UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

Commission File Number 000-26785

PACKETEER, INC.

10201 North De Anza Boulevard, Cupertino, CA 95014
(Address of principal executive offices)

Registrant’s telephone number, including area code: (408) 873-4400

     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 such filing requirements for the past 90 days.

Yes [X]       No [  ]

     Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes [X]       No [  ]

     The number of shares outstanding of Registrant’s common stock, $0.001 par value, was 33,229,752 at October 26, 2004.

TABLE OF CONTENTS

     In addition to historical information, this Form 10-Q contains forward-looking statements regarding our strategy, financial performance and revenue sources that involve a number of risks and uncertainties, including those discussed below at “Factors That May Affect Future Results” and in the “Risk Factors” section of Packeteer’s Annual Report on Form 10-K as filed with the SEC on March 5, 2004. Forward-looking statements in this report include, but are not limited to, those relating to the general expansion of our business, express or implied statements regarding future revenues, revenue growth, long-term business model targets and profitability, our ability to continue to innovate and protect our proprietary rights, our planned introduction of new products and services, the possibility of acquiring complementary businesses, products, services and technologies, our development of relationships with providers of leading Internet technologies and our competition. While this outlook represents our current judgment on the future direction of the business, such risks and uncertainties could cause actual results to differ materially from any future performance suggested below. Readers are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this Form 10-Q. Packeteer undertakes no obligation to publicly release any revisions to forward-looking statements to reflect events or circumstances arising after the date of this document.

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PACKETEER, INC.

See accompanying notes to condensed consolidated financial statements.

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PACKETEER, INC.

See accompanying notes to condensed consolidated financial statements.

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PACKETEER, INC.

See accompanying notes to condensed consolidated financial statements.

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PACKETEER, INC.

1. BASIS OF PRESENTATION

     The accompanying unaudited condensed consolidated financial statements have been prepared by Packeteer, Inc., pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and include the accounts of Packeteer, Inc. and its wholly-owned subsidiaries (“Packeteer” or collectively the “Company”). All significant intercompany accounts and transactions have been eliminated in consolidation. Certain information and footnote disclosures, normally included in financial statements prepared in accordance with generally accepted accounting principles, have been condensed or omitted pursuant to such rules and regulations. While in the opinion of the Company’s management, the unaudited condensed financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary for a fair statement of interim periods presented, these financial statements and notes should be read in conjunction with its audited consolidated financial statements and notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 5, 2004.

     The results of operations for the three and nine months ended September 30, 2004 are not necessarily indicative of results that may be expected for any other interim period or for the full year ending December 31, 2004.

2. STOCK-BASED COMPENSATION

     The Company adopted Statement of Financial Accounting Standards (SFAS) No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure”, which amended SFAS 123, “Accounting for Stock-Based Compensation”, in December 2002. As permitted under SFAS 148, Packeteer has elected to continue to follow the intrinsic value method in accounting for its stock-based employee compensation arrangements. The following table illustrates the effect on net income and net income per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation (in thousands, except per share data):

3. CONTINGENCIES

     In November 2001, a putative class action lawsuit was filed in the United States District Court for the Southern District of New York against the Company, certain officers and directors of the Company, and the underwriters of the Company’s initial public offering. An amended complaint, captioned In re Packeteer, Inc. Initial Public Offering Securities Litigation, 01-CV-10185 (SAS), was filed on April 20, 2002.

     The amended complaint alleges violations of the federal securities laws on behalf of a purported class of those who acquired the Company’s common stock between the date of the Company’s initial public offering, or IPO, and December 6, 2000. The amended complaint alleges that the description in the prospectus for the Company’s IPO was materially false and misleading in describing the compensation to be earned by the underwriters of the Company’s IPO, and in not describing certain alleged arrangements among

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underwriters and initial purchasers of the Company’s common stock. The amended complaint seeks damages and certification of a plaintiff class consisting of all persons who acquired shares of the Company’s common stock between July 27, 1999 and December 6, 2000.

     A special committee of the board of directors has authorized the Company to negotiate a settlement of the pending claims substantially consistent with a memorandum of understanding negotiated among class plaintiffs, all issuer defendants and their insurers. The parties have negotiated a settlement, which is subject to approval by the Court. If the settlement is not approved, we intend to vigorously defend ourselves against plaintiffs’ allegations. We do not currently believe that the outcome of this proceeding will have a material adverse impact on our financial condition, results of operations or cash flows. No amount has been accrued as of September 30, 2004, as management believes a loss is not probable or estimable.

     We are routinely involved in legal and administrative proceedings incidental to our normal business activities and believe that these matters will not have a material adverse effect on our financial position, results of operations or cash flows.

4. GUARANTEES

     The Company’s standard warranty period is twelve months. We record a liability for estimated warranty obligations at the date products are sold. This warranty reserve approximates the aggregate amount of expected replacement and repair costs for our products. Our warranty reserve is based on historical product repair and replacement information. The following provides a reconciliation of the changes in Packeteer’s warranty reserve from December 31, 2003 to September 30, 2004 (in thousands):

     We occasionally provide guarantees that could require us to make future payments in the event that the third party primary obligor does not make its required payments. In March 2004, we entered into such an agreement guaranteeing the performance of our contract manufacturer in meeting their obligations on a specific purchase order that covers a 15-month supply of a particular component. At September 30, 2004, our maximum remaining liability under this guarantee is $54,000. In accordance with the Financial Accounting Standards Board (FASB) Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (FIN 45), we have not recorded a liability for this guarantee.

     Additionally, our distributor and reseller agreements generally include a provision for indemnifying such parties against certain liabilities if our products are claimed to infringe a third party’s intellectual property rights. To date we have not incurred any costs as a result of such indemnifications and have not accrued any liabilities related to such obligations in the accompanying condensed consolidated financial statements.

5. INCOME TAXES

     Our income tax provision for the periods ended September 30, 2004 and 2003 is primarily attributable to income taxes payable in foreign jurisdictions. The effective tax rate for the nine-month periods ended September 30, 2004 and 2003 is approximately 10%.

     Our future effective tax rates could be significantly impacted by lower than anticipated earnings in countries where we have lower statutory rates and higher than anticipated earnings in countries where we have higher statutory rates, changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws or interpretations thereof. In addition, our income tax returns may be examined by various tax authorities. We regularly assess the likelihood of adverse outcomes which could result from any such examination to determine the adequacy of our income tax provision.

     As of December 31, 2003, deferred tax assets of approximately $23.6 million were available to the Company to offset future taxable income. Due to the uncertainty regarding the realizability of the deferred tax assets, a full valuation allowance has been recorded. Management will re-evaluate the need for the valuation allowance in future periods. The Company does not expect to recognize a significant tax provision until after a substantial portion of the net operating losses are utilized.

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6. NET INCOME PER SHARE

     Basic net income per share has been computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share has been computed using the weighted average number of common and potential common shares outstanding during the period. At September 30, 2004 and 2003, there were 2,576,233 and 352,305 shares, respectively, issuable upon the exercise of stock options excluded from the computation because the exercise price was greater than the average market price.

     The following table presents the calculation of basic and diluted net income per share (in thousands, except per share amounts):

7. COMPREHENSIVE INCOME (LOSS)

     The Company reports comprehensive income (loss) in accordance with the provisions of SFAS 130, “Reporting Comprehensive Income.” SFAS 130 establishes standards for reporting comprehensive income and its components in financial statements. The difference between reported net income and comprehensive income (loss) is not considered material for the periods presented.

8. SEGMENT REPORTING

     The Company has adopted the provisions of SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.” The Company’s chief operating decision maker is considered to be the Company’s Chief Executive Officer, or CEO. The CEO reviews financial information presented on a consolidated basis substantially similar to the accompanying condensed consolidated financial statements. Therefore, the Company has concluded that it operates in one segment and accordingly has provided only the required enterprise-wide disclosures.

     The Company operates in the United States and internationally and derives its revenues from the sale of products and software licenses and maintenance contracts related to these products. For the three months ended September 30, 2004, sales to two customers, Alternative Technology, Inc. and Westcon, Inc., accounted for 26% and 16% of total net revenues, respectively. For the nine months ended September 30, 2004, sales to the same two customers accounted for 23% and 19% of total net revenues, respectively. For the three months ended September 30, 2003, sales to three customers, Alternative Technology, Inc., Westcon, Inc. and Macnica Inc., accounted for 20%, 12% and 11% of total net revenues, respectively. For the nine months ended September 30, 2003, sales to two customers, Alternative Technology, Inc. and Westcon, Inc., accounted for 22% and 13% of total net revenues, respectively.

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     Geographic information (in thousands):

     Net revenues reflect the destination of the shipped product. The Americas net revenue includes Latin America and South America, which have historically accounted for between 1% and 2% of total net revenues. These revenues were previously included in Europe and Rest of World.

     Long-lived assets are primarily located in North America. Assets located outside North America are not significant.

9. RECENT ACCOUNTING PRONOUNCEMENTS

     In November 2003, the Emerging Issues Task Force, or EITF, reached a consensus on certain portions of EITF 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. EITF 03-01 provides new disclosure requirements for other-than-temporary impairments on debt and equity investments. Investors are required to disclose quantitative information about: (i) the aggregate amount of unrealized losses, and (ii) the aggregate related fair values of investments with unrealized losses, segregated into time periods during which the investment has been in an unrealized loss position of less than 12 months and greater than 12 months. In addition, investors are required to disclose the qualitative information that supports their conclusion that the impairments noted in the qualitative disclosure are not other-than temporary. The Company adopted the initial disclosure requirements of EITF 03-01 in December 2003. The adoption of the remaining portions of EITF 03-01 has been postponed by the Financial Accounting Standards Board pending issuance of additional implementation guidance regarding the impairment of certain debt securities.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW

     Packeteer is the pioneer and global market leader in Application Traffic Management for wide area networks. Our solutions are designed to empower IT organizations with patented network visibility, control, and acceleration capabilities delivered through a family of intelligent, scalable appliances.

     The Packeteer application traffic management system consists of a family of appliances with performance capabilities that make them capable of deployment within large data centers as well as smaller remote sites throughout a distributed enterprise. Each appliance can be configured to deliver the full range of application traffic management solutions, from visibility with PacketSeeker®, to control with PacketShaper®, to compression with PacketShaper Xpress™. In addition, each appliance can be managed individually or in the context of a completely integrated policy-based application traffic management system distributed across multiple locations, using our ReportCenter™ or PolicyCenter™ software products.

     Packeteer’s products are deployed at more than 7,000 enterprises and service providers worldwide, and are sold through an established network of more than 100 resellers, distributors and system-integrators in more than 50 countries, complemented by our direct sales force. Our sales force and marketing efforts are used to develop brand awareness, drive demand for system solutions and support our indirect channels.

     Although we have reported net income for eleven consecutive quarters, we have a prior history of losses. As of September 30, 2004, we had an accumulated deficit of $83.6 million. Although we earned net income of $8.8 million for the nine months ended September 30, 2004, and $11.0 million and $3.7 million for the years ended December 31, 2003 and 2002, respectively, we incurred losses since we commenced operations in 1996 until 2002, and our profitability could be difficult to sustain. We expect to continue to incur significant sales and marketing, product development and administrative expenses and, as a result, will need to generate significant quarterly revenues to maintain profitability. With the increase in our installed base, we plan to continue to invest in our customer support group. We plan to continue to invest in the development and support of our reseller and distributor relationships. We

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also plan to continue to invest in various marketing campaigns and expand our international sales operations. We plan to continue to invest in research and development activities to enhance existing products and develop new features in response to customer demands. We will also add to our infrastructure to support our growing business.

     We believe that our current value proposition, which enables our enterprise customers to get more value out of existing network resources and improved performance of their critical applications, should allow us to continue to grow our business during the remainder of 2004. Our growth rate and net revenues depend significantly on continued growth in the application traffic management market, our ability to develop and maintain strong partnering relationships with our indirect channel partners and our ability to expand or enhance our current product offerings or respond to technological change. Our growth in service revenues is dependent upon increasing the number of units under maintenance, which is dependent on both growing our installed base and renewing existing maintenance contracts. Our future profitability and rate of growth, if any, will be directly affected by the continued acceptance of our product in the marketplace, as well as the timing and size of orders and shipments, product mix, average selling price of our products and general economic conditions. Our failure to successfully convince the market of our value proposition and maintain strong relationships with our indirect channel partners to ensure the success of their selling efforts on our behalf, would adversely impact our net revenues and operating results.

SOURCES OF REVENUE

     We derive our revenue from two sources, product revenues and service revenues. Product revenues consist primarily of sales of our application traffic management systems. Service revenues consist primarily of maintenance revenues and, to a lesser extent, training revenues. Product revenues accounted for 79% and 81% of our net revenues for the three and nine months ended September 30, 2004, respectively, and 82% and 83% of our net revenues for the three and nine months ended September 30, 2003, respectively. Service revenues continue to increase as our installed base grows, accounting for 21% and 19% of net revenues for the three and nine months ended September 30, 2004, respectively, and 18% and 17% of net revenues for the three and nine months ended September 30, 2003, respectively. Maintenance revenues are recognized on a monthly basis, over the life of the contract. The typical subscription and support term is twelve months, although multi-year contracts are sold.

COST OF REVENUES AND OPERATING EXPENSES

     Cost of Revenues. Our cost of revenues consists of the cost of finished products purchased from our contract manufacturer, overhead costs and service support costs.

     For finished product, we outsource all of our manufacturing to one contract manufacturer, SMTC Manufacturing Corporation, or SMTC. We design and develop a majority of the key components of our products, including printed circuit boards and software. In addition, we determine the components that are incorporated into our products and select the appropriate suppliers of these components. Our overhead costs consist primarily of personnel related costs for our product operations and order fulfillment groups and other product costs such as warranty and fulfillment charges. Service support costs consist primarily of personnel related costs for our customer support and training groups, as well as fees paid to third-party service providers to facilitate next business day replacement for end user customers located outside the United States. Additionally, we allocate overhead such as facilities, depreciation and IT costs to all departments based on headcount and usage. As such, general overhead costs are reflected in each cost of revenue and operating expense category.

     We must continue to work closely with our contract manufacturer as we develop and introduce new products and try to reduce production costs for existing products. To the extent our customer base continues to grow, we intend to continue to invest additional resources in our customer support group and expect that our fees to third-party service providers will continue to increase as our international installed base grows.

     Research and Development. Research and development expenses consist primarily of salaries and related personnel expenses, allocated overhead, consultant fees and prototype expenses related to the design, development, testing and enhancement of our products and software. We have historically focused our research and development efforts on developing and enhancing our application traffic management solutions. We expect that in the future, our research and development spending will increase in absolute dollars as we continue to develop and maintain competitive products and enhance our current products by adding innovative features that differentiate our products from those of our competitors. We believe that continued investment in research and development is critical to attaining our strategic product and cost control objectives. Although we expect higher absolute spending levels in the upcoming quarters, we intend that our spending will remain within, or slightly below, our current long-term business model target of 18% of net revenues.

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     Sales and Marketing. Sales and marketing expenses consist primarily of salaries, commissions and related personnel expenses for those engaged in the sales, marketing and support of the product, as well as related trade show, promotional and public relations expenses and allocated overhead. Sales and marketing is our largest cost, accounting for 36% and 38% of net revenues for the three and nine months ended September 30, 2004, respectively. We plan to continue to increase sales and marketing headcount for the remainder of 2004, as we continue to expand our global presence. We intend to continue to invest in various sales and marketing campaigns and, expect expenses in absolute dollars to increase in the fourth quarter of 2004. Particularly, we have introduced new channel marketing programs, replacing previous channel rebate programs, and will see the impact of these changes in operating expenses for the fourth quarter of 2004. We expect that sales and marketing expenses will continue to exceed our current long-term business model target of 30% to 32% of net revenues for at least the next twelve to eighteen months.

     General and Administrative. General and administrative expenses consist primarily of salaries and related personnel expenses for administrative personnel, professional fees, allocated overhead and other general corporate expenses. We expect general and administrative expenses to continue to be in line with our long-term business model target of 6% to 7% of net revenues.

CRITICAL ACCOUNTING POLICIES

     Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to inventory valuation, valuation allowances including sales return reserves and allowance for doubtful accounts, and other liabilities, specifically warranty reserves. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates.

     We believe that of our significant accounting policies, which are described in Note 1 of the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, we believe the accounting policies below are the most critical to aid in fully understanding and evaluating our condensed consolidated results of operations and financial condition.

     Revenue recognition. The Company applies the provisions of Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions,” to all transactions involving the sale of hardware and software products. Revenue is generally recognized when all of the following criteria are met as set forth in paragraph 8 of SOP 97-2:

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persuasive evidence of an arrangement exists,

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delivery has occurred,

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the fee is fixed or determinable, and

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collectibility is probable.

     Receipt of a customer purchase order is persuasive evidence of an arrangement. Sales through our distribution channel are evidenced by an agreement governing the relationship together with purchase orders on a transaction-by-transaction basis.

     Delivery generally occurs when product is delivered to a common carrier from Packeteer or its designated fulfillment house. For maintenance contracts, delivery is deemed to occur ratably over the contract period.

     The Company’s fees are typically considered to be fixed or determinable at the inception of the arrangement and are negotiated at the outset of an arrangement, generally based on specific products and quantities to be delivered. In the event payment terms are provided that differ significantly from our standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized as the fees become due and payable.

     We assess collectibility based on a number of factors, including credit worthiness of the customer and past transaction history with the customer.

     Our standard revenue recognition policy includes modifications under certain circumstances as follows: Product revenue on sales to major new distributors is recorded based on sell-through to the end user customers until such time as the Company has established

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significant experience with the distributor’s product exchange activity. Additionally, when the Company introduces a new product into its distribution channel for which there is no historical customer demand or acceptance history, revenue is recognized on the basis of sell-through to end user customers until such time as demand or acceptance history has been established.

     The Company has analyzed all of the elements included in its multiple element arrangements and has determined that it has sufficient vendor specific objective evidence, or VSOE, of fair value to allocate revenue to the maintenance component of its product and to training. VSOE is based upon separate sales of maintenance renewals and training to customers. Accordingly, assuming other revenue recognition criteria are met, revenue from product sales is recognized upon delivery using the residual method in accordance with SOP 98-9. Revenue from maintenance is recognized ratably over the maintenance term and revenue from training is recognized when the training has taken place. To date, training revenues have not been material.

     Inventory valuation. Inventories consist primarily of finished goods and are stated at the lower of cost (on a first-in, first-out basis) or market. We currently contract with SMTC for the manufacture of all of our products. We record inventory reserves for excess and obsolete inventories based on historical usage and forecasted demand. Factors which could cause our forecasted demand to prove inaccurate include our reliance on indirect sales channels and the variability of our sales cycle; the potential of announcements of our new products or enhancements to replace or shorten the life cycle of our current products, or cause customers to defer their purchases; loss of sales due to product shortages; and the potential of new or alternative technologies achieving widespread market acceptance and thereby rendering our existing products obsolete. If future demand or market conditions are less favorable than our projections, additional inventory write-downs may be required and would be reflected in cost of sales in the period the revision is made.

     Sales return reserve and allowance for doubtful accounts. In accordance with Statement of Financial Accounting Standards (SFAS) 48, “Revenue Recognition When Right of Return Exists”, management must use judgment and make estimates of potential future product returns related to current period product revenue. When providing for sales return reserves, we analyze historical return rates as they are the primary indicator for estimating future returns. Material differences may result in the amount and timing of our revenue if for any period actual returns differ from our judgments or estimates. The sales return reserve balances at September 30, 2004 and December 31, 2003 were $1.1 million and $713,000, respectively. We must also make estimates of the uncollectibility of accounts receivable. When evaluating the adequacy of the allowance for doubtful accounts, we review the aged receivables on an account-by-account basis, taking into consideration such factors as the age of the receivables, customer history and estimated continued credit-worthiness, as well as general economic and industry trends. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances could be required. The allowance for doubtful accounts was $179,000 at September 30, 2004 and $149,000 at December 31, 2003.

     Rebate Reserves. Certain distributors and resellers can earn rebates under several Packeteer programs. The rebates earned are recorded as a reduction to revenues in accordance with EITF 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendors Products)”. For established programs, the Company’s estimates for rebates are based on historical usage rates. For new programs, rebate reserves are calculated to cover the Company’s maximum exposure until such time as historical usage rates are developed. When sufficient historical experience is established, there may be a reversal of previously accrued rebates if actual rebate claims are less than the maximum exposure. Additionally, there may be a reversal of previously accrued rebate reserves if rebates are not claimed before the expiration dates established for each program. Rebate reserves at September 30, 2004 and December 31, 2003 were $1.5 million and $877,000, respectively.