian is based on a platform consisting of the Tumbleweed Secure Policy Gateway and a series of protocol enablers that allow virtually any application to connect to it. The Secure Policy Gateway enables the enterprise to apply security to and manage content policies for bi-directional communications traffic. Policies include protection from viruses or SPAM attacks, as well as protection from dangerous exposure of company, partner or customer confidential information. Tumbleweed protocol enablers allow a wide range of protocols and enterprise systems to be centrally managed from the Secure Policy Gateway to allow organizations to safely extend communications from enterprise applications, groupware and legacy systems.

        Additionally, Tumbleweed Secure Guardian enables a broad spectrum of network extension solutions that help companies leverage the business efficiencies and benefits of the business Internet, including secure communications between trading partners, moving paper-based processes—such as statement presentment—online, and delivery and storage of aggregated enterprise communications into a single, branded secure inbox. Tumbleweed is trusted by 1,000 blue-chip customers including American Century Services Corp.; American Express Travel Related Services Company, Inc.; Amgen Inc.; Beckman Coulter, Inc.; Best Buy Co., Inc.; Broadcom Corp.; Capital One Financial Corp.; ChevronTexaco Corp.; Diners Club International Ltd.; Gap, Inc.; Harley-Davidson, Inc.; JP Morgan Chase & Co.; National Semiconductor Corp.; Phoenix Home Life Insurance Co.; Salomon Smith Barney Inc.; Siebel Systems, Inc.; Union Minere Oxyde (U.K.) Ltd.; the U.S. Food & Drug Administration; Verizon Communications; Wachovia Securities, Inc.; and Wells Fargo & Co. Over 100 of the Fortune 500 use various Tumbleweed solutions today.

        Revenue, which consists of both product and intellectual property ("IP") revenue as well as services revenue, results from new contracts and backlog. We define backlog as deferred revenue and contractual commitments that are not due and payable as of the balance sheet date. Product and IP revenue consists of license and transaction fees, and patent license agreement fees. We typically offer our software products under a perpetual license. Under a perpetual license our customers pay a one-time license fee for the right to use our software. We recognize revenue from perpetual licenses upon shipment when the following provisions are met: (i) persuasive evidence of an arrangement exists, generally based on an executed contract and non-binding purchase order; (ii) the product has been delivered, generally to a common carrier, including electronic distribution; (iii) the fee is fixed and determinable; and (iv) collection of the resulting receivable is reasonably probable. We enter into

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patent license agreements whereby licensees gain access to one or more of our patents for the duration of the patent(s) in exchange for a licensing fee. We recognize revenue from IP licensing when (i) the patent license agreement is executed and (ii) the amounts due are billable. Transaction revenue is recognized based on payment schedules or transaction reports from our customers. A number of our contracts include minimum transaction volume requirements. In these cases, the minimum guaranteed revenue is recognized when fees are due and payable during those months where transaction volume does not exceed the designated minimums.

        Services revenue consists of consulting fees, training fees, and support and maintenance fees. Revenue from consulting fees related to installation or customization is recognized upon client acceptance or percentage of completion. Training revenue is recognized upon completion of the training. Support and maintenance fees are paid for ongoing customer support and in some instances for the right to receive future upgrades of our products during the term of the maintenance agreement. Revenue from support and maintenance is recognized ratably over the period the support is provided. Revenue from the reseller channel is recognized upon software shipment and the execution of a distribution agreement and receipt of substantive identification of the end-user customer.

        A portion of our revenue comes from our international customers or operations. Most of our international contracts are denominated in foreign currencies. We currently do not have hedging or similar arrangements to protect us against foreign currency fluctuations. Therefore, we increasingly may be subject to currency fluctuations, which could harm our operating results in future periods.

        Our future net income and cash flow may be adversely affected by limitations on our ability to apply net operating losses for federal income tax reporting purposes against taxable income in future periods, including limitations due to ownership changes, as defined in Section 382 of the Internal Revenue Code, arising from issuance of stock.

        In January 2001, our Board of Directors approved a restructuring program intended to align our cost structures with our company-wide focus on customer service, sales and research and development. The restructuring involved consolidating our facilities in the United States and closing international sales office locations in Paris, France; Chatsworth, Australia; and Stockholm, Sweden. The restructuring program also realigned our professional services organization and reduced headcount in most areas of our business. The reduction in force involved approximately 100 employees and total charges incurred as a result of the restructuring were $8.9 million during the three months ended March 31, 2001, which includes charges related to vacating leased facilities domestically and abroad. As of June 30, 2002, we had no remaining liabilities from the January 2001 restructuring.

        In July 2002, our Board of Directors approved a program to repurchase up to $10 million of our common stock. Although we are not required to purchase any stock under the program, we may purchase shares either in the open market or in negotiated transactions as market and business conditions warrant. The timing and amount of any shares repurchased will be determined by our management based on our evaluation of market conditions and other factors. The purchases will be made at current market prices or in negotiated transactions off the market and will be funded using our working capital. The repurchase program extends over a twelve month period and may be suspended or discontinued at any time.

        After June 30, 2002, we made a decision to transition from direct sales operations to indirect sales operations in Europe and Japan due to significant sustained declines in the operating results of those regions.

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RESULTS OF OPERATIONS

Three and Six Month Periods Ended June 30, 2002 and 2001

Revenue.    Revenue is composed of product and IP revenue and service revenue. Total revenue for the three months ended June 30, 2002 decreased to $6.0 million from $7.7 million for the same three months in 2001. The decrease in revenue for the three month period was due to decreases in revenue from our international regions in Europe and Asia, which decreased to $559,000 from $1.9 million and to $199,000 from $463,000, respectively. Additionally, the decrease in revenue was due to decreases in transaction revenue and consulting revenue. Total revenue for the six months ended June 30, 2002 increased to $14.1 million from $11.7 million for the same six months in 2001. The increase in total revenue for the six month period was due to a number of new contracts being recognized on a subscription basis in the six months ended June 30, 2001 as well as increases in maintenance revenue from growth in our installed customer base in the six months ended June 30, 2002. Revenue from our international regions in Europe and Asia could decrease on a year-over-year basis in future quarters as we transition from direct sales operations to indirect sales operations.

        Product and IP revenue for the three months ended June 30, 2002 decreased to $3.4 million from $5.1 million for the same three months in 2001. The decrease in product and IP revenue for the three month period was due to a drop in transaction revenue and a smaller decrease in license revenue. Product and IP revenue for the six months ended June 30, 2002 increased to $8.9 million from $6.8 million for the same six months in 2001.The increase in product and IP revenue for the six month period was due to a number of new contracts being recognized on a subscription basis in the six months ended June 30, 2001. Additionally, we recognized no IP revenue in the six months ended June 30, 2001.

        Service revenue for the three months ended June 30, 2002 remained at $2.6 million from $2.6 million for the same three months in 2001 as increases in maintenance revenue from growth in our installed customer base were offset by decreases in consulting revenue. Service revenue for the six months ended June 30, 2002 increased to $5.1 million from $4.9 million for the same six months in 2001. The increase in service revenue for the six month period was due to increases in maintenance revenue from growth in our installed customer base.

Cost of Revenue.    Cost of revenue is comprised of product and IP costs and service costs. Product license cost is primarily comprised of royalties paid to third parties for software licensed by us for inclusion in our products and bandwidth costs associated with hosting servers for those customers who use our hosting services. Service costs are comprised primarily of personnel and overhead costs related to customer support and contract development projects. Total cost of revenue for the three months ended June 30, 2002 decreased to $1.9 million from $3.1 million for the same three months in 2001. Total cost of revenue for the six months ended June 30, 2002 decreased to $4.0 million from $6.1 million for the same six months in 2001. The decrease in total cost of revenue was primarily due to a decrease in service costs caused by a decrease in headcount and decreased product and IP costs resulting from lower royalty expenses.

Research and Development Expenses.    Research and development expenses are comprised of engineering and related costs associated with the development of our applications, quality assurance and testing. Research and development expenses for the three months ended June 30, 2002 decreased to $2.4 million from $4.4 million for the same three months in 2001. Research and development expenses for the six months ended June 30, 2002 decreased to $5.6 million from $8.1 million for the same si