UNITED STATES
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 March 31, 2004
Commission File Number 000-26819
WATCHGUARD TECHNOLOGIES, INC.
(Exact Name of Registrant as Specified in Its Charter)
| Delaware | 91-1712427 | |
| (State or Other Jurisdiction of Incorporation or Organization) |
(I.R.S. Employer Identification No.) |
505 Fifth Ave. South, Suite 500, Seattle WA 98104-3892
(Address of Principal Executive Offices) (Zip Code)
Registrant’s telephone number, including area code: (206) 521-8340
Not Applicable
(Former name, former address and former fiscal year, if changed since last report.)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to the filing requirements for the past 90 days. Yes x No ¨
Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
33,461,744 shares of WatchGuard common stock were outstanding as of April 30, 2004.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2004
TABLE OF CONTENTS
Page 2
WATCHGUARD TECHNOLOGIES, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
| December 31, 2003 |
March 31, 2004 |
|||||||
| (unaudited) | ||||||||
| ASSETS |
||||||||
| Current assets: |
||||||||
| Cash and cash equivalents |
$ | 3,899 | $ | 4,697 | ||||
| Short-term investments |
74,890 | 73,107 | ||||||
| Trade accounts receivable, net |
6,700 | 8,359 | ||||||
| Inventories, net |
3,068 | 3,650 | ||||||
| Prepaid expenses and other current assets |
3,924 | 3,258 | ||||||
| Total current assets |
92,481 | 93,071 | ||||||
| Property and equipment, net |
5,471 | 5,219 | ||||||
| Restricted cash |
3,000 | 3,000 | ||||||
| Goodwill |
66,605 | 66,605 | ||||||
| Other intangibles, net and other assets |
3,562 | 3,312 | ||||||
| Total assets |
$ | 171,119 | $ | 171,207 | ||||
| LIABILITIES AND STOCKHOLDERS’ EQUITY |
||||||||
| Current liabilities: |
||||||||
| Accounts payable |
$ | 3,676 | $ | 4,175 | ||||
| Accrued expenses and other liabilities |
6,819 | 6,500 | ||||||
| Short-term accrued restructuring and acquisition costs |
2,271 | 2,028 | ||||||
| Short-term deferred revenues |
15,675 | 16,091 | ||||||
| Total current liabilities |
28,441 | 28,794 | ||||||
| Long-term accrued restructuring costs |
4,268 | 3,983 | ||||||
| Long-term deferred revenues |
1,072 | 1,205 | ||||||
| Total liabilities |
33,781 | 33,982 | ||||||
| Stockholders’ equity: |
||||||||
| Preferred stock, $0.001 par value: |
||||||||
| Authorized shares: 10,000,000 |
||||||||
| No shares issued and outstanding |
— | — | ||||||
| Common stock, $0.001 par value: |
||||||||
| Authorized shares: 80,000,000 |
||||||||
| Shares issued and outstanding: 33,091,787 at December 31, 2003 and 33,409,705 at March 31, 2004 |
33 | 33 | ||||||
| Additional paid-in capital |
267,649 | 269,038 | ||||||
| Deferred stock-based compensation |
(25 | ) | (13 | ) | ||||
| Accumulated other comprehensive income (loss) |
(41 | ) | 60 | |||||
| Accumulated deficit |
(130,278 | ) | (131,893 | ) | ||||
| Total stockholders’ equity |
137,338 | 137,225 | ||||||
| Total liabilities and stockholders’ equity |
$ | 171,119 | $ | 171,207 | ||||
See accompanying notes.
Page 3
WATCHGUARD TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(unaudited)
| Three Months Ended March 31, |
||||||||
| 2003 |
2004 |
|||||||
| Revenues: |
||||||||
| Product |
$ | 14,579 | $ | 14,994 | ||||
| Service |
7,230 | 6,482 | ||||||
| Total revenues |
21,809 | 21,476 | ||||||
| Cost of revenues: |
||||||||
| Product |
4,975 | 6,397 | ||||||
| Service |
1,475 | 1,344 | ||||||
| Total cost of revenues |
6,450 | 7,741 | ||||||
| Gross margin |
15,359 | 13,735 | ||||||
| Operating expenses: |
||||||||
| Sales and marketing (1) |
8,673 | 8,395 | ||||||
| Research and development (2) |
5,219 | 4,539 | ||||||
| General and administrative (3) |
1,934 | 2,252 | ||||||
| Stock-based compensation |
121 | 11 | ||||||
| Amortization of other intangible assets acquired |
518 | 244 | ||||||
| Total operating expenses |
16,465 | 15,441 | ||||||
| Operating loss |
(1,106 | ) | (1,706 | ) | ||||
| Interest income, net: |
||||||||
| Interest income |
413 | 274 | ||||||
| Interest expense |
(150 | ) | (169 | ) | ||||
| Total interest income, net |
263 | 105 | ||||||
| Loss before income taxes |
(843 | ) | (1,601 | ) | ||||
| Provision for income taxes |
6 | 14 | ||||||
| Net loss |
$ | (849 | ) | $ | (1,615 | ) | ||
| Basic and diluted net loss per share |
$ | (0.03 | ) | $ | (0.05 | ) | ||
| Shares used in calculation of basic and diluted net loss per share |
32,740 | 33,250 | ||||||
| (1) | Sales and marketing expenses exclude amortization of stock-based compensation of $13 and $2 for the three months ended March 31, 2003 and 2004, respectively. |
| (2) | Research and development expenses exclude amortization of stock-based compensation of $94 and $6 for the three months ended March 31, 2003 and 2004, respectively. |
| (3) | General and administrative expenses exclude amortization of stock-based compensation of $14 and $3 for the three months ended March 31, 2003 and 2004, respectively. |
See accompanying notes.
Page 4
WATCHGUARD TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(unaudited)
| Three Months Ended March 31, |
||||||||
| 2003 |
2004 |
|||||||
| Operating activities: |
||||||||
| Net loss |
$ | (849 | ) | $ | (1,615 | ) | ||
| Adjustments to reconcile net loss to net cash used in operating activities: |
||||||||
| Noncash expenses: |
||||||||
| Depreciation and amortization of property and equipment |
722 | 723 | ||||||
| Amortization of other intangible assets acquired |
518 | 244 | ||||||
| Stock-based compensation |
121 | 11 | ||||||
| Changes in operating assets and liabilities: |
||||||||
| Trade accounts receivable, net |
(1,370 | ) | (1,659 | ) | ||||
| Inventories, net |
(1,817 | ) | (582 | ) | ||||
| Prepaid expenses and other current assets |
500 | 666 | ||||||
| Other assets |
138 | 6 | ||||||
| Accounts payable |
776 | 499 | ||||||
| Accrued expenses and other liabilities |
1,427 | (319 | ) | |||||
| Accrued restructuring and acquisition costs |
(1,590 | ) | (528 | ) | ||||
| Deferred revenues |
363 | 549 | ||||||
| Net cash used in operating activities |
(1,061 | ) | (2,005 | ) | ||||
| Investing activities: |
||||||||
| Purchases of property and equipment |
(757 | ) | (471 | ) | ||||
| Proceeds from maturities of marketable securities |
42,655 | 9,115 | ||||||
| Purchases of marketable securities |
(37,992 | ) | (7,231 | ) | ||||
| Net cash provided by investing activities |
3,906 | 1,413 | ||||||
| Financing activities: |
||||||||
| Proceeds from stock option exercises and issuances of common stock under the employee stock purchase plan |
751 | 1,390 | ||||||
| Net cash provided by financing activities |
751 | 1,390 | ||||||
| Net increase in cash and cash equivalents |
3,596 | 798 | ||||||
| Cash and cash equivalents at beginning of period |
8,890 | 3,899 | ||||||
| Cash and cash equivalents at end of period |
$ | 12,486 | $ | 4,697 | ||||
See accompanying notes.
Page 5
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
NOTE 1 – DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION
Description of Business
WatchGuard Technologies, Inc. (WatchGuard) is a leading provider of Internet security solutions designed to protect small- to medium-sized enterprises, or SMEs, that use the Internet for electronic commerce and secure communications.
Interim Financial Information
The accompanying consolidated unaudited financial statements of WatchGuard, which include the December 31, 2003 balance sheet that was derived from audited consolidated 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, the unaudited financial statements include all adjustments, consisting of normal recurring accruals, necessary for a fair presentation. Operating results for the three-month period ended March 31, 2004 are not necessarily indicative of the results that may be expected for future quarters or for the year ending December 31, 2004. The financial statements should be read in conjunction with the financial statements and related notes for the year ended December 31, 2003 included in WatchGuard’s annual report on Form 10-K, filed with the Securities and Exchange Commission (SEC) on March 15, 2004.
NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Revenue Recognition
WatchGuard generates revenues through sales of its Firebox products, including licenses for related software options, subscriptions for its LiveSecurity Service, which includes access to technical support, software updates (if and when available), early-warning vulnerability alerts and expert instruction and training, and sales of ServerLock products. Software license revenues are generated from licensing the rights to use WatchGuard’s products directly to end-users, from sublicense fees from resellers and distributors and from sales of its managed security solution products to Internet service providers and other service providers that utilize WatchGuard’s products to provide managed security services to their customers.
WatchGuard recognizes revenue in accordance with accounting standards for software companies, including Statement of Position (SOP) 97-2, “Software Revenue Recognition,” as amended by SOP 98-9, and related interpretations, including Technical Practice Aids and the SEC Topic 13 “Revenue Recognition” of the codification of the Staff Accounting Bulletins. Topic 13 summarizes certain of the SEC’s views in applying generally accepted accounting principles to revenue recognition in financial statements. WatchGuard believes its current revenue recognition policies and practices are consistent with the current accounting standards.
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 of fair value for undelivered elements of the arrangement has been established. Vendor-specific objective evidence of fair value is typically based on the price charged when an element is sold separately or, if an element is 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 revenues to delivered elements once it has established vendor-specific objective evidence of fair value for all undelivered elements. Under the residual method, any discount in the arrangement is allocated to the delivered element.
WatchGuard provides allowances for estimated returns and return rights and pricing protection rights, which are offered to most customers. WatchGuard also provides allowances for promotional rebates offered to its customers. A customer’s return rights are generally limited to the lesser of its on-hand inventory or a percentage of the customer’s purchases for the previous quarter. Pricing protection rights, offered to many of WatchGuard’s customers, are generally limited to 60 to 90 days after notification of a price change. Revenues are reduced by the provision for estimated returns and allowances at the time the sales are made.
Page 6
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
The promotional rebates vary by type and term and are earned by customers in accordance with various conditions. WatchGuard accounts for promotional rebates given to customers in accordance with the Emerging Issues Task Force (EITF) Issue No. 01-09, “Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Product,” which requires that sales incentives given to customers or resellers be accounted for as a reduction of revenue unless a vendor receives a benefit that is identifiable and can be reasonably estimated. WatchGuard accrues allowances for rebates to the maximum amount possible unless there are sufficient historical trends which would indicate a lower rate of accrual is appropriate.
Revenues from some distribution arrangements where the distributor has unlimited stock returns and rotation rights are not recognized until the distributors sell the products to their customers.
Revenues from LiveSecurity Service subscriptions are recognized ratably over the term of the subscription, typically 90 days to two years. WatchGuard’s payment terms typically range from 30 to 60 days.
Principles of Consolidation
The consolidated financial statements include the accounts of WatchGuard and its wholly owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation.
Net Loss Per Share
Basic and diluted net loss per share is calculated using the average number of shares of common stock outstanding. Other common stock equivalents, including stock options, are excluded from the computation because their effect is antidilutive.
Comprehensive Loss
WatchGuard’s investments consist of corporate and government debt securities, are considered available-for-sale, and are stated at fair value, with unrealized gains and losses included as a component of stockholders’ equity. During the three-month periods ended March 31, 2003 and March 31, 2004, there were no material realized gains or losses on securities available-for-sale. All such investments mature within two years, with the weighted average life of the investment portfolio being approximately one year. The following table sets forth the components of comprehensive loss (in thousands):
| Three Months Ended March 31, |
||||||||
| 2003 |
2004 |
|||||||
| Net loss |
$ | (849 | ) | $ | (1,615 | ) | ||
| Unrealized gain (loss) on investments |
(10 | ) | 101 | |||||
| Comprehensive loss |
$ | (859 | ) | $ | (1,514 | ) | ||
Stock-based Compensation
WatchGuard has elected to apply the disclosure-only provisions of Statement of Financial Accounting Standard (SFAS) 123, “Accounting for Stock-Based Compensation,” as amended by SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” Accordingly, WatchGuard accounts for employee stock-based compensation using the intrinsic value method prescribed in Accounting Principle Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Compensation cost for stock options is measured as the excess, if any, of the fair value of WatchGuard’s common stock at the date of grant over the stock option exercise price.
Pro Forma Disclosures Under SFAS 123
The following pro forma information regarding stock-based compensation has been determined as if WatchGuard had accounted for its employee stock options and its employee stock purchase plan shares under the fair market value method of SFAS 123. The fair value of the employee stock options was estimated at the date of grant, using a minimum value option pricing model through the date of WatchGuard’s initial public offering in July 1999 and using the Black-Scholes pricing model thereafter. The estimated fair value of the options is amortized over their vesting periods using the accelerated method.
Page 7
WATCHGUARD TECHNOLOGIES, INC.