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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

Form 10-K

 
 
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the year ended December 31, 2009

or
 
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from              to             .

Commission File Number 000-27723
 
SonicWALL, Inc.
(Exact name of registrant as specified in its charter)
     
California
 
77-0270079
(State or other jurisdiction of incorporation or organization)
 
(IRS Employer Identification No.)

2001 Logic Drive
San Jose, CA 95124
(Address of Principal Executive Offices, including zip code)

(408) 745-9600
(Registrant’s Telephone Number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
Name of each exchange on which registered
Common Stock, no par value
The NASDAQ Stock Market LLC
 
(The Nasdaq Global Select Market)

Securities registered pursuant to Section 12(g) of the Act:
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  ¨    No  x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes  ¨    No  x
 
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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨                                                                               Accelerated filer x
 
Non-accelerated filer  ¨                                                                              Smaller reporting company ¨
(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes  ¨    No  x
 
As of June 30, 2009, the aggregate market value of Common Stock held by non-affiliates of the registrant (based upon the closing sale price on the NASDAQ Global Market on that date) was approximately $225,880,586.  Shares held by each executive officer, director and by each person who owns 10% or more of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates.  This determination of affiliate status is not necessarily a conclusive determination for other purposes.
 
As of February 28, 2010, there were 54,577,511 shares of the Registrant’s Common Stock outstanding.  This is the only outstanding class of common stock of the Registrant.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Certain portions of the registrant’s proxy statement for its 2009 annual meeting of shareholders, to be filed with the Securities and Exchange Commission pursuant to Regulation 14A, are incorporated by reference into Part III of this Form 10-K.

 



 
EXPLANATORY NOTE

The Consolidated Financial Statements of SonicWALL, Inc. as of and for the fiscal years ended December 31, 2008 and 2007, and related financial information, have been restated to correct errors in the accounting for deferred tax assets related to unrealized gains and losses on available-for-sale securities as discussed in Note 5 of the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report. As the net unrealized losses from available-for-sale securities are recognized through Other Comprehensive Income, the impacts of these errors do not affect tax expense and are recorded in Other Comprehensive Income. Consequently, the Company has restated the Consolidated Balance Sheet as of December 31, 2008 and the Consolidated Statement of Shareholder’s Equity for the years ended December 31, 2008 and December 31, 2007.  The errors have no effect on the previously reported Consolidated Statements of Operations or Consolidated Statements of Cash Flows.  Restated balances have been identified where appropriate.

We are filing this comprehensive Annual Report on Form 10-K for the fiscal year ended December 31, 2009 with expanded financial and other disclosures in lieu of filing a separate amended Annual Report on Form 10-K/A for the fiscal years ended December 31, 2008 and 2007. This comprehensive report is being filed to facilitate the dissemination of current financial and other information to investors. The Company does not intend to file a separate amended Annual Report on Form 10-K/A for the fiscal years ended December 31, 2008 and 2007 to reflect restated financial information. The financial information that has been previously filed or otherwise reported for these periods is superseded by the information in this Annual report on Form 10-K, and the financial statements and related financial information contained in those previously filed reports should no longer be relied upon.



 
     
   
 Page  
   
PART I
   5   
 
ITEM 1. Business
  
 
ITEM 1A. Risk Factors
  16 
 
ITEM 1B. Unresolved Staff Comments
  27
 
ITEM 2. Properties
  27 
 
ITEM 3. Legal Proceedings
  28
 
ITEM 4. Submission of Matters to a Vote of Security Holders
  28
PART II
  29  
 
ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters
  29
 
ITEM 6. Selected Consolidated Financial Data
  31
 
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
  32
 
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk
  55
 
ITEM 8. Financial Statements and Supplementary Data
  57
 
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
  93
 
ITEM 9A. Controls and Procedures
  93
 
ITEM 9B. Other Information
  94
PART III
  95
 
ITEM 10. Directors, Executive Officers and Corporate Governance
  95
 
ITEM 11. Executive Compensation
  95
 
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
  95
 
ITEM 13. Certain Relationships and Related Transactions, and Director Independence
  95
 
ITEM 14. Principal Accounting Fees and Services
  95
PART IV
  96
 
ITEM 15. Exhibits and Financial Statement Schedules
  96 
SIGNATURES
 102
 
 
 

 
CAUTIONARY NOTE ON FORWARD-LOOKING STATEMENTS

This Annual Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act and Section 21E of the 1934 Act.  We intend that the forward-looking statements be covered by the safe harbor provisions for forward-looking statements in these sections.  In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “intend,” or “continue,” the negative of such terms or other comparable terminology.  These statements are only predictions, reflecting our expectations for future events or our future financial performance.  Actual events or results may differ materially.  In evaluating these statements you should specifically consider various factors, including the risks outlined under “Risk Factors.”  These factors may cause our actual results to differ materially from any forward-looking statement.

We cannot guarantee future results, levels of activity, performance, or achievements.  You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Annual Report.

PART I


Overview

SonicWALL designs, develops, manufactures, and sells network security, content security, and business continuity solutions for businesses of all sizes.  Our products are designed to provide secure Internet access to both wired and wireless broadband customers, enable secure Internet-based connectivity for distributed organizations, inspect  the content entering and leaving our customers’ networks, protect organizations against inbound and outbound email threats, and provide business continuity in the case of data or connectivity loss.  We believe our security appliances and software provide high-performance, robust, reliable, easy-to-use, and affordable security solutions for our customers.  Additionally, our Internet security products are designed to make our customers more productive and more mobile, while still maintaining a high level of security.  As of December 31, 2009, we have sold more than 1.5 million of our Internet security appliance platforms worldwide.  We also sell value-added services for our security appliances, including content filtering, anti-spam protection, client anti-virus protection, integrated gateway anti-virus, anti-spyware, email protection, offsite data backup, and intrusion prevention on a subscription basis and license software packages such as our Global Management System (“GMS”), our Global Virtual Private Networks (“VPN”) Client, and our email security licenses.  Our GMS solutions enable distributed enterprises and service providers to manage and monitor a large number of SonicWALL Internet security appliances and deploy our security software and services from a central location thereby reducing staffing requirements, increasing the speed of deployment and lowering costs.  Our Global VPN Client provides mobile users with a simple, easy-to-use solution for securely accessing the network.

Our products and services are sold, and software licensed, through a two tiered distribution model: first to distributors and then to resellers, who provide solutions using our products, services, and software to end-user customers.

SonicWALL, Inc. was incorporated in California in 1991 as Sonic Systems.  The company name was changed to SonicWALL, Inc. in August 1999.  References in this report to “we,” “our,” “us,” and “the Company” refer to SonicWALL, Inc.  Our principal executive offices are located at 2001 Logic Drive, San Jose, California 95124, and our telephone number is (408) 745-9600.

Industry Background

Businesses access the Internet for a wide variety of uses including communications, information gathering, and commerce.  Businesses and enterprises of all sizes have accepted the Internet as a critical yet affordable means of achieving global reach and brand awareness, allowing access and shared information among a large number of geographically dispersed employees, customers, suppliers, and business partners.  The Internet has become a particularly attractive solution for small and medium size businesses due to its cost effectiveness and ease-of-use.  Larger enterprises also connect their internal networks to the Internet allowing for greater and quicker communications and expanded operations.  Many of today’s larger enterprises also have branch offices, mobile workers, and telecommuters who connect electronically through the Internet to the corporate office and each other.  The Internet has also become a vital tool of information access and communication for schools, libraries, government agencies, and other institutions.
 
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Increasing Use of Broadband Access Technologies

The connection speed by which individuals, businesses and enterprises of all sizes connect to the Internet is increasing.  Small to medium enterprises, branch offices, and consumers are benefiting from increasingly faster and always connected internet connections such as digital subscriber lines (“DSL”) and cable Internet access.  Larger enterprises are moving from T1 connectivity to T3 connectivity and in some cases to OC-3 or Ethernet connectivity.  These “broadband” connections allow for substantially faster Internet access among many simultaneous users.  Additionally, as Internet access speeds increase, both network bandwidth and network traffic speeds have significantly increased, further reflecting the ubiquity and the importance of the Internet to business operations.

Importance of Data Security

We believe Internet security is essential for businesses and enterprises due to the large amount of confidential information transmitted or accessible over the Internet.  Broadband technologies, including DSL and cable, are always connected to the Internet.  This constant connectivity increases the risk that confidential information, information controlled by privacy regulations, and other sensitive business information might be compromised by computer hackers, identity thieves, disgruntled employees, contractors, or competitors.  In addition, business or enterprise data and networks become increasingly vulnerable to security threats and sophisticated attacks as the number of connections to the Internet and the volume of confidential information accessible through the Internet increases.  Breaches of network security are costly to a business, both financially and as a source of lost productivity resulting from network and computer downtime.

The productivity gains of network use are also threatened by large volumes of unsolicited email (“spam”), which can overload mail servers and applications as well as consuming employee time.  Additionally, some types of unsolicited e-mail are conduits for network attacks, or attempt to deceive the recipient into disclosing confidential information.

As networks and the data carried on them become more essential to the conduct of business, the financial risk associated with data loss also increases.  Network security breaches can cause data loss, as can cause disk drive failures and accidental or intentional deletion of critical files.

The market for security and productivity products includes a variety of applications to address vulnerabilities and protect critical data both during transmission and at rest.  These applications include, among others, firewalls, VPN access products, anti-virus solutions, intrusion prevention, content filtering, backup and restore systems, and e-mail security products.

Integrated Solutions for Internet Security

As network connection speeds and bandwidth have increased, and as more complex forms of data are transmitted by and within enterprises, reliable solutions have developed that emphasize high rates of data transfer while maintaining the integrity and security of network data.  Enterprises of all sizes require a broad array of high performance, cost-effective products to protect their networks, delivering security and productivity not only for the central office headquarters and for perimeter branch offices but also for telecommuters and other employees working from remote locations.

We believe solutions that integrate hardware, software, and service elements overcome many of the shortcomings of solutions based upon software alone.  Software based security solutions can be difficult to install and manage, often requiring dedicated and highly skilled in-house information technology (“IT”) personnel.  Additionally, software only security solutions can also be difficult to integrate within networks, often requiring installation of dedicated server equipment and the use of complex load balancing switches to provide reliable, high-speed performance.  Our integrated solution approach can overcome many of these limitations by integrating multiple security and productivity functions into easy-to-deploy devices that are interoperable with many industry standards.  These integrated solutions can remain current through automatic update services.

The Advent of Secure Virtual Private Networks

Large and small enterprises utilize VPNs in the place of more costly private, dedicated networks or leased lines.  VPNs allow for two or more individual networks to be linked creating one large private network.  The private network is “virtual” because it leverages the public Internet as the network infrastructure.  Enterprises use VPNs to achieve a variety of objectives.  Telecommuters and traveling workers can access a corporate network to work from their out-of-office locations using remote
 
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access VPN.  Satellite and branch offices can connect to the home office network using site-to-site VPNs.  An enterprise can connect with its business partners, suppliers, and customers utilizing an Extranet VPN.  These VPN connections must be secure from unauthorized access and safe from unauthorized alteration.  To secure a VPN, information traveling between the locations is encrypted and authenticated.  To help deliver the desired quality and security levels, businesses can monitor and prioritize network traffic for business-critical applications and allocate bandwidth for specific traffic, typically using customer premises equipment encryption and authentication products.

In a distributed business model, branch offices and point-of-sale (“POS”) and other locations extend a company’s reach into key markets.  To realize these benefits, the communication link must be available at all times and be able to support the application.  VPN solutions help companies establish centralized control over branch offices, POS locations, or remote kiosks by providing the robust security and performance needed for business continuity.  A traditional site-to-site connection often requires the leasing of expensive, dedicated data lines that are difficult to deploy and manage.  With the advent of affordable broadband and standards-based VPN, organizations can deploy secure remote access via Internet connections.  With today’s VPN technology and broadband connections, enterprises of any size may use the Internet to securely communicate with their multiple locations.

Changing Mobile Computing Environment and Demand for SSL-VPN

In today’s mobile environment, information needs to be accessed by a highly diverse community of users from essentially anywhere an internet connection exists and through access devices that are not always owned or controlled by the IT organization.  For large enterprises with in-house IT personnel and higher IT spending budgets, these challenges are more easily addressable than for the more IT constrained small and mid-sized business (“SMB”).

SSL-VPN allows any user in any location where internet connectivity is available to connect to any network resource reliably and conveniently, with enhanced levels of security.  The Web browser on the user’s device provides the means for establishing an encrypted tunnel between the user’s device and the SSL-VPN gateway.  Through a Web browser, users can access applications and resources behind the gateway.  SSL-VPN solutions were originally designed for large enterprises with a feature set and price that exceeded SMB needs and means.  This situation is changing with a new generation of SSL-VPN product offerings specifically designed to meet the remote access needs of SMBs at affordable prices.

Need for Anti-Virus, Intrusion Prevention and Content Filtering Solutions

In addition to lost productivity, companies, their partners, and customers are vulnerable to severe financial losses.  This reality has been underscored by the rapid infection of many users through widespread and highly publicized virus outbreaks affecting business networks around the globe.  At the same time, we believe that issues such as loss of employee productivity, liability concerns, and network bandwidth constraints continue to fuel the growth of content filtering.  Enterprises are deploying anti-virus protection, content filtering, and intrusion prevention solutions across the enterprise and expending technical resources to keep these defenses updated against the latest virus threats and objectionable or inappropriate content.

Rising Value of Data and Demand for Business Continuity

As enterprises increase their reliance on networked computer systems to develop products, maintain relationships with customers, and conduct commerce, the data stored on the networked systems become increasingly critical to the productivity and success of the business.  Loss of important files or data can result in significant interruptions in the ability of a company to conduct business.  To counter this risk and to meet emerging and existing regulatory requirements, companies have traditionally turned to tape-based backup and restoration technologies.  Increasing performance of hard disk drives and the speed of internet connectivity coupled with reduced costs have given rise to alternatives to tape-based solutions.  These solutions offer continuous, rather than point-in-time, data protection as well as higher performance.

Increases in Unsolicited E-Mail

Email is one of the most critical business applications making use of the Internet.  Recent years have seen a dramatic rise in the amount of unsolicited email (“spam”) directed to both consumers and business Internet users.  This unsolicited email can be a nuisance at best, consuming employee productivity.  In more extreme cases, spam can cause email servers to slow down or even stop working, causing delays or interruptions in business operations.  Aside from the employee and network
 
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productivity degradations, some forms of unsolicited mail may be conduits for network attacks or may contain other types of threats, including attempts to cause recipient computers to execute malicious code, or attempts to mislead recipients into disclosing confidential information to criminal enterprises engaged in fraud or theft.

Strategy

Our goal is to build on our leadership position in Internet security by continuing the transition of our company to a comprehensive provider of integrated network security, content security, and business continuity solutions.  We plan to accomplish our goal by focusing on value innovation, the process whereby we deliver solutions with price-performance advantages.

Key elements of our strategy include:

Global Growth.  We plan to focus our investment in those geographical areas that can sustain rates of growth consistent with our business objectives.  Part of our global growth initiative also includes taking advantage of supply chain improvements wherever possible.  We believe that this type of alignment of our resources will strengthen our global position.

Continue to Bring New Products to the Market.  We use our internal product design and development and integration expertise to produce solutions that deliver value to our end-users.

Cost Reduction.  We intend to be vigorous in our pursuit to lower costs in all aspects of our business.  Supply chain improvements and continual business process improvement are key components of this initiative.  We believe that the associated cost reductions will strengthen our market position and assist us in penetrating new markets.

Strengthen Our Indirect Channel.  Our global target markets are generally served by a two-tier distribution model.  We have achieved varying degrees of regional penetration in these markets with large-scale distributors at the hub of our model fulfilling the needs of authorized resellers and systems integrators and creating a distribution web that covers over 50 countries.  We intend to continue to implement programs designed to enhance our competitive position through distributors and authorized resellers.

Increase Services and Software Revenue.  We intend to continue to develop new services and licensed software offerings to generate additional revenue from our installed base and to provide additional sources of revenue ancillary to our product sales.  We currently offer a selection of integrated functionality including gateway anti-virus, client anti-virus, anti-spyware, anti-spam protection, intrusion prevention, offsite data backup, email security, and content filtering subscription services.  We also offer fee-based customer support services and training.  We have dedicated sales and marketing personnel and programs that focus on selling these services, as well as add-on products to our existing base of customers.

Inorganic Growth.  We intend to continue to explore corporate opportunities to enhance our ability to broaden the product range that we bring to the market.  Where appropriate, we may license, OEM, or acquire technologies in order to better address the current and future requirements of our customers.

The SonicWALL Solutions

SonicWALL provides comprehensive Internet security solutions that include network security, business continuity and content security, training and support services.  Our Internet gateways serve as platforms for which SonicWALL sells additional software and services to enhance customer security and productivity.  Our solutions provide cost effective and high performance Internet security solutions to small, medium, and large enterprise users in commercial, healthcare, education, and government markets.

SonicWALL products are designed to provide comprehensive Internet security solutions for (1) networks ranging in size from one to many thousands of end points; (2) enterprises having branch offices, telecommuting employees or POS locations; and (3) e-commerce applications that handle millions of secure transactions daily.  Our security appliances span a wide range of requirements, from single-user appliances to rack-mounted enterprise-class units capable of supporting thousands of users.  Our products offer substantial flexibility in the number of supported users, the number of ports, and a variety of software
 
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options such as gateway anti-virus, anti-spyware, intrusion prevention and content filtering, protection against spam, phishing, virus, and other attacks, as well as management and reporting tools that enable our customers to easily manage SonicWALL appliances installed throughout their networks.

Security Appliances

SonicWALL’s current generation line of security appliances can be categorized into the following groups. Each group provides appliances for small, medium, and large networks and businesses.

SonicWALL Unified Threat Management (UTM) Appliances.  The UTM products consist of the TZ, NSA, and NSA E-class appliance series. The TZ series is a security platform for home, small and remote/branch offices. The TZ series offerings include wireless features. The Network Security Appliance (NSA) and the NSA E-class appliance series represent our higher performance UTM appliances and are designed to provide a comprehensive security platform for complex networks.

SonicWALL SSL VPN Appliances.  The SSL-VPN products are designed to provide a secure remote network and application access solution that requires no pre-installed client software.  Utilizing only a standard Web browser, users can access e-mail, files, intranets, remote desktops (including both full desktop and individual application access), and other resources on the corporate LAN from any location.

SonicWALL Email Security Appliances.  The Email Security products are designed to provide inbound and outbound email threat protection for the small to medium size business by protecting against spam, virus, and phishing attacks.

SonicWALL Data Backup Appliances.  The  Continuous Data Protection (CDP) Backup and Recovery products are integrated, end-to-end backup and recovery solutions for businesses and remote offices that are designed to provide automatic, real-time, disk-based data backup for productivity files, Microsoft Exchange, SQL Server, and business applications, as well as remote laptops and desktops.  These solutions also integrate “bare metal restore” capability, allowing full data restoration in circumstances where a catastrophic disk failure has occurred.

Security Application and Services

SonicWALL Internet security appliances are designed to integrate seamlessly with our line of value-added security applications to provide a comprehensive Internet security solution.  With SonicWALL’s integrated security applications and services, we believe users can reduce the integration and maintenance problems that often result from sourcing, installing, and maintaining security products and services from multiple vendors.  Our security applications and services include:

SonicWALL Global VPN Client.  Our virtual private networking capabilities enable communications over the Internet between geographically dispersed offices, workers, and partners.

SonicWALL Content Filtering Service.  Our content filtering service enables businesses, families, schools and libraries to control access to objectionable or inappropriate web sites by uniform resource locator (“URL”), keyword or application type.  We offer a content filtering subscription service that provides a list of objectionable web sites that is automatically updated.

SonicWALL Enforced Anti-Virus and Anti-Spyware Client. Our enforced anti-virus and anti-spyware subscription service for desktops and laptops integrates with our security appliances to deploy and maintain anti-virus and anti-spyware software for each user on the network without the need for desktop-by-desktop installation, configuration, and maintenance.  Users of this service receive automatic anti-virus and anti-spyware updates to all network nodes.

SonicWALL Gateway Anti-Virus, Anti-Spyware, and Intrusion Prevention. SonicWALL Gateway Anti-Virus, Anti-Spyware, and Intrusion Prevention Service is a bundled offering designed to provide a fully integrated approach against sophisticated application layer and content-based attacks.  Utilizing a deep packet inspection architecture, SonicWALL Gateway Anti-Virus, Anti-Spyware, and Intrusion Prevention Service is designed to secure the network from the core to the perimeter against a comprehensive array of dynamic threats and software vulnerabilities.

SonicWALL Anti-Virus, Email Security. SonicWALL Anti-Spam / Email Security solutions provide effective, high-performance and easy-to-use inbound and outbound email threat protection. This self-running, self-updating solution, delivers powerful protection against spam, virus and phishing attacks in addition to preventing leaks of confidential
 
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information. Combining anti-spam, anti-phishing, content filtering, policy management and content compliance capabilities in a single seamlessly integrated solution, SonicWALL Anti-Spam / Email Security solutions provide powerful protection without complexity.

SonicWALL Backup and Recovery Offsite Services.  Coupled with SonicWALL CDP, we provide offsite data protection at our secure offsite data centers.  Data replicated to SonicWALL data centers is transmitted and stored with an encryption key that is designed to be known only to the end user or SonicWALL channel partner.  This service is designed to enable customers to recover data lost in the event of natural disasters such as floods, fires, and electrical power surges, or from a theft in the business.

Global Security Management Applications

Today, enterprises and service providers face an increasing security management challenge resulting from geographically distributed networks.  As a distributed network grows and branches into multiple sub-networks linked by the Internet, so does the complexity of managing security policies.  A weakness in security implementation at any remote location can expose the entire network infrastructure to attack.

For network administrators, managing security for distributed networks on a site-by-site basis places a strain on resources.  Visits to remote sites to setup security, inspect security installations, or provide training to local personnel is time consuming, expensive, and impractical.  Administrators cannot be certain that every installation in the distributed network is complying with company security policies.  To address these realities, SonicWALL’s Global Management System (“GMS”) is designed to provide network administrators with configuration and management tools to globally define, distribute, enforce, and deploy the full range of security application services and upgrades for thousands of SonicWALL Internet security appliances. GMS is available as either software or as an integrated appliance.

Value Proposition

The SonicWALL product line of Internet security solutions provides our customers with the following key benefits:

 
High-Performance, Scalable, and Robust Access Security.  We offer our customers a comprehensive integrated security solution that includes firewall, VPN, gateway anti-virus, anti-spyware, intrusion prevention, content security, and content filtering.  Specifically, we offer the following values:
 
-   
Our access security products protect private networks against Internet-based theft, destruction, or modification of data, and can automatically notify customers if their network is under certain types of attack.  SonicWALL has been awarded the internationally recognized International Computer Security Association (“ICSA”) Firewall and VPN Certification.
 
-   
Our SSL-VPN product family  provides organizations of various  sizes with an affordable, simple and secure clientless remote network and application access solution that requires no pre-installed client software.
 
-   
Our client anti-virus services provide comprehensive virus protection with automatic updates and minimal administration.
 
-   
Our gateway anti-virus, anti-spyware, and intrusion prevention services shield networks from infection from malicious code by blocking transmissions through the gateway and disrupting background communications from existing spyware programs that transmit confidential data.
 
-   
Our content filtering service enables customers such as businesses, schools, government agencies, and libraries to restrict access to objectionable or inappropriate web sites.

 
Ease of Installation and Use.  The SonicWALL product line of Internet security solutions delivers “plug-and-play” appliances designed for easy installation and use.  SonicWALL products are configured and managed through a web browser-based interface or through our GMS and do not require reconfiguration of personal computer applications.
 
 
Low Total Cost of Ownership.  The SonicWALL product design minimizes the purchase, installation, and maintenance costs of Internet security.  The suggested retail prices of our security solutions start below $300 and scale up to over $100,000.
 
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Reliability.  The SonicWALL products are designed for reliability and uptime.  Our products use an embedded single purpose operating system.

Technology

We have designed our SonicWALL products using a unique combination of hardware and software that delivers Internet security with what we believe is excellent ease-of-use and industry-leading price/performance.

Appliance Platforms

SonicWALL’s TZ, NSA and NSA E-class products are based on a new, highly efficient processor technology, allowing us to offer a level of performance beyond any of our previous designs.  The processor technology scales from 1 to 16 cores in the current product line and is capable of expanding further to create an entire scalable product line based on this one design.

The SonicWALL’s UTM appliance solutions provide the following core features:

 
Deep Packet Inspection UTM and IPSec VPN.  The core technology is the deep packet inspection UTM software that examines all layers of the packet (from the physical layer up to application layer) and determines whether to accept or reject the requested communication based on information derived from previous communications and the applications in use.  Deep packet inspection dynamically adjusts based on the changing state of the communication running across the firewall and is invisible to users on the protected network.

 
IP Address Management.  Our appliances manage the complexity of IP addressing through Network Address Translation (“NAT”) tools which allow networks to share a small number of valid public IP addresses with an equal or larger number of client computers on the LAN.

The SonicWALL security solutions offer the following options for device management:

 
Web Browser-Based Management Interface.  This interface is designed to provide an intuitive and easy-to-use web-based management interface for rapid installation, configuration, and maintenance.  This interface can be accessed from any web browser on the internal, private network.  This interface can also be accessed remotely in a secure manner.

 
SonicWALL Global Management System.  Our global management system, SonicWALL GMS, is an enterprise software application or integrated appliance designed to enable service providers and distributed enterprises to manage their SonicWALL appliances from a central location.  SonicWALL GMS software is available to use in Windows and Sun Solaris operating environments.  SonicWALL GMS is also compatible with leading relational database management systems such as Oracle and Microsoft SQL Server.

 
Logging and Reporting.  SonicWALL appliances maintain an event log of potential security concerns, which can be viewed with a web browser or automatically sent on a periodic basis to any e-mail address.  SonicWALL appliances notify the administrator of high-priority security issues, such as an attack on a server, by immediately sending an alert message to a priority e-mail account such as an e-mail pager.  SonicWALL appliances also provide pre-defined reports that show different views of Internet usage, such as the most commonly accessed web sites.

The SonicWALL SSL-VPN solutions provide the following core features:

The SonicWALL Aventail E-Class Secure Remote Access offerings are clientless SSL-VPN solutions that deliver secure, easy-to-manage remote access for mobile enterprise organizations, supporting up to thousands of concurrent users from a single appliance.

The SonicWALL SSL-VPN Series provides organizations of all sizes with an affordable, simple and secure remote network and application access solution that requires no pre-installed client software.
 
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The SonicWALL content security solutions provide the following core features:

SonicWALL Email Security solutions provide inbound and outbound e-mail management, content compliance capabilities, anti-spam and Time Zero anti-virus technology, DHA, DoS and Zombie attack protection, end-user spam management, seamless LDAP integration, and robust reporting.

The SonicWALL CDP solutions provide the following core features:

SonicWALL CDP is a proprietary software / hardware appliance that continuously searches servers, mobile laptops, and connected desktops for file changes, coordinates protection of multiple networked client PCs and servers, updates client servers with latest versions, and coordinates updates with the SonicWALL web infrastructure.

Applications and Services

SonicWALL Internet security appliances are designed to integrate with a complete line of value-added security services to provide comprehensive Internet security.  With SonicWALL’s integrated security services, we believe that integration and maintenance problems that often result from sourcing, installing, and maintaining security products from multiple vendors are minimized.  Our security services are enabled on the base hardware platform via a software key.
 
Content Filtering.  Our Internet content filter blocks objectionable content using a list of prohibited URLs and keywords as well as cookies, Java and ActiveX scripts.
 
Gateway Anti-Virus.  Our gateway anti-virus service is intended to provide anti-virus protection throughout a business and across a distributed network and delivers protection for high threat viruses and malware by conducting inspections over the most common protocols used in today's networked environments.  Automatic anti-virus updates are available for all network nodes to protect them from new virus outbreaks.
 
Anti-Spyware.  Our gateway anti-spyware service is intended to provide anti-spyware protection throughout a business and across a distributed network and delivers protection for intrusive and unwanted applications, from being loaded onto user’s computers without their knowledge.  Automatic anti-spyware updates are available for all network nodes to protect them from new virus outbreaks.
 
Instrusion Prevention. Our intrusion prevention service utilizes a configurable, ultra-high performance deep packet inspection engine to deliver network protection while preventing known buffer overflow vulnerabilities in software.  This service also defends against various worms, Trojans, and backdoor exploits.  The service not only protects networks from attacks originating outside the network (WAN), but also from internal attacks targeting network segments (LANs), and provides a robust database of attack and vulnerability signatures that is dynamically updated as new exploits and vulnerabilities are discovered.
 
Anti-Spam Protection. Our anti-spam protection service offers end-to-end attack monitoring through a response network consisting of over one million nodes worldwide. Feedback from this service provides SonicWALL with daily information on the latest spam attacks, new spam domains and other e-mail threats, which in turn is used to deliver the most current, updated anti-spam engine on the market.

Offsite Data Backup. Our offsite data backup service uses SSL encryption, advanced compression, and backup of only binary differences. Data can be sent to a secure datacenter, via SonicWALL CDP Offsite Service, or to another CDP Appliance, via SonicWALL CDP Site-to-Site Backup. This offsite feature protects data against the risks of fire, theft, misplacement and other issues relating to tape or CD-based backup.

Competition

The market for Internet security solutions is global and highly competitive.  Competition in the markets in which we participate continues to increase.  There are few substantial barriers to entry.  Additional competition from existing competitors and new market entrants will likely occur in the future.
 
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Our competitors may be able to respond more quickly than we can to new or emerging technologies and changes in customer requirements.  In addition, our current and future competitors may integrate security solutions into the infrastructure of their existing product lines, including operating systems, routers, and browsers, in a manner that may discourage users from purchasing the products and services we offer.  Many of our current and potential competitors have greater name recognition, larger customer bases to leverage, and greater access to proprietary technology, and could therefore gain market share to our detriment.  In addition, our current and potential competitors may consolidate through mergers or acquisitions or establish cooperative relationships among themselves or with third parties.  These actions may further enhance their financial, technical, and other resources.  We expect additional competition as other established and emerging companies enter the Internet security market and new products and technologies are introduced.

Principal competitors in our markets include, but are not limited to the following, all of which sell worldwide or have a presence in most of the major markets for such products:

Enterprise firewall software providers such as Check Point, Microsoft, and Symantec;

Network equipment providers such as Cisco Systems, Lucent Technologies, and Check Point;

Security appliance providers such as WatchGuard Technologies, Fortinet, and Juniper Networks;

Content security providers such as Barracuda Networks and McAfee.

Our primary competitors in the backup / recovery market are tape drive manufacturers, software providers whose software points to tape devices, and offsite backup providers.  Competitive tape manufacturers include Sony, Hewlett-Packard, and Quantum, while software competitors include Symantec, CA, Seagate, and Iron Mountain.

Customer Service and Technical Support

We offer our customers a complete range of support programs that include electronic support, product maintenance, and personalized technical support services on a worldwide basis.  We offer direct support to customers in North America, Europe, Japan, and selected countries in Asia Pacific.  Support services in other locations are provided through SonicWALL distributors.  We now have customer support centers located in California, Arizona, Washington, United Kingdom, Japan, and India. A small portion of our technical support function is outsourced to third party service providers under agreements having an initial term of one (1) year subject to six (6) month extensions thereafter unless terminated upon 90 days prior written notice.

Our standard service offerings include support which is available during normal business hours, as well as an enhanced offering providing access to support services 24 hours a day, seven days a week.  These support offerings provide problem identification, problem resolution, replacement for failing hardware, telephone or web-based technical support, and firmware updates.  For certain large customers, SonicWALL offers custom support agreements that may include additional features including dedicated technical account management, accelerated escalation, and logistical support.

Customers

We sell our products primarily through distributors who resell the products to authorized resellers who in turn market and sell our products to end-user customers.  Our top worldwide distributors based on revenues in the year ended December 31, 2009 were Ingram Micro, Inc. (“Ingram Micro”), Tech Data Product Management, Inc. (“Tech Data”), and Alternative Technology, Inc. In November 2006, Alternative Technology was acquired by Arrow Electronics, Inc. As of June 1, 2009, Alternative Technology was absorbed into Arrow Enterprise Computing Solutions, Inc. “(Arrow”), a subsidiary of Arrow Electronics, Inc.

Sales and Marketing

Our sales and marketing efforts focus on generating and fulfilling demand for our products in the small to mid-sized business, enterprise and government markets.  Our marketing programs promote SonicWALL brand awareness and reputation as a provider of reliable, high-performance, easy-to-use, and affordable Internet security solutions including a suite of value added support, service, and software offerings.  We try to strengthen our brand through a variety of marketing programs including
 
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on-going public relations, our web site, advertising, direct mail, industry and regional trade shows, and seminars.  We intend to continue expanding and strengthening our indirect channel relationships through additional marketing programs and increased promotional activities.

We believe that SonicWALL solutions are ideally suited for the indirect channel business model.  We market and sell our solutions in this indirect channel through a two-tiered distribution structure consisting of distributors and authorized resellers in the United States and over 50 other countries.  Distributors and authorized resellers accounted for approximately 99% of our total revenue for the year ended December 31, 2009.  Authorized resellers, including systems integrators, ISPs, dealers, and mail order online catalogs, generally purchase our products from our distributors and then sell our products to end-users in our target markets.

We divide our sales organization regionally into the following territories: the Americas; Asia Pacific (“APAC”); and Europe, the Middle East and Africa (“EMEA”).  Regional sales representatives manage our relationships with our network of distributors, value-added resellers, and customers, help our value-added reseller network sell and support key customer accounts, and act as a liaison between our value-added reseller network and our marketing organization.  The regional sales representative’s primary responsibility is to help the indirect channel succeed and grow within the territory.  We also have an internal sales staff that supports the indirect channel.

Domestic Channel.  In the Americas, the primary distributors of our products to resellers are Ingram Micro, Tech Data, and Arrow.  Ingram Micro accounted for approximately 18%, 16%, and 16% of total revenue in 2009, 2008, and 2007, respectively.  Tech Data accounted for approximately 17%, 17%, and 17% of total revenue in 2009, 2008, and 2007, respectively.  Arrow accounted for 11%, 16%, and 18%, of total revenue in 2009, 2008, and 2007, respectively.

Domestic resellers receive various benefits and product discounts, generally depending on the level of purchase commitment and achievement.  Our standard reseller program offers access to sales and marketing materials.  Certain of our resellers qualify for our Medallion program, which extends those benefits by adding access to an expanded set of partnership benefits including sales and marketing tools, priority technical support and other benefits.

International Channel.  We believe there is a strong international market for our products.  International sales represented approximately 33%, 34%, and 32%, of our total revenue in 2009, 2008, and 2007.  We direct substantially all of our international resellers to an appropriate distributor in each territory.  We support our international distributors by offering localized marketing materials, sales tools, leads, co-operative marketing funds, joint advertising, discounted demonstration units, and training.  We also participate in regional press tours, trade shows, and seminars.

Original Equipment Manufacturer Channel.  From time to time we may enter into select original equipment manufacturer relationships in order to take advantage of opportunities to rapidly penetrate certain target markets.  We believe these opportunities expand our overall market while having a minor impact on our own indirect channel sales.

Research and Development

We believe that our future success will depend in large part on our ability to develop new and enhanced Internet security solutions and our ability to meet the rapidly changing needs of our target customers who have broadband access to the Internet.  We focus our research and development on evolving Internet security needs.  We have made substantial investments in hardware, firmware, and software, which are critical to drive product cost reductions and higher performance solutions.  Our research and development activities are primarily conducted at our headquarters facilities in San Jose, California as well as in Seattle, Washington, Shanghai, China and Bangalore, India.

Intellectual Property

We currently rely on a combination of patent, trademark, copyright, and trade secret laws, confidentiality provisions and other contractual provisions to protect our intellectual property.  Our intellectual property program consists of an on-going patent disclosure and application process, the purchase of intellectual property assets and the licensing of intellectual property from others.  We plan to continue our aggressive plan to build our intellectual property portfolio.  We believe that the duration of the patents we have been granted is adequate relative to the expected market lives of our products.  Despite our efforts to protect our intellectual property, unauthorized parties may misappropriate or infringe our intellectual property.  We plan to aggressively pursue any such misappropriation or infringement of our intellectual property.  Our patent applications
 
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may not result in the issuance of any patents.  Even if we obtain the patents we are seeking, we cannot guarantee that our patent rights will be valuable, create a competitive barrier, or will not be infringed by others.  Furthermore, if any patent is issued, it might be invalidated or circumvented or otherwise fail to provide us any meaningful protection.  We face additional risk of adequately protecting our intellectual property when conducting business in countries that have poorly developed or inadequately enforced intellectual property laws.  In addition, competitors may independently develop similar or superior technologies or duplicate the technologies we have developed, which could substantially limit the value of our intellectual property.

U.S. Government Export Regulation Compliance

Our products are subject to federal export restrictions on encryption strength.  Federal legal requirements allow the export of any-strength encryption to designated business sectors overseas, including U.S. subsidiaries, banks, financial institutions, insurance companies, and health and medical end-users.  We have federal export authorization that allows us to export encryption technology to commercial entities in approved countries.  In certain instances, we are required to obtain individual export licenses as a prerequisite to the exportation of the technology.  With appropriate approvals, we are able to export strong encryption to a wide range of foreign end-users, subject to certain limitations and record-keeping requirements.  Our agreements with our distributors require them to understand and comply with these export requirements in the sale and distribution of our products.

Manufacturing

We currently outsource our hardware manufacturing and assembly to contract manufacturers in the U.S. and Taiwan.  Typically, the agreements with our contract manufacturers specify an initial term of one (1) year with automatic yearly renewal terms unless terminated by either party upon 90 days prior written notice. Outsourcing our manufacturing and assembly enables us to reduce fixed overhead and personnel costs and to provide flexibility in meeting market demand.

We design and develop the key components for the majority of our products.  In addition, we generally determine the components that are incorporated in our products and select the appropriate suppliers of these components.  Product testing and burn-in are performed by our contract manufacturer using tests that we typically specify.

As part of our design and development activity, we constantly review environmental and safety regulations in the jurisdictions in which we do business.  Working with our contract manufacturers, we review the applicability of these regulations to our products and the established timetables for implementation of the regulations to position us to meet various environmental and safety restrictions on product content.

Information about Segments and Geographic Areas

Financial information relating to our segments and information on revenues generated in different geographic areas are set forth in Note 10, entitled “Segment Reporting,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this report.  In addition, information regarding risks attendant to our foreign operations is set forth under the heading “RISK FACTORS” included later in this report.

Employees

As of December 31, 2009, we had 819 employees.  Of these, 220 were employed in sales and marketing, 62 in finance and administration, 295 in research and development and 242 in support and operations.  We are not party to any collective bargaining agreements with our employees and we have not experienced any work stoppages.  We believe we have excellent relations with our employees.

Where You Can Find More Information

We make our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to such reports filed pursuant to Section 13(a) or 15(d) of the Exchange Act, available free of charge on or through our Internet website located at www.sonicwall.com, as soon as reasonably practicable after they are filed with or furnished to the SEC.
 
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We also make available on our Internet website our Corporate Governance Principles and other corporate governance related documents including the charters of the Audit Committee, Compensation Committee, and Nominations and Corporate Governance Committee of our Board of Directors, the Code of Conduct for all employees and directors, and our Code of Ethics for Principal Executive and Senior Financial Officers.  Such information is also available in print to shareholders upon request.


 
You should carefully review the following risks associated with owning our common stock.  Our business, operating results or financial condition could be materially adversely affected in the event any of the following risks were to be realized.  You should also refer to the other information set forth in this report and incorporated by reference herein, including our financial statements and the related notes.  Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

Rapid changes in technology, regulatory requirements and industry standards could render our products, software and services unmarketable or obsolete, and we may be unable to successfully introduce new products and services.

To succeed, we must continually introduce new products, software and services and change and improve our solutions in response to new competitive product introductions, rapid technological developments, changes in regulatory requirements, and changes in operating systems, Internet access, application and networking software, computer and communications hardware, programming tools, computer language technology and other security threats.  Product and service development for security, productivity, mobility, and data protection solutions requires substantial engineering time and testing.  The disparities between the laws and administrative measures adopted by various jurisdictions in which we do business create uncertainty over the applicability, scope, and form of the regulations affecting our products and services and the timing for compliance with applicable regulations.  Releasing new products, software and services prematurely may result in quality problems, and delays may result in loss of customer confidence and market share.  In the past, we have on occasion experienced delays in the scheduled introduction of new and enhanced products, software and services, and we may experience delays in the future.  We may be unable to develop new products, software, and services or achieve and maintain market acceptance of them once they have come to market.  Furthermore, when we do introduce new or enhanced products, software and services, we may be unable to manage the transition from previous generations of products or previous versions of software and services to minimize disruption in customer ordering patterns, avoid excessive inventories of older products, and deliver enough new products, software, and services to meet customer demand.  If any of the foregoing were to occur, our business could be adversely affected.

Sales to three major distributors account for a significant amount of our revenue, and if they or others cancel or delay purchase orders or fail to pay us in a timely fashion, and we are unable to offset these factors our revenue may decline and the price of our stock may fall.

Sales through Ingram Micro, Tech Data, and Arrow account for a significant portion of our revenue.  For the fiscal years ended December 31, 2009, 2008, and 2007, substantially all of our sales were to distributors and authorized resellers as shown in the following table, expressed as a percentage of total revenue:

   
2009
   
2008
   
2007
 
Distributors/Resellers
   
99%
     
99%
     
98%
 

Sales through Ingram Micro, Tech Data, and Arrow for the fiscal years ended December 31, 2009, 2008, and 2007 represented the following percentages of total revenue:

   
2009
   
2008
   
2007
 
Ingram Micro
   
18%
     
16%
     
16%
 
Tech Data
   
17%
     
17%
     
17%
 
Arrow
   
11%
     
16%
     
18%
 

For the fiscal year ended December 31, 2009, 2008, and 2007, our top 10 distributors and resellers accounted for 74%, 67%, and 67% of our total revenue, respectively.
 
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We anticipate that sales of our solutions to relatively few distributors will continue to account for a significant portion of our revenue.  Although we have renewable one-year agreements with Ingram Micro, Tech Data, Arrow and certain other large distributors, these contracts are subject to termination at any time.  We cannot assure you that any of these distributors will continue to place orders with us, that orders will continue at the levels of previous periods, or that we will be able to obtain large orders from new distributors or resellers.  We also anticipate that sales of our solutions to certain enterprise customers will account for an increasing portion of our revenue.  We cannot assure you that sales to enterprise customers will materialize at anticipated levels.  The financial turmoil impacting the banking systems and financial markets worldwide may continue to result in tight credit markets.  The lowering of the level of liquidity in the credit markets may impact the ability of our distributors to obtain credit to finance purchases of our products and services. If any of the foregoing should occur, our rate of revenue growth will suffer, our revenue may decline and our business will be adversely affected.

In addition, Ingram Micro, Tech Data, and Arrow represented the following dollar amount and percentages of our accounts receivable balance (in millions, except for percentages):

   
December 31,
 
   
2009
   
2008
   
2007
 
Ingram Micro
   
$5.5M
     
22%
     
$2.5M
     
12%
     
$3.6M
     
14%
 
Tech Data
   
$1.6M
     
6%
     
$2.0M
     
10%
     
$3.1M
     
12%
 
Arrow
   
$0.9M
     
4%
     
$2.8M
     
13%
     
$1.1M
     
4%
 

In the event the liquidity of our distributors or enterprise customers is adversely impacted by uncertainties in the financial markets, they may be unable to pay us in a timely manner. The failure to receive timely payment from our distributors or enterprise customers could adversely affect our balance sheet, our results of operations and our creditworthiness.

If we are unable to compete successfully in the highly competitive market for Internet security products, software, and services, our business could be adversely affected.

The market for Internet security products, software, and services is global and highly competitive.  Competition in markets in which we compete continues to increase, and we expect competition to intensify in the future.  There are few substantial barriers to entry and additional competition from existing competitors and new market entrants will likely occur in the future.  Current and potential competitors in our markets include, but are not limited to, Check Point, Microsoft, Symantec, Cisco Systems, Lucent Technologies, Nokia, Fortinet, WatchGuard Technologies, Barracuda Networks, and Juniper Networks, all of which sell worldwide or have a presence in most of the major markets for such products.

Competitors to date have generally targeted the security needs of enterprises of every size with firewall and VPN products that range in price starting from below $300 to more than $100,000. We may experience increased competitive pressure for some of our products, software, and services.  This increased competitive pressure may result in both lower prices and gross profits.  Many of our current or potential competitors have longer operating histories, greater name recognition, larger customer bases, and significantly greater financial, technical, marketing, and other resources than we do.  Some of our competitors focus all of their attention on a single market area rather than offering a comprehensive suite of security solutions and services.  In addition, our competitors may bundle products, software and services that are competitive to ours with other products, software and services that they may sell to our current or potential customers.  These customers may accept these bundled offerings rather than separately purchasing our offerings.  If any of the foregoing were to occur, our business could be adversely affected.

The current global economic slowdown can adversely affect our revenue, results of operations and overall financial strength.

The continuing global economic slowdown and the uncertainty over its breadth, depth and duration may continue to have a negative effect on our business. The shortage of liquidity and credit may result in an extended period of slow economic growth in the United States and worldwide. Governments have taken unprecedented actions intended to stimulate economic growth. There can be no assurance that these macro economic conditions will not impair our operating results.  If conditions in the global economy, United States economy or other key vertical or geographic markets remain uncertain or weaken further, we could experience material adverse impacts on our business, overall financial condition, results of operations, cash flow, capital resources and liquidity.
 
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Difficulty predicting our future operating results or profitability due to volatility in general economic conditions and in the security, productivity, mobility, and data protection markets may result in a misallocation in spending, and a shortfall in revenue which would harm our operating results.

Changes in general economic conditions and the volatility in the demand for network security, content security, and business continuity solutions are two of the many factors underlying our inability to predict our revenue for a given period.  Our operating results may be affected by uncertain or changing economic conditions impacting particular customer and geographic segments of our business.  A large proportion of our expenses for product development, sales and marketing are fixed for a particular quarter or year, and therefore, we may be unable to implement an immediate decrease in our spending in time to compensate for any unexpected quarterly or annual shortfall in revenue.  As a result, any shortfall in revenue would likely adversely affect our operating results.  For the year ended December 31, 2009, we reported a net income of $13.2 million. For the year ended December 31, 2008, we reported a net income of $4.9 million.  For the year ended December 31, 2007, we reported a net income of $28.6 million.  Our accumulated deficit as of December 31, 2009 is $108.1 million.  We do not know if we will be able to sustain profitability in the future.

The selling prices of our solution offerings may decrease, which may reduce our gross profits.

The average selling prices for our solution offerings may decline as a result of competitive pricing pressures, an overall reduction in demand for our products and services, a change in our mix of products, software, and services, anticipation of introduction of new functionality in our products or software, promotional programs and customers who negotiate price reductions in exchange for longer-term purchase commitments.  In addition, competition continues to increase in the market segments in which we participate and we expect competition to further increase in the future, thereby leading to increased pricing pressures.  Furthermore, we anticipate that the average selling prices and gross profits for our products will decrease over product life cycles.  We cannot assure you that we will be successful in developing and introducing new offerings with enhanced functionality on a timely basis, or that our product, software and service offerings, if introduced, will enable us to maintain our prices and gross profits at current levels.  If the price of individual products, software, or services decline or if the price of our solution offerings decline, our overall revenue may decline and our operating results may be adversely affected.

We offer retroactive price protection to our major distributors and if we fail to balance their inventory with end- user demand for our products, our allowance for price protection may be inadequate.  This could adversely affect our results of operations.

We provide our major distributors with price protection rights for inventories of our products held by them.  If we reduce the list price of our products, our major distributors receive refunds or credits from us that reduce the price of such products held in their inventory based upon the new list price.  As of December 31, 2009, we estimated that approximately $24.0 million of our products in our distributors’ inventory were subject to price protection.  We have issued credits of approximately $646,000, $1,040,000, and $494,000 under our price protection policies in 2009, 2008, and 2007, respectively.  Future credits for price protection will depend on the percentage of our price reductions for the products in inventory and our ability to manage the level of our major distributors’ inventory.  If future price protection adjustments are higher than expected, our future results of operations could be materially adversely affected.

We are dependent on international sales for a substantial amount of our revenue.  We face the risk of international business and associated currency fluctuations, which might adversely affect our operating results.

International revenue represented 33%, 34%, and 32% of total revenue in 2009, 2008, and 2007, respectively.  We expect that international revenue will continue to represent a substantial portion of our total revenue in the foreseeable future.  Our performance depends significantly on worldwide economic conditions.  Our risks of doing business abroad include the impact of global economic conditions on the demand for our products and services, the ability of our international channel partners to pay us in a timely fashion, the ability of our international channel partners to obtain credit to finance purchases of our products and services, and our ability to structure our distribution relationships in a manner consistent with marketplace requirements and on favorable terms.  Our sales are denominated in U.S. dollars. As a result, the strengthening of the U.S. dollar against a local foreign currency will increase the price of our products, software, and services in such country and may reduce our sales by making our products, software, and services more expensive in the local currency.  A weakened dollar could increase the cost of local operating expenses and procurement of raw materials.  We are subject to other risks of operating a global business, including potential foreign government regulation of our technology, geopolitical risks
 
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associated with political and economic instability, changes in diplomatic and trade relationships, and changes in foreign countries’ laws affecting such areas as employment relationships, environmental and safety regulation, intellectual property protection and the Internet generally.

Delays in deliveries from our suppliers could cause our revenue to decline and adversely affect our results of operations.

Our products incorporate certain components, component subassemblies, or technologies, including our highly integrated system-on-a-chip architecture, that are available from single or limited sources of supply.  Specifically, our products rely upon components from companies such as Intel, Cavium, and Marvell. We do not have long-term supply arrangements with any vendor, and any disruption in the supply of these products or technologies may adversely affect our ability to obtain necessary components or technology for our products.  If this were to happen, our product shipments may be delayed and business lost, resulting in a decline in sales.  In addition, our products utilize components that have in the past been subject to market shortages and price fluctuations.  If we experience price increases in our product components, we will experience declines in our gross profit.

We license intellectual property, including certain databases and software, and if our licensors experience delays in product updates or provide us with products of substandard quality, the revenue we receive from our products and services that use this intellectual property would be at risk.

We have agreements to license intellectual property, including databases and software, which we incorporate as part of certain of our products and services.  Licensors of such databases and software may fail to provide us with updated products or may experience delays in providing us with updated products.  In addition, our licensors may provide us with products of substandard quality.  If either of these events happens, we may be unable to provide our customers with the appropriate level of functionality in our solution offerings.  In that event, our customers may purchase similar offerings from one of our competitors, or sales to our customers may be delayed.  In either case, our revenue would be adversely affected.

We rely primarily on contract manufacturers for our product manufacturing and assembly, and if these operations are disrupted for any reason, we may not be able to ship our products.

We currently outsource our hardware manufacturing and assembly to contract manufacturers in the U.S. and Taiwan. Typically, the agreement with our contract manufacturers specify an initial term of one (1) year with automatic yearly renewal terms unless terminated by either party upon 90 days prior written notice.  Our operations could be disrupted if we have to switch to a replacement vendor or if our hardware supply is interrupted for any reason.  In addition, we provide forecasts of our demand to our contract manufacturers nine months prior to scheduled delivery of products to our customers.  If we overestimate our requirements, our contract manufacturers may have excess inventory, which would increase our costs.  If we underestimate our requirements, our contract manufacturers may have an inadequate component inventory, which could interrupt manufacturing of our products and result in delays in shipments and revenue.  In addition, lead times for materials and components that we order vary significantly and depend on factors such as the specific supplier, contract terms and demand for each component at a given time.  Liquidity or other financial problems of our contract manufacturers or reservation of manufacturing capacity by other companies, inside or outside of our industry, could either limit supply or increase costs.  We may also experience shortages of components from time to time, which also could delay the manufacturing of our products.  If any of the foregoing occurs we could lose customer orders and revenue could decline.

Sales of our solutions may be adversely affected by various factors which would adversely affect our revenue.

Sales of our solutions may be adversely affected in the future by changes in the geopolitical environment including the financial stability of our customers and supply chain; sales and implementation cycles; changes in our product mix; structural variations in sales channels; ability of our channel to absorb new product, software and service introductions; ability of our sales organization to sell into enterprise level accounts; acceptance of our solutions in the market place; and changes in our supply chain model. These changes may result in corresponding variations in order backlog.  A variation in backlog levels could result in less predictability in our quarter-to-quarter net sales and operating results.  Sales may also be adversely affected by fluctuations in demand, price and product competition in the markets we service, introduction and market acceptance of new technologies and new product, software or service offerings, and financial difficulties experienced by our distributors, resellers or end-users. We may, from time to time, experience manufacturing issues that create a delay in our suppliers’ ability to provide specific components resulting in delayed shipments.  To the extent that manufacturing issues and any related component shortages result in delayed shipments in the future, and particularly in periods when we and our
 
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suppliers are operating at higher levels of capacity, it is possible that revenue could be adversely affected for a quarter or longer.

The failure to successfully conduct offshore activities could adversely affect results of operations.

To better align our costs with market conditions, increase its presence in growing markets, and enhance productivity and operational efficiency, we conduct engineering, development and certain technical support activities in the United Kingdom, India and China.  We have undertaken a transition of certain technical support activities to facilities located in India and United Kingdom.  In addition, we conduct certain engineering and development activities in Shanghai, China.  As part of these offshore activities we have established a corporate presence and have hired employees in the United Kingdom, India and China, entered into a long-term lease for facilities to support these offshore efforts.  If we are unable to effectively develop and implement our offshore strategies, including the ability to recruit or retain qualified technical personnel, or are unable to build the necessary corporate infrastructure in a timely and efficient manner, or are unable to effectively integrate certain technical support and engineering functions, the costs associated with the these offshore activities may be greater than anticipated and we may not realize anticipated productivity improvements and may experience other operational difficulties, and or all of which could materially and adversely affect our business, financial condition and results of operations.

Environmental and safety regulations enacted in various jurisdictions in which we do business may increase the component costs of our products and if we experience delays in shipment of compliant products our revenue would decline and our operating results would be adversely affected.

We are subject to environmental and safety regulations in connection with out global business operations, including but not limited to regulations relating to the development, manufacture, and use of its products and, the safe use of chemicals, and recycling and disposal of material used in its products.  Various jurisdictions in which we do business are implementing environmental and safety directives that impact manufacturers doing business in those jurisdictions.  The disparities between the regulatory frameworks adopted create uncertainty over the applicability, scope, and form of the regulations affecting our products and the timing for compliance with the applicable regulations.   Our inability to comply with applicable environmental and safety regulations in a timely fashion may subject us to fines and penalties levied by appropriate regulatory authorities.  Certain of these regulations may necessitate changes to the components used in our products which could result in an increase in product cost and a decrease in our gross profit.  Further, while we and our contract manufacturers constantly review environmental and safety regulations in the jurisdictions in which we do business, the timetable for implementation of these regulations may result in delays in our ability to provide compliant products in a timely manner to those markets which would cause our revenues to decline and our operating results to be adversely affected.

If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results.  As a result, current and potential shareholders could lose confidence in our financial reporting which would harm our business and the trading price of our stock.

Section 404 of the Sarbanes-Oxley Act of 2002 requires our management to report on, and our independent registered public accounting firm to attest to, the effectiveness of our internal control over financial reporting.  We have an ongoing program to perform the system and process evaluation and testing necessary to comply with these requirements.  We have incurred considerable expense and have devoted additional management resources to on going Section 404 compliance activity.  Effective internal controls are necessary for us to provide reliable financial reports.  If we cannot provide reliable financial reports, our business and operating results could be harmed.

Acquisitions could be difficult to integrate, disrupt our business, dilute shareholder value and the products and services acquired may not be accepted by the market. As a result, our operating results would be adversely affected.

We are continually reviewing the market for possible corporate opportunities and we may announce acquisitions or investments in other companies, products, or technologies in the future. As part of each transaction, we will be required to integrate operations, train, retain, and motivate the personnel of these entities. We may be unable to maintain uniform standards, controls, information technology systems, procedures and policies across our entire enterprise and if the products and services released as a result of these acquisitions experience quality problems or are otherwise not accepted by the market, we may suffer a loss of confidence by our distributors, resellers and end users and sales of these products and services will not meet expectations. As a consequence, these acquisitions may cause disruptions in our operations and divert
 
Page 20 of 103

 
management’s attention from day-to-day operations, which could impair our relationships with our current employees, customers, and strategic partners.

We may have to incur debt or issue equity securities to pay for any future acquisitions. The issuance of equity securities for any acquisition could be substantially dilutive to our shareholders. In addition, due to acquisitions made in the past, our profitability has suffered because of acquisition-related costs, amortization costs, and impairment losses for acquired goodwill and other intangible assets.

We cannot be certain that our internal controls over financial reporting will be effective or sufficient when tested by increased scale of growth or the impact of acquisitions.

It may be difficult to design and implement effective internal controls over financial reporting for combined operations and differences in existing controls of acquired businesses may result in weaknesses that require remediation when internal controls over financial reporting are combined.  Our ability to manage our operations and growth will require us to improve our operations, financial and management controls, as well as our internal reporting systems and controls.  We may not be able to implement improvements to our internal reporting systems and controls in an efficient and timely manner and may discover deficiencies and weaknesses in existing systems and controls especially when such systems and controls are tested by increased scale of growth or the impact of acquisitions.

Our Financial Statements could be affected by the need to restate previously issued annual or interim financial statements.

In the event an error in our financial statements requires us to report that previously reported financial statements should no longer be relied upon, amended financial statements for such previously reported periods would be required.  In such an event, we may be unable to file our current interim or annual reports with the Securities and Exchange Commission in a timely fashion and may be subject to delisting by the NASDAQ Global Market.  Furthermore, we may be unable to certify the adequacy of our internal controls over financial reporting and our independent registered public accounting firm may be unable to attest thereto.  In such circumstances, investors could lose confidence in our internal controls over financial reporting, our disclosure controls, and the reliability of our financial statements, which could result in a decrease in the value of our common stock and could cause serious harm to our business, financial condition, and results of operations.

Changes in our effective tax rate or tax liability may have an adverse effect on our results of operations.

As a global company, we are subject to taxation in the United States and various other countries.  Significant judgment is required to determine and estimate worldwide tax liabilities.  Our future effective tax rates may be adversely affected by a number of factors including changes in the valuation of our deferred tax assets; our ability to use net operating losses of acquired companies to the fullest extent; increases in expenses not deductible for tax purposes, including write-offs of acquired in-process research and development and impairment of goodwill in connection with acquisitions; changes in share-based compensation expense; and changes in tax laws in the countries in which we operate or the interpretation of such tax laws and changes in generally accepted accounting principles. Any significant change in our future effective tax rates could adversely impact our consolidated financial position, results of operations, and cash flows.

If our estimates or judgments relating to our critical accounting policies  based on assumptions change or prove to be incorrect, our operating results could fall below expectations of securities analysts and investors, resulting in a decline in our stock price.

Our discussion and analysis of financial condition and results of operations in this report is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States.  The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes.  On an ongoing basis, we evaluate significant estimates used in preparing our financial statements, including those related to: the valuation and recognition of investments, the valuation of the revenue and accounts receivable, the valuation of inventory, the assessment of recoverability of intangible assets and their estimated useful lives, the valuation and recognition of stock based compensation and the recognition and measurement of current and deferred income tax assets and liabilities.
 
Page 21 of 103

 
We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, as provided in our discussion and analysis of financial condition and results of operations in this annual report, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  The current volatility in the financial markets and overall economic uncertainty increases the risk that actual amounts realized from the sale or exchange of certain of our financial instruments may differ significantly from those in our assumptions.  In any such case, our operating results could fall below the expectations of securities analysts and investors, resulting in a decline in our stock price.

Changes to our senior management may have an adverse effect on our ability to execute our business strategy.

Our future success will depend largely on the efforts and abilities of our senior management to execute our business plan.  Changes in our senior management and any future departures of key employees may be disruptive to our business and may adversely affect our operations. Experienced senior management in the technology industry is in high demand and competition for their talents is intense, especially in Silicon Valley, where many of our senior management reside. Historically, we have relied on equity awards in the form of stock options as one means of recruiting and retaining senior management. If the quantity of equity awards we are able to make to our senior management under our equity plans falls below what is available to our senior management from other potential employers or if a stock option’s exercise price exceeds the underlying stock’s market value, the effectiveness of our equity awards as a means for retaining senior management will lessen.

Our ability to attract, retain, and motivate key qualified employees is vital to our success.

Our success depends in part on our ability to attract, retain, and motivate key engineering, operations, finance, information systems, customer support, and sales and marketing personnel.  Our employees may leave us at any time, and we have continuing challenges in retaining employees from acquired companies.  The loss of services of any of our key personnel, the inability to attract, retain, and motivate qualified personnel in the future, or delays in hiring required personnel, particularly engineering and sales personnel, could delay the development and introduction of, and negatively impact our ability to sell our products, software and services.  Historically, we have relied on equity awards in the form of stock options as one means of recruiting and retaining key employees. If the quantity of equity awards we are able to make to our key employees under our equity plans falls below what is available to our key employees from other potential employers or if a stock option’s exercise price exceeds the underlying stock’s market value, the effectiveness of our equity awards as a means of retaining key employees will lessen. If we are not successful in attracting, retaining, and motivating key employees, our ability to capitalize on our business opportunities and our operating results may be materially and adversely affected.

We may be unable to adequately protect our intellectual property proprietary rights, which may limit our ability to compete effectively.

We currently rely on a combination of patent, trademark, copyright, and trade secret laws, confidentiality provisions and other contractual provisions to protect our intellectual property.  Our intellectual property program consists of an on-going patent disclosure and application process, the purchase of intellectual property assets including intellectual property assets from acquisition activity, and the licensing of intellectual property from others.  We plan to continue our aggressive plan to build our intellectual property portfolio.  Despite our efforts to protect our intellectual property, unauthorized parties may misappropriate or infringe our intellectual property.  We plan to aggressively pursue any such misappropriation or infringement of our intellectual property.  Our patent applications may not result in the issuance of any patents.  Even if we obtain the patents we are seeking, that will not guarantee that our patent rights will be valuable, create a competitive barrier, or will be free from infringement.  Furthermore, if any patent is issued, it might be invalidated or circumvented or otherwise fail to provide us any meaningful protection.  We face additional risk of adequately protecting our intellectual property when conducting business in countries that have poorly developed or inadequately enforced intellectual property laws.  In addition, competitors may independently develop similar or superior technologies or duplicate the technologies we have developed, which could substantially limit the value of our intellectual property.

Potential intellectual property claims and litigation could subject us to significant liability for damages and invalidation of our proprietary rights.

Litigation over intellectual property rights is not uncommon in our industry.  We face infringement claims from third parties. We may have to resort to litigation to protect our intellectual property rights.  We expect that infringement or
 
Page 22 of 103

 
misappropriation claims will be more frequent as the number of products, feature sets in software and services, and the number of competitors grows in the market segments in which we do business.  Any litigation, regardless of its success, is costly and requires significant time and attention of our key management and technical personnel.  An adverse result in litigation could also force us to:

·  
stop or delay selling, incorporating or using products that incorporate the challenged intellectual property;

·  
pay damages;

·  
enter into licensing or royalty agreements, which may be unavailable on acceptable terms; or

·  
redesign products or services that incorporate infringing technology.

If any of the above occurs, our revenue could decline and our business could suffer.

We have been named as defendant in litigation matters that could subject us to liability for significant damages.

We are a defendant in on-going litigation matters.  No estimate can be made of the possible loss or possible range of loss, if any, associated with the resolution of these litigation matters.  Failure to prevail in these matters could have a material adverse effect on our consolidated financial position, results of operations, and cash flows in the future.

In addition, the results of litigation are uncertain and the litigation process may utilize a significant portion of our cash resources and divert management’s attention from the day-to-day operations, all of which could harm our business.

Any alleged or actual failure of our products, software or services to operate as warranted may require us to defend product liability or breach of warranty claims.

Our products, software, and services provide network security, business continuity and content security.  Networks protected by our products, software and services may be vulnerable to electronic break-ins.  Because the techniques used by computer hackers to access or sabotage networks change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques.  If a third party were able to successfully overcome our security measures, such a person or entity could misappropriate customer data, third party data stored by our customers and other information, including intellectual property.  In addition, the operations of our end user customers may be interrupted.  If that happens, affected end-users or others may file actions against us alleging product liability, tort, or breach of warranty claims.  Although we attempt to reduce the risk of losses from claims through contractual warranty disclaimers and liability limitations, these provisions may not be enforceable.  Some courts, for example, have found contractual limitations of liability in standard computer and software contracts to be unenforceable in some circumstances.  Defending a lawsuit, regardless of its merit, could be costly and could divert management attention.  Although we currently maintain business liability insurance, this coverage may be inadequate or may be unavailable in the future on acceptable terms, if at all.  In addition, the market perception of our products, software, and services would likely be adversely affected which could cause us to lose current and potential customers, resellers, distributors or other business partners.  If any of the above occurs, our revenue could decline and our business would suffer.

A security breach of our internal systems could harm our business.

Because we provide Internet security, we may be a more attractive target for attacks by computer hackers.  We will not succeed unless the marketplace is confident that we provide effective Internet security protection.  Although we have not experienced significant damages from acts of sabotage or unauthorized access by a third party of our internal network, if an actual or perceived breach of Internet security occurs in our internal systems it could adversely affect the market perception of our products, software and services.  In addition, such a security breach may impact the ability of our company to operate, including the ability to adequately support our customers.  If this happens, our revenue could decline and our business could suffer.
 
Page 23 of 103

 
If our solutions do not interoperate with our end customers’ networks, installations could be delayed or cancelled, which could significantly reduce our revenue.

Our solutions are designed to interface with existing networks of our end-users, each of which have different specifications and utilize multiple protocol standards.  Many of the networks of our end-user’s contain multiple generations of products that have been added over time as these networks have grown and evolved.  Our solutions must interoperate with the products within these networks as well as with future products that might be added to these networks in order to meet the requirements of our end-users.  If we find errors in the existing software used in the networks of our end-users, we may elect to modify our software to fix or overcome these errors so that our solutions will interoperate and scale with their existing software and hardware.  If our solutions do not interoperate properly, installations could be delayed or orders for our solutions could be cancelled, which could significantly reduce our revenue.

Product errors or defects could result in loss of revenue, delayed market acceptance, and claims against us.

We offer one and two year warranty periods on our products.  During the warranty period end users may receive a refurbished or replacement product for any defective unit subject to completion of certain procedural requirements.  Our products may contain undetected errors or defects.  If there is a product failure, we may have to replace all affected products without being able to record revenue for the replacement units, or we may have to refund the purchase price for such units if the defect cannot be resolved.  Despite extensive testing, some errors are discovered only after a product has been installed and used by customers.  Any errors discovered after commercial release could result in loss of revenue and an increase in warranty related claims against us.  Such product defects can negatively impact our products’ reputation and result in reduced sales.

Industry consolidation may lead to increased competition and may harm our operating results.

There has been a trend toward industry consolidation in our market.  We expect this trend toward industry consolidation to continue as companies attempt to strengthen or hold their market positions in an evolving industry and as companies are acquired or are unable to continue operations.  We believe that industry consolidation may result in stronger competitors that are better able to compete with us.  This could lead to more variability in operating results and could have a material adverse effect on our business, operating results, and financial condition.

If we are unable to meet our future capital requirements, our business will be harmed.

We expect our cash on hand, cash equivalents and short-term investments to meet our working capital and capital expenditure needs for at least the next twelve months.  However, at any time, we may decide to raise additional capital to take advantage of strategic opportunities available or attractive financing terms.  If we issue equity securities, shareholders may experience additional dilution or the new equity securities may have rights, preferences, or privileges senior to those of existing holders of common stock.  If we cannot raise funds, if needed, on acceptable terms, we may not be able to develop or enhance our products, software or services, take advantage of future opportunities, or respond to competitive pressures or unanticipated requirements, which could have a material adverse effect on our business, operating results, and financial condition.

Governmental regulations of imports or exports affecting Internet security could affect our revenue.

Any additional governmental regulation of imports or exports or failure to obtain required export approval of our encryption technologies could adversely affect our international and domestic sales.  The United States and various foreign governments have imposed controls, export license requirements, and restrictions on the import or export of some technologies, especially encryption technology.  In addition, from time to time, governmental agencies have proposed additional regulation of encryption technology, such as requiring the escrow and governmental recovery of private encryption keys.  In response to terrorist activity, governments could enact additional regulation or restriction on the use, import, or export of encryption technology.  This additional regulation of encryption technology could delay or prevent the acceptance and use of encryption products and public networks for secure communications resulting in decreased demand for our products and services.  In addition, some foreign competitors are subject to less stringent controls on exporting their encryption technologies.  As a result, they may be able to compete more effectively than we can in the United States and the international Internet security market.
 
Page 24 of 103

 
Our stock price may be volatile.

The market price of our common stock has been highly volatile and has fluctuated significantly in the past.  We believe that it may continue to fluctuate significantly in the future in response to the following factors, some of which are beyond our control:

·  
general economic conditions and the effect that such conditions have upon customers’ purchasing decisions;

·  
variations in quarterly operating results;

·  
changes in financial estimates by securities analysts;

·  
changes in market valuations of technology and Internet infrastructure companies;

·  
announcements by us of significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments;

·  
the accretive or dilutive effects of acquisitions on operating results;

·  
loss of a major client or failure to complete significant license transactions;

·  
additions or departures of key personnel;

·  
our ability to remediate material weaknesses and/or significant deficiencies, if any, in internal controls over financial reporting in an effective and timely manner;

·  
receipt of an adverse or qualified opinion from our independent auditors regarding our internal controls over financial reporting;

·  
sales of common stock in the future; and

·  
fluctuations in stock market price and volume, which are particularly common among highly volatile securities of Internet-related companies.

The long sales and implementation cycles for our solutions may cause revenue and operating results to vary significantly.

The decision of an end-user to purchase our solutions often involves a significant commitment of resources and a lengthy evaluation and qualification process.  Throughout the sales cycle, we often spend considerable time educating our channel partners and providing information for prospective end-users regarding the use and benefits of our products, software, and services.  Budget constraints, the availability of credit, and the need for multiple approvals within enterprises, carriers, and government entities may delay purchase decisions.  Failure to obtain the required approval for a particular project or purchase decision may delay the purchase of our solutions from our channel partners.  As a result, the sales cycle for our security solutions could be longer than 90 days.

Even after making the decision to purchase our solutions end-users may not deploy these solutions broadly within their networks.  The timing of implementation can vary widely and depends on the skill set of the end-user, the size of the network deployment, the complexity of the network environment, and the degree of specialized hardware and software configuration necessary to deploy.  End-users with large networks usually expand their networks in large increments on a periodic basis.  Large deployments and purchases of our security solutions also require a significant outlay of capital by the end-user.  If the deployment of our solutions in these complex network environments is slower than expected, sales through our distributors to our resellers would slow, our revenue could be below our expectations, and our operating results could be adversely affected.
 
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The inability to obtain any third-party license required to developing new products or software or enhancements to our products or software could require us to obtain substitute technology of lower quality or performance standards or at greater cost, which could seriously harm our business, financial condition, and results of operations.

We license intellectual property from third parties to develop new products or software or enhancements to existing products or software.  Third-party licenses may not be available to us on commercially reasonable terms or at all.  The inability to obtain third-party licenses required developing new products or software or enhancements to existing products or software could require us to obtain substitute technology of lower quality or performance standards or at greater cost, any of which could seriously harm our business, financial condition, and results of operations.

Seasonality and concentration of revenue at the end of the quarter could cause our revenue to fall below the expectations of securities analysts and investors, resulting in a decline in our stock price.

The rate of our domestic and international sales has been and may continue to be lower in the summer months or be adversely affected by other seasonal factors, both domestically and internationally.  During these periods, businesses often defer purchasing decisions.  As a result of customer buying patterns and the efforts of our sales force to meet or exceed quarterly and year-end quotas,  we have historically received a substantial portion of a quarter’s sales orders and earned a substantial portion of a quarter’s revenue during our last month of each quarter.  If expected revenue at the end of any quarter is delayed, our revenue for that quarter could fall below the expectations of securities analysts and investors, resulting in a decline in our stock price.

Our business is especially subject to the risks of earthquakes, floods and other natural catastrophic events, and to interruption by manmade problems such as computer viruses or terrorism.

Our corporate headquarters, including certain of our research and development operations and some of our contract manufacturer’s facilities, are located in the Silicon Valley area of Northern California, a region known for seismic activity.  Additionally, certain of our facilities, which including contracted manufacturing facilities, are located in areas that are subject to typhoons and other natural disasters.  A significant natural disaster, such as an earthquake or a flood, could have a material adverse impact on our business, operating results, and financial condition.  In addition, despite our implementation of network security measures, our servers are vulnerable to computer viruses, break-ins, and similar disruptions from unauthorized tampering with our computer systems.  Any such event could have a material adverse effect on our business, operating results, and financial condition.  In addition, the effects of war or acts of terrorism could have a material adverse effect on our business, operating results, and financial condition.  The continued threat of terrorism and heightened security and military action in response to this threat, or any future acts of terrorism, may cause further disruptions to these economies and create further uncertainties.  To the extent that such disruptions or uncertainties result in delays, curtailment or cancellations of customer orders, or the manufacture or shipment of our products, our revenue, gross profits and operating profits may decline and we may not achieve our financial goals and achieve or maintain profitability.

We face risks associated with changes in telecommunications regulation and tariffs.

Changes in telecommunications requirements in the United States or other countries could affect the sales of our products.  We believe it is possible that there may be changes in U.S. telecommunications regulations in the future that could slow the expansion of the service providers’ network infrastructures and materially adversely affect our business, operating results, and financial condition.  Future changes in tariffs by regulatory agencies or application of tariff requirements to currently untariffed services could affect the sales of our products for certain classes of customers.  Additionally, in the United States, our products must comply with various Federal Communications Commission requirements and regulations.  In countries outside of the United States, our products must meet various requirements of local telecommunications authorities.  Changes in tariffs or failure by us to obtain timely approval of products could have a material adverse effect on our business, operating results, and financial condition.

Due to the global nature of our business, economic or social conditions or changes in a particular country or region could adversely affect our sales or increase our costs and expenses, which would have a material adverse impact on our financial condition.

We conduct significant sales, research and development, and customer support operations in countries outside of the United States.  Accordingly, our future results could be materially adversely affected by a variety of uncontrollable and changing
 
Page 26 of 103

 
factors including, among others, political or social unrest or economic instability or terrorist activity in a specific country or region; macro economic conditions adversely affecting geographies where we do business; trade protection measures; environmental and safety directives and other regulatory requirements which may affect our ability to import or export our products from various countries; government spending patterns affected by political considerations; and difficulties in staffing and managing international operations. Any or all of these factors could have a material adverse impact on our revenue, costs, expenses, and financial condition.

We are exposed to various risks associated with the credit and capital markets.

Included within our investment portfolio at December 31, 2009 were auction rate securities (ARS) and asset backed securities (ABS).  In connection with the liquidity issues experienced in the global credit and capital markets, our ARS and ABS holdings have experienced failed auctions or thinly traded markets.  The Company has recognized unrealized losses in its consolidated financial statements as of December 31, 2009. If the credit ratings of these investments continue to deteriorate, the fair value of these securities may decline further.  If uncertainties in the credit and capital markets continue or if the Company experiences any rating downgrades on any investments in its portfolio, the Company may incur impairment charges to its investment portfolio, which would negatively affect our financial condition, cash flow, and reported earnings.



None.



The Company leases office space in several U.S. locations including California, Washington, and Arizona. Additional facilities are leased worldwide under leases that expire at various dates ranging from 2010 to 2015.

The Company’s corporate headquarters and executive offices are located in approximately 72,000 square feet of office space in San Jose, California under a lease that expires in September 2014.  The lease provides for a one year renewal option. In addition, the Company leases office space of approximately 32,000 square feet in Tempe, Arizona.  The lease term is for 7.5 years and expires in August 2015.  The base rent for this lease escalates annually at 3%.

In July 2007, the Company assumed a five-year lease for approximately 20,000 square feet of office space located in Seattle, Washington.  This lease expires in February 2012. In September 2008, the Company closed approximately half of its leased facility and recorded a liability of approximately $0.9 million equivalent to the net present value of the expected future lease costs, net of estimated future sublease.

In February 2008, the Company entered into a lease agreement to lease approximately 36,000 square feet of office space in Bangalore, India to carry out certain research and development and technical support activities.  The lease term is for a period of five years commencing in March 2008 and requires a lock in period of 4 years, after which either party to the contract can terminate the lease with notice duly given.  The base rent for this lease escalates annually at 5%.

In November 2008, the Company expanded its existing facility in Shanghai, China to a total of approximately 16,000 square feet of office space to carry out our research and development activities. The lease term is for a period of three years and expires in November 2011.

In December 2009, the Company expanded its existing facility in London, United Kingdom to a total of approximately 7,000 square feet of office space to carry out our sales and technical support activities. The lease term will expire in February 2013.
 
We believe that our existing facilities are suitable and adequate for our current needs and that the capacity of such facilities is substantially being utilized or we have plans to utilize it.
 
Page 27 of 103


The information set forth under Note 11 of the Notes to Consolidated Financial Statements, included in Part II, Item 8 of this Form 10-K, is incorporated herein by reference. For an additional discussion of certain risks associated with legal proceedings, see the section entitled “Risk Factors” in Part I, Item 1A of this Form 10-K.



None.

Page 28 of 103

 
PART II


Price Range of Common Stock

Our common stock commenced trading on the NASDAQ Global Market on November 11, 1999 and is traded under the symbol “SNWL”.  As of December 31, 2009, there were approximately 83 shareholders of record of the common stock.  The high and low sale prices for the common stock as reported on the NASDAQ Global Market were:

   
High
   
Low
 
Fiscal 2008
           
First Quarter
   
$10.91
     
$7.51
 
Second Quarter
   
$ 8.74
     
$6.45
 
Third Quarter
   
$ 6.82
     
$4.78
 
Fourth Quarter
   
$ 5.23
     
$2.90
 
Fiscal 2009
               
First Quarter
   
$ 4.88
     
$3.38
 
Second Quarter
   
$ 6.07
     
$4.32
 
Third Quarter
   
$ 8.53
     
$5.34
 
Fourth Quarter
   
$ 8.80
     
$7.32
 

Dividend Policy

We have never paid a cash dividend on our capital stock.  We currently anticipate that we will retain all available funds, for use in our business and we do not currently anticipate paying any cash dividends.

Stock Performance Graph

Below is a line graph comparing relative performance in the cumulative return to shareholders of our common stock with the cumulative return on the Nasdaq Composite Index, Russell 2000 Index and RDG Technology Composite Index over a 60-month period commencing December 31, 2004 and ending on December 31, 2009.  This graph assumes the investment of $100 on December 31, 2004 and the reinvestment of dividends, if any, through December 31, 2009.
 
Page 29 of 103

 
The comparisons shown in the graph below are based upon historical data.  We consistently caution that the stock price performance shown in the graph below is not indicative of, nor intended to forecast, the potential future performance of our common stock.
 
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among SonicWALL, Inc.
 
 
* $100 invested on 12/31/04 in stock or index, including reinvestment of dividends.
Fiscal year ending December 31.
 
 
Recent Sales of Unregistered Securities

None.

Issuer Purchases of Equity Securities

None.

Page 30 of 103

 

The following selected consolidated financial data should be read in conjunction with our consolidated financial statements and related notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this Form 10-K.

   
Year Ended December 31,
 
   
2009
   
2008
   
2007
   
2006
   
2005
 
Statements of Operations Data:
 
(In thousands, except per share data)
 
Revenue:
                             
Product
 
$
73,847
   
$
90,857
   
$
98,936
   
$
92,797
   
$
75,525
 
License and service
   
126,728
     
127,787
     
100,263
     
82,741
     
59,799
 
Total revenue
   
200,575
     
218,644
     
199,199
     
175,538
     
135,324
 
Cost of revenue:
                                       
Product
   
39,038
     
43,507
     
40,555
     
39,164
     
27,699
 
License and service
   
15,857
     
20,102
     
15,894
     
12,287
     
8,031
 
Amortization of purchased technology
   
3,017
     
3,017
     
2,232
     
5,387
     
4,552
 
Total cost of revenue
   
57,912
     
66,626
     
58,681
     
56,838
     
40,282
 
Gross profit
   
142,663
     
152,018
     
140,518
     
118,700
     
95,042
 
Operating expenses:
                                       
Research and development
   
37,858
     
44,176
     
39,410
     
33,670
     
22,768
 
Sales and marketing
   
70,000
     
82,348
     
77,741
     
71,256
     
53,403
 
General and administrative
   
17,134
     
18,613
     
21,473
     
20,324
     
15,535
 
Amortization of purchased intangible assets
   
1,095
     
1,114
     
715
     
2,721
     
2,893
 
Restructuring charges
   
-
     
1,683
     
-
     
1,409
     
-
 
In-process research and development
   
-
     
-
     
1,930
     
1,580
     
-
 
Total operating expenses
   
126,087
     
147,934
     
141,269
     
130,960
     
94,599
 
Income (loss) from operations
   
16,576
     
4,084
     
(751
)
   
(12,260
)
   
443
 
Interest income and other expense, net
   
3,164
     
6,368
     
11,771
     
9,713
     
6,867
 
Income (loss) before income taxes
   
19,740
     
10,452
     
11,020
     
(2,547
)
   
7,310
 
Benefit (provision) for income taxes
   
(6,586
)
   
(5,571
)
   
17,601
     
(8,206
)
   
(1,034
)
Net income (loss)
 
$
13,154
   
$
4,881
   
$
28,621
   
$
(10,753
)
 
$
6,276
 
Net income (loss) per share:
                                       
Basic
 
$
0.24
   
$
0.09
   
$
0.45
   
$
(0.17
)
 
$
0.10
 
Diluted
 
$
0.24
   
$
0.08
   
$
0.43
   
$
(0.17
)
 
$
0.09
 
Shares used in computing net income (loss) per share:
                                       
Basic
   
53,914
     
56,069
     
64,305
     
65,117
     
64,684
 
Diluted
   
55,568
     
57,897
     
67,099
     
65,117
     
66,797
 
                                         
   
As of December 31,
 
     
2009
     
2008
     
2007
     
2006
     
2005
 
   
(In thousands, except per share data)
 
Consolidated Balance Sheet Data:
                                       
Cash and cash equivalents
 
$
39,071
   
$
45,127
   
$
33,324
   
$
25,927
   
$
42,593
 
Short-term investments
   
161,079
     
60,327
     
195,647
     
209,251
     
197,849
 
Total assets
   
450,557
     
401,836
     
472,635
     
416,291
     
387,683
 
Total shareholders’ equity
   
301,265
     
265,771
     
327,704
     
318,068
     
320,170
 
Long-term liabilities
   
24,920
     
15,072
     
17,495
     
6,269
     
636
 
 
Page 31 of 103


 
This Form 10-K contains forward-looking statements which relate to future events or our future financial performance.   In many cases you can identify forward-looking statements by terminology such as “may”, “will”, “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “intend” or “continue,” or the negative of such terms and other comparable terminology.  In addition, forward-looking statements in this document include, but are not limited to, those regarding the dedication of resources to develop new products and services and marketing those products and services to channel partners and customers; the introduction of more service offerings on our platforms as a vehicle to generate additional revenue from our installed base of products; our ability to deliver comprehensive and profitable solutions to our channel partners; the growth opportunity associated with sales through our indirect channel to larger distributed enterprises; weakening economic conditions that could lead to decreases in IT spending that could adversely impact operating results;  the level of comfort of our channel partners in offering our solutions to their customers; the growth of the Network Security, Secure Content Management and Business Continuity markets; the impact of a failure to achieve greater international sales; our  ability to maintain and enhance current product lines, develop new products, maintain technological competitiveness and meet the expanding range of customer requirements;  the market opportunity for license and service revenue growth;  our ability to deliver comprehensive solutions to channel partners, the positive characteristics of our software license and service revenue model on future revenue growth and the predictability of our revenue stream; the impact on revenue of the combination of subscription services sold in conjunction with new product offerings;  expected competition in the Internet security market and our ability to compete in markets in which we participate; impact of service renewal rates on lowering selling and marketing expense; our ability to achieve increased incremental revenue per transaction through success of our software license and service revenue model; the impact of IT spending on demand for our products and services;  the current and likely future impact of share-based compensation expense on reported operating results; the impact of changes in tax laws and rates on the Company’s operating results, cash flows or financial position; anticipated revenue contributions of new products including continuous data protection, email security and SSL-VPN products and related services; the impact of growth in international operations on our exposure to foreign currency fluctuations; the possible impact of uncertainties in the auction rate and asset backed securities markets on the Company’s financial performance; our ability to access funds held as auction rate securities in our investment portfolio; the impact of significant fluctuations in the exchange rate of some foreign currencies in relation to the US Dollar; diverging economic conditions in foreign markets in which we do business;  pricing pressures on our solution based offerings; anticipated higher gross margins associated with our license and service offerings; the probability of realization of all deferred tax assets; assessment of future effective tax rates and the continued need for a partial tax valuation allowance; the expected impact on reported revenue associated with the adoption of amendments to FASB 605 and FASB ASC 985; the potential for product gross margins to erode based upon changes in product mix; downward pressure on product pricing or upward pressure on production costs; the impact of product mix on product gross profits; the impact of the completion of “in sourcing” certain technical support functions on period over period comparisons of cost of license and service revenue and gross margin; the implementation of a second phase of technical support “in sourcing” activity; our ability to maintain investment in current and future product development and enhancement efforts; the introduction of new products and the broadening of existing product offerings; planned investments and expenses in current and future product development; production costs and sales volume comparisons between the NSA and SSL-VPN products and other hardware appliances; the rate of change of general and administrative expenses;  the impact of geopolitical and macro-economic conditions on demand for our offerings; the ability of our contract manufacturers to meet our requirements; the belief that existing cash, cash equivalents and short-term investments will be sufficient to meet our cash requirements at least through the next twelve months; factors potentially impacting operating cash flows in future periods; and expected fluctuations in days sales outstanding. These statements are only predictions, and they are subject to risks and uncertainties.  Our actual results may differ materially from those anticipated in these forward-looking statements as a result of a variety of factors, including, but not limited to, those set forth herein under the heading “Risk Factors”.  References to “we,” “our,” and “us” refer to SonicWALL, Inc. and its subsidiaries.

Overview

SonicWALL provides network security, secure remote access, content security, and business continuity solutions for businesses of all sizes.  Our solutions are typically deployed at the edges of networks.  These networks are often aggregated into broader distributed deployments to support companies that do business in multiple physical locations, interconnect their networks with trading partners, or support a mobile or remote workforce.  Our solutions are sold in over 50 countries worldwide.  Our descriptions of regions of the world in which we do business specifically excludes Cuba, Iran, Syria, Sudan and any other country identified by the United States Government as being state sponsors of terrorism and subject to economic sanctions or export controls.
 
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The Company groups revenue into the following primary product categories of similar products:

(1)
Unified Threat Management (“UTM”) including both NSA and TZ products; subscription services such as Comprehensive Gateway Security Suite, Comprehensive Anti-Spam Service, integrated Gateway Anti-Virus, and Intrusion Prevention; software licenses such as our enhanced “SonicOS” operating system, node upgrades, and other services such as extended warranty and service contracts, training, consulting and engineering services.
(2)
Secure Content Management (“SCM”) including CSM and email security appliances, subscription services such as internet filtering and email protection term and perpetual licenses, and other services such as extended warranty and service contracts, training, consulting and engineering services.
(3)
SSL VPN Secure Remote Access (“SSL”) including SSL-VPN appliances, add-on software licenses and other services such as extended warranty and service contracts, training, consulting and engineering services.
(4)
Continuous Data Protection (“CDP”) including the CDP appliances, off-site data backup subscription services, site-to-site back-up licenses, and other services such as extended warranty and service contracts, training, consulting and engineering services.

We generate revenue within these product categories primarily from the sale of: (1) products, (2) software licenses, (3) subscriptions for services such as content filtering, anti-virus protection and intrusion prevention, offsite data backup, email protection, and (4) other services such as extended warranty and service contracts, training, consulting and engineering services.

We currently outsource our hardware manufacturing and assembly to third party contract manufacturers and some of the key components in the Company’s products come from a single or limited number of suppliers.  Outsourcing our manufacturing and assembly enables us to reduce fixed overhead and personnel costs and to provide flexibility in meeting market demand.

We design and develop the key components for the majority of our products.  In addition, we generally determine the components that are incorporated in our products and select the appropriate suppliers of these components.  Product testing and burn-in are performed by our contract manufacturers using tests that we typically specify.

We sell our solutions primarily through distributors and value-added resellers, who in turn sell our products to end-users.  Some of our resellers are carriers or service providers who provide solutions to the end-user customers as managed services.  Channel sales accounted for approximately 99%, 99%, and 98% of total revenue in 2009, 2008, and 2007, respectively.  Ingram Micro, Tech Data, and Arrow, all of whom are technology product distributors, collectively accounted for approximately 46%, 49%, and 50% of our revenue during 2009, 2008, and 2007, respectively.

We seek to provide our channel partners and customers with differentiated solutions that are innovative, easy to use, reliable, and provide good value.  To support this commitment, we dedicate significant resources to developing new products and marketing our products to our channel partners and customers.


Key Success Factors of our Business

We believe that there are several key success factors of our business, and that we create value in our business by focusing on our execution in these areas.

Channel

Our distributors and authorized resellers provide a valuable service in assisting end-users in the design, implementation, and service of our network security, content security, and business continuity solutions.  We support our distribution and channel partners with sales, marketing, and technical support to help them create and fulfill demand for our offerings.  We also focus on helping our channel partners succeed with our solutions by concentrating on comprehensive reseller training and certification, and support for our channel’s sales activities.

Product and Service Platform

Our products serve as a platform for revenue generation for both us and our channel partners.  Most product sales can result in additional revenue through the simultaneous or subsequent acquisition of software licenses, such as our Global Management System, or through the sale of additional value-added subscription services, such as Content Filtering; client
 
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Anti-Virus and integrated Gateway Anti-Virus; Anti-Spyware and Intrusion Prevention Services; email protection and off-site data backup.

Distributed Architecture

Our security solutions are based on a distributed architecture, which we believe allows our offerings to be deployed and managed at the most efficient location in the network.  We are providing our customers and their service providers with mechanisms to enforce the networking and security policies they have defined for their business.  We also use the flexibility of a distributed architecture to allow us to enable new functionality in already-deployed platforms through the provisioning of an electronic key, which may be distributed through the Internet.

Market Acceptance

We began offering integrated security appliances in 1997, and since that time we have shipped over 1.5 million revenue units.   Our experience in serving a broad market and our installed base of customers provides us with opportunities to sell our new network security, content security, and business continuity solutions as they become available.  The market acceptance of our current solutions provides our current and prospective channel partners with an increased level of comfort when deciding to offer our new solutions to their customers.

Integrated Design

Our platforms utilize a highly integrated design in order to improve ease-of-use, lower acquisition and operational costs for our customers, and enhance performance.  Various models also integrate functionality to support different internet connection alternatives.  Every appliance also ships with pre-loaded firmware to provide for rapid set up and easy installation.  Each of these tasks can be managed through a simple web-browser session.


Our Opportunities, Challenges, and Risks

We serve substantial markets for network security, content security, and business continuity.  Our goal is to deliver comprehensive and profitable solutions to our channel partners which address their customers' needs.  We pursue the creation of these solutions through a blend of organic and inorganic growth strategies including internal development efforts, licensing and OEM opportunities, and acquisition of other companies.  To the extent that these efforts result in solutions which fit well with our channel and end-users, we would expect to generate increasing sales.  To the extent that these efforts are not successful, we would expect to see loss of sales and/or increased expenses without commensurate return.

International Growth

We expect that international revenue will continue to represent a substantial portion of our total revenue in the foreseeable future.  Our percentage of sales from international territories does not represent the same degree of penetration of those markets as we have achieved domestically.  We believe that a significant opportunity exists to grow our revenue by increasing our international penetration rate to match our penetration rate in the domestic market.

If we fail to structure our distribution relationships in a manner consistent with marketplace requirements and on favorable terms, the percentage of sales from international territories will decline and the revenue from our international operations may decrease.

Growth in Enterprises

We believe that sales through our indirect channel to enterprise class customers represent a growth opportunity for the Company.  Our percentage of revenues from such customers does not represent the same degree of penetration of that segment as we have achieved with small to medium sized businesses.  We believe that a significant opportunity exists to grow our revenue by increasing our penetration rate with this segment by leveraging the company’s technological and channel strengths.

If we fail to establish competitive products and services for this segment, or fail to develop the correct channel partners and resources, the percentage of our revenue derived from enterprise class customers will not increase, and may, in fact, decrease.
 
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License and Services Revenue

We believe that the software license and services component of our revenue has several characteristics that are positive for our business as a whole: our license and services revenue is associated with a higher gross profit than our product revenue; the subscription services component of license and services revenue is recognized ratably over the services period, and thus provides, in the aggregate, a more predictable revenue stream than product or license revenue, which are generally recognized at the time of the sale; and to the extent that we are able to achieve good renewal rates, we have the opportunity to lower our selling and marketing expenses attributable to that segment.  We expect our revenue from software licenses and services to continue to represent the majority of our total revenue subject to (1) continuing demand from our installed base of customers for the renewal and upgrading of such service, (2) the number of new hardware appliances sold, and (3) the demand for such services as attached to new hardware appliances sold.

Macro-Economic Factors Affecting IT Spending

We believe that our products and services are subject to the macro-economic factors that affect much of the information technology (“IT”) market.  Growing IT budgets and an increased funding for projects to provide security, mobility, data protection, and productivity could drive product upgrade cycles and/or create demand for new applications of our solutions.  Contractions in IT spending can affect our revenue by causing projects incorporating our products and services to be delayed and/or canceled.  We believe that demand for our solutions correlate with increases or decreases in global IT spending and we believe that economic uncertainties, including fluctuating energy prices, difficulties in the financial sector, the availability of credit, softness in the housing market, underlying market liquidity, and geopolitical uncertainties may continue to have an adverse impact on IT spending in the markets in which we do business.

Critical Accounting Policies and Critical Accounting Estimates
 
The preparation of our financial statements and related disclosures in conformity with accounting principles generally accepted in the United States (“U.S. GAAP”) requires us to make judgments, assumptions, and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes.  We believe that the judgments, assumptions and estimates upon which we rely are reasonable based upon information available to us at the time that these judgments, assumptions and estimates are made.  However, any differences between these judgments, assumptions and estimates and actual results could have a material impact on our statement of operations and financial condition.  The current volatility in the financial markets and associated general economic uncertainty increase the risk that such differences may be realized.  The accounting policies that reflect our most significant judgments, assumptions and estimates and which we believe are critical in understanding and evaluating our reported financial results include: (1) revenue recognition; (2) sales returns and other allowances, allowance for doubtful accounts and warranty reserve; (3) valuation of inventory; (4) accounting for income taxes; (5) valuation of long-lived and intangible assets and goodwill, (6) share-based compensation, and (7) fair value of investments. 

Revenue Recognition

The Company derives its revenue primarily from the sale of: (1) products, (2) software licenses, (3) subscriptions for services, and (4) other services such as extended warranty and service contracts, training, consulting and engineering services.  As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period.  The Company may experience material differences in the amount and timing of its revenue for any period if management makes different judgments or utilizes different estimates.

The Company recognizes revenue for products when persuasive evidence of an arrangement exists, the product has been delivered, title and risk of loss have been transferred to the customer, the fee is fixed or determinable, and collection of the resulting receivable is reasonably assured.  While the Company’s sales agreements contain standard terms and conditions, there are agreements that contain non-standard terms and conditions.  In these cases, interpretation of non-standard provisions is required to determine the appropriate accounting for the transaction.

Retroactive price protection rights resulting from price reductions on products previously sold to customers are contractually offered to the Company’s channel partners.  The Company evaluates the revenue impact of these rights carefully based on stock on hand in the channels and records a provision for estimated future price protection credit. Revenue from certain distributors is not recognized until these distributors sell the product to their customers.  As a consequence, there is no
 
Page 35 of 103

 
provision required for sales to these distributors.  In general, retroactive price adjustments are not significant.  At December 31, 2009, 2008, and 2007, the Company recorded a provision for price protection on sales to the Company’s channel partners in the amounts of $0, $200,000, and $985,000, respectively.

Delivery to customers is generally deemed to occur when we deliver the product to a common carrier.  Certain distributor agreements provide customers with rights of return for stock rotation.  These stock rotation rights are generally limited to 15% to 25% of the distributor's purchases for the immediately prior 3 to 6 months period or contain other measurable restrictions, and we estimate reserves for these return rights as discussed below.  Certain distributors, have rights of return under certain circumstances that are not limited, therefore, we do not deem delivery to have occurred for any sales to these distributors until they sell the product to their customers.

Evidence of an arrangement is manifested by a master distribution or OEM (Original Equipment Manufacturer) agreement, an individual binding purchase order, or a signed license agreement.  In most cases, sales through our distributors and OEM partners are governed by a master agreement against which individual binding purchase orders are placed on a transaction-by-transaction basis.

At the time of the transaction, the Company assesses whether the fee associated with the transaction is fixed or determinable, and whether or not collection is reasonably assured.  The Company assesses whether the fee is fixed or determinable based upon the terms of the binding purchase order, including the payment terms associated with the transaction.  If a significant portion of a fee is due beyond the Company’s normal payment terms, typically 30 to 90 days from invoice date, the Company accounts for the fee as not being fixed or determinable and recognizes revenue as the fees become due.
 
The Company assesses probability of collection based on a number of factors, including past transaction history with and the credit-worthiness of the customer.  The Company does not request collateral from its customers.  If the Company determines that collection of a fee is not reasonably assured, it defers the fee and recognizes revenue at the time collection becomes reasonably assured, which is generally upon receipt of cash.
 
For arrangements with multiple elements (for example, the sale of an appliance which includes a year of maintenance or a subscription based product), the Company allocates revenue first to undelivered components of the arrangement based on the vendor specific objective evidence of fair value of the undelivered elements, which is generally the average selling price of each element when sold separately.  This allocation process means that the Company defers revenue from the arrangement equal to the fair value of the undelivered elements and recognizes such amounts as revenue when the elements are delivered.

The Company’s arrangements do not generally include acceptance clauses.  However, if an arrangement includes an acceptance provision, recognition of revenue occurs upon the earlier of receipt of a written customer acceptance or expiration of the acceptance period.

License and service revenue includes revenue from subscription service licenses, technical support services and perpetual software licenses. The Company recognizes revenue for subscriptions and services such as content filtering, anti-virus protection and intrusion prevention, and extended warranty and service contracts, ratably over the contract term.  The Company’s training, consulting and engineering services are generally billed and recognized as revenue as these services are performed.

The Company collects and remits sales taxes on products and services that it purchases and sells under its contracts with customers, and reports such amounts under the net method in its consolidated statements of operations.  Accordingly, there are no sales taxes included in revenue.
 
In October 2009, the FASB issued Accounting Standard Update (“ASU”) No. 2009-13, Multiple-Deliverable Revenue Arrangements (“ASU 2009-13”) and No. 2009-14, Certain Revenue Arrangements that include Software Elements (“ASU 2009-14”). These standards update FASB ASC 605, Revenue Recognition (“ASC 605”) and FASB ASC 985, Software (“ASC 985”). The amendments to ASC 605 requires entities to allocate revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy. The amendments to ASC 985 remove tangible products from the scope of software revenue guidance and provide guidance on determining whether software deliverables in an arrangement that includes a tangible product are covered by the scope of the software revenue guidance. These amendments to ASC 605 and ASC 985 should be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. The Company adopted these amendments on January 1, 2010.  Management estimates that the impact of the adoption on the Company’s consolidated financial statements will be a 2% increase in revenue recognized in the fiscal year with a corresponding decrease in deferred revenue.
Page 36 of 103

 
Sales Returns and Other Allowances, Allowance for Doubtful Accounts, and Warranty Reserve

The preparation of financial statements in accordance with U.S. GAAP requires us to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period.  Specifically, we must make estimates of potential future product returns and price changes related to current period product revenue.  We analyze historical returns, current economic trends, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and other allowances.  Significant management judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period.  We may experience material differences in the amount and timing of our revenue for any period if management makes different judgments or utilizes different estimates.
 
In addition, we must make estimates based upon a combination of factors to ensure that our accounts receivable balances are not overstated due to uncollectibility.  We specifically analyze accounts receivable and historical bad debts, the length of time receivables are past due, macroeconomic conditions including liquidity and the availability of credit facilities, deterioration in customer’s operating results or financial position, customer concentrations, and customer credit-worthiness, when evaluating the adequacy of the allowance for doubtful accounts.
 
Our appliance products are generally covered by a warranty period of one or two years.  We accrue a warranty reserve for estimated costs to provide warranty services, including the cost of technical support, product repairs, and product replacement for units that cannot be repaired.  Our estimate of costs to fulfill our warranty obligations is based on historical experience and expectation of future conditions.  To the extent we experience increased warranty claim activity or increased costs associated with servicing those claims, our warranty accrual will increase, resulting in decreased gross profit.
 
Valuation of Inventory

We continually assess the valuation of our inventory and periodically write-down the value for estimated excess and obsolete inventory based upon assumptions about future demand and market conditions.  Such estimates are difficult to make since they are based, in part, on estimates of current and future economic conditions.  Reviews for excess inventory are done on a quarterly basis and required reserve levels are calculated with reference to our projected ultimate usage of that inventory.  In order to determine the ultimate usage, we take into account forecasted demand, rapid technological changes, product life cycles, projected obsolescence, current inventory levels, and purchase commitments.  The excess balance determined by this analysis becomes the basis for our excess inventory charge.  If actual demand is lower than our forecasted demand, and we fail to reduce manufacturing output accordingly, we could be required to record additional inventory write-downs, which would have a negative effect on our gross profit and earnings. 

Accounting for Income Taxes

As part of the process of preparing our consolidated financial statements we are required to estimate our taxes in each of the jurisdictions in which we operate.  We must make certain estimates and judgments in determining income tax expense for financial statement purposes.  These estimates and judgments occur in the calculation of tax credits, benefits, and deductions, and in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes, as well as the interest and penalties related to these uncertain tax positions. Significant changes to these estimates may result in an increase or decrease to our tax provision in a subsequent period.

We must assess the likelihood that we will be able to recover our deferred tax assets. If recovery is not likely, we must increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be recoverable.  We believe that we will ultimately recover a substantial majority of the deferred tax assets recorded on our consolidated balance sheets.  However, should there be a change in our ability to recover our deferred tax assets, our tax provision would increase in the period in which we determined that the recovery was not likely.
 
The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations. We recognize liabilities for uncertain tax positions based on the two-step process.  The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any.  The second step requires us to
 
Page 37 of 103

 
estimate and measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement.  It is inherently difficult and subjective to estimate such amounts, as we have to determine the probability of various possible outcomes.  We reevaluate these uncertain tax positions on a quarterly basis.  This evaluation is based on factors including, but not limited to, changes in facts or circumstances, changes in tax law, effectively settled issues under audit, and new audit activity.  Such a change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision. 
 
Valuation of Long-Lived Assets, Intangible Assets and Goodwill

Purchased intangibles consist of purchased technology, customer installed base/relationships, customer backlog and other intangibles.  Intangible assets are amortized on a straight-line basis over their estimated useful lives which range from 3 months to eight years.  We periodically evaluate our intangible assets for indications of impairment.  If this evaluation indicates that the value of the intangible asset may be impaired, we make an assessment of the recoverability of the net carrying value of the asset over its remaining useful life.  If this assessment indicates that the intangible asset is not recoverable, based on the estimated undiscounted future cash flows of the technology over the remaining amortization period, we reduce the net carrying value of the related intangible asset to fair value and may adjust the remaining amortization period.

Goodwill represents the excess of the aggregate purchase price over the fair market value of the net tangible and intangible assets acquired by the Company.  Goodwill is tested for impairment on December 31st of each fiscal year or more often if an event or circumstances indicate that an impairment loss has been incurred.  An impairment charge is recognized if a reporting unit’s goodwill carrying amount exceeds its implied fair value.  Goodwill impairment is determined using a two-step approach and one or more of the following fair value measures including: present value techniques of estimated future cash flows; or valuation techniques based on multiples of earnings or revenue, or a similar performance measure.  Any such impairment charge could be significant and could have a material adverse effect on our reported financial statements.  Based on the impairment tests performed, there was no impairment of goodwill in 2009, 2008, and 2007.  The goodwill recorded as a result of the business combinations in the years presented is not deductible for tax purposes.

We continually monitor events and changes in circumstances that could indicate carrying amounts of long-lived assets, including intangible assets, may not be recoverable.  When such events or changes in circumstances occur, we assess the recoverability of long-lived assets by determining whether the carrying value of such assets will be recovered through undiscounted expected future cash flows.  If the total of the future cash flows is less than the carrying amount of those assets, we record an impairment charge based on the excess of the carrying amount over the fair value of the assets.

Share-Based Compensation

The Company measures and recognizes the compensation expenses for all share-based payment awards made to employees and directors including employee stock options and employee stock purchases related to the Employee Stock Purchase Plan based on the grant date fair value estimated using a Black-Scholes option-pricing model.  The Company estimates the forfeiture rate at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Share-based compensation expense recognized in the Consolidated Statements of Operations are based on awards ultimately expected to vest and has been reduced for estimated forfeitures.  The value of the portion of the award that is ultimately expected to vest is recognized as expenses using the straight-line single option method over the requisite service periods in the Company’s Consolidated Statements of Operations.

Share-based compensation expenses recognized in the Company’s Consolidated Statements of Operations for the years ended December 31, 2009, 2008, and 2007 included compensation expenses for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions and compensation expenses for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated using a Black-Scholes option-pricing model.
 
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Fair Value of Investments

Fair Value

Our investments consist of U.S. Treasury and U.S. government agency securities, municipal notes and bonds, auction rate securities (“ARS”), asset backed securities (“ABS”), corporate notes and bonds, commercial paper, and money market funds. In the current market environment, the assessment of the fair value of the debt securities can be difficult and subjective. The volume of trading activity of certain debt instruments has declined, and the rapid changes occurring in the financial markets can lead to changes in the fair value of financial instruments in a relatively short period of time.  The Company designated all investments, except for ARS held by UBS, as available-for-sale and therefore these investments are reported at fair value, with unrealized gains and losses recorded in accumulated other comprehensive income.  During the fourth quarter of fiscal 2008, the Company reclassified ARS from UBS, one of its investment providers, from available-for-sale to trading securities.  Investments that the Company designates as trading assets are reported at fair value, with gains or losses resulting from changes in fair value recognized in earnings.  The information contained in Note 2 and Note 4 of the Company’s Consolidated Financial Statements is hereby incorporated by reference.

Other-Than-Temporary Impairment. All of the Company’s available-for-sale investments are subject to a periodic impairment review.  The Company recognizes an impairment charge when a decline in the fair value of its investments below the cost basis is judged to be other-than-temporary.  The Company considers various factors in determining whether to recognize an impairment charge, including the length of time and extent to which the fair value has been less than the Company’s cost basis, the financial condition and near-term prospects of the investee, and the Company’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in the market value.  During the years ended December 31, 2009, 2008 and 2007 the Company did not record any other-than-temporary impairment charges on its available-for-sale securities.

 
Significant Transactions

Acquisitions

On July 10, 2007, the Company completed the acquisition of 100% of the outstanding shares of Aventail Corporation (“Aventail”) for approximately $25.6 million in purchase consideration, consisting of cash of approximately $23.6 million, $2.0 million in direct transaction costs incurred in connection with the acquisition, and stock options assumed.  The Company acquired Aventail to complement and extend its current SSL-VPN product offering.  Of the total purchase price of $25.6 million, approximately $1.9 million was allocated to in-process research and development, approximately $6.9 million was allocated to purchased technology that will be amortized over its estimated useful life of six years, approximately $7.9 million was allocated to customer relationship that will be amortized over eight years, approximately $2.6 million was used to pay off an assumed loan, and approximately $4.0 million was recorded for net liabilities assumed.  The remaining $15.4 million was allocated to goodwill. In addition, pursuant to the terms of the Merger Agreement, 744,043 stock options held by employees of Aventail were assumed by SonicWALL.  The fair value as of the acquisition date of these stock options assumed, using the Black-Scholes valuation method, was $2.2 million.  There were no options vested as of the acquisition date thus the purchase price component related to the assumption was zero.  The total fair value of $2.2 million is being recognized as compensation cost over the requisite service period.

The Consolidated Financial Statements include the operating results of each business from the date of acquisition.  The above transaction was accounted for as a purchase business combination.  The Company allocated the purchase price based upon the fair value of the assets acquired and liabilities assumed.  The excess of the purchase price over the fair value of the assets acquired and liabilities assumed has been allocated to the identified intangible assets.
 
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Restructuring
 
During the first quarter of fiscal year 2008, the Company commenced the implementation of a 2008 restructuring plan associated primarily with the relocation of support activities, the closure of facilities in Pune, India and Sunnyvale, California, and other employee reductions for the purpose of better integration and alignment of Company functions.

The information contained in Note 8 to the Consolidated Financial Statements is hereby incorporated by reference into this Part II, Item 7.
 
Results of Operations

The following table sets forth financial data for the years indicated as a percentage of total revenue:

   
Year Ended December 31,
 
   
2009
   
2008
   
2007
 
Revenue:
                 
Product
   
   36.8%
     
   41.6%
     
   49.7%
 
License and service
   
63.2
     
58.4
     
50.3
 
Total revenue
   
100.0
     
100.0
     
100.0
 
Cost of revenue:
                       
Product
   
19.5
     
19.9
     
20.4
 
License and service
   
7.9
     
9.2
     
8.0
 
Amortization of purchased technology
   
1.5
     
1.4
     
1.1
 
Total cost of revenue
   
28.9
     
30.5
     
29.5
 
Gross profit
   
71.1
     
69.5
     
70.5
 
Operating expenses:
                       
Research and development
   
18.9
     
20.2
     
19.8
 
Sales and marketing
   
34.9
     
37.7
     
38.9
 
General and administrative
   
8.5
     
8.5
     
10.8
 
Amortization of purchased intangible assets
   
0.5
     
0.5
     
0.4
 
Restructuring charges
   
-
     
0.8
     
-
 
In-process research and development
   
-
     
-
     
1.0
 
Total operating expenses
   
62.8
     
67.7
     
70.9
 
Income (loss) from operations
   
8.3
     
1.8
     
(0.4)
 
Interest income and other expense, net
   
1.6
     
2.9
     
5.9
 
Income before income taxes
   
9.9
     
4.7
     
5.5
 
Benefit (provision) for income taxes
   
(3.3)
     
(2.5)
     
8.9
 
Net income
   
   6.6%
     
   2.2%
     
  14.4%
 

The following table shows share-based compensation cost before taxes as a percent of total revenues for the periods indicated:

   
Year Ended December 31,
 
   
2009
   
2008
   
2007
 
Cost of sales
   
0.2%
     
0.2%
     
0.3%
 
Research and development
   
1.4%
     
1.5%
     
2.3%
 
Sales and marketing
   
1.6%
     
1.7%
     
2.4%
 
General and administrative
   
1.3%
     
1.4%
     
2.0%
 
Total share-based compensation expenses
   
4.5%
     
4.8%
     
7.0%
 
 
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Total Revenue

Total Revenue by Product Category (in thousands, except for percentage data)
 
   
Year Ended December 31,
   
Dollar Change
   
Percent Change
 
   
2009
   
2008
   
2007
   
2009 vs. 2008
   
2008 vs. 2007
   
2009 vs. 2008
   
2008 vs. 2007
 
UTM
  $ 155,052     $ 164,788     $ 147,696     $ (9,736 )   $ 17,092       (6%)       12%  
  % of total revenue
    77%       75%       74%                                  
SCM
    19,805       22,988       23,604       (3,183 )     (616 )     (14%)       (3%)  
  % of total revenue
    10%       11%       12%                                  
SSL
    17,160       20,668       15,706       (3,508 )     4,962       (17%)       32%  
  % of total revenue
    9%       9%       8%                                  
CDP
    8,558       10,200       12,193       (1,642 )     (1,993 )     (16%)       (16%)  
  % of total revenue
    4%       5%       6%                                  
Total revenue
  $ 200,575     $ 218,644     $ 199,199     $ (18,069 )   $ 19,445       (8%)       10%  

The 6% decline in revenue in the UTM product category in 2009 compared to 2008 was due to the combination of a 12% decrease in product revenue and a 1% decrease in revenue from software license and subscription services. The decline in product revenue was due to the combination of a 10% decrease in average net revenue per unit and a 2% decrease in units sold. The decrease in software license and subscription services revenue was offset by a 16% increase in revenue from our CGSS subscription services. The 14% decline in revenue in the SCM product category in 2009 compared to 2008 was due to the combination of a 47% decrease in product revenue and a 10% decrease in revenue from software license and subscription services.  The decline in product revenue was due to the combination of a 42% decrease in units sold and a 9% decrease in average net revenue per unit. The 17% decline in revenue in the SSL product category in 2009 compared to 2008 was due to the combination of a 47% decrease in product revenue and a 4% decrease in subscription services revenue, offset by an 81% increase in software license revenue.  The decrease in product revenue was due to the combination of a 22% decrease in units sold and a 32% decrease in average net revenue per unit. The increase in software license revenue was primarily due to a change that was effected in the fourth quarter of 2008 to the pricing structure of Aventail SSL-VPN solutions that offered end user licenses separately from the base appliances. The 16% decline in revenue in the CDP product category in 2009 compared to 2008 was due to a 31% decrease in product revenue, offset by a 7% increase in revenue from software license and subscription services.  The decline in product revenue was primarily due to a 33% decrease in units sold.

The 12% increase in revenue in the UTM product category in 2008 compared to 2007 was due to a 29% increase in revenue from software license and subscription services, offset by a 5% decrease in product revenue. The increase in software license and subscription services revenue was primarily due to a 99% increase in revenue from our CGSS subscription services. The decline in product revenue was primarily due to a 6% decrease in units sold. The 3% decline in revenue in the SCM product category in 2008 compared to 2007 was due to a 42% decrease in product revenue, offset by a 7% increase in revenue from software license and subscription services.  The decline in product revenue was due to the combination of a 38% decrease in units sold and a 7% decrease in average net revenue per unit. The 32% increase in revenue in the SSL product category in 2008 compared to 2007 was primarily due to a 100% increase in software license revenue.  The 16% decline in revenue in the CDP product category in 2008 compared to 2007 was due to a 28% decrease in product revenue, offset by a 13% increase in revenue from software license and subscription services.  The decline in product revenue was primarily due to a 28% decrease in units sold.
 
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Total Revenue by Geographic Area (in thousands, except for percentage data)
 
   
Year Ended December 31,
   
Dollar Change
   
Percent Change
 
   
2009
   
2008
   
2007
   
2009 vs. 2008
   
2008 vs. 2007
   
2009 vs. 2008
   
2008 vs. 2007
 
Americas
  $ 139,458     $ 149,986     $ 138,678     $ (10,528 )   $ 11,308       (7%)       8%  
% of total revenue
    70%       69%       70%                                  
EMEA
    40,949       46,144       40,420       (5,195 )     5,724       (11%)       14%  
% of total revenue
    20%       21%       20%                                  
APAC
    20,168       22,514       20,101       (2,346 )     2,413       (10%)       12%  
% of total revenue
    10%       10%       10%                                  
Total revenue
  $ 200,575     $ 218,644     $ 199,199     $ (18,069 )   $ 19,445       (8%)       10%  

Revenue in the Americas included sales from regions outside the United States and Canada of $4.3 million and $5.6 million for 2009 and 2008, respectively. The decline in revenue in the Americas for 2009 compared to 2008 was primarily due to the combination of decreases in the units sold in the SCM, SSL and CDP product categories, average net revenue per unit in the UTM and SSL product categories, and sales of software license and subscription services in the UTM and SCM product categories, offset by increased sales of software license and subscription services in the SSL product category.  The decline in revenue in EMEA for 2009 compared to 2008 was primarily due to the combination of decreases in the units sold in the UTM, SSL and CDP product categories and average net revenue per unit in the UTM and SSL product categories, offset by increased sales of software licenses and subscription services in the SSL product category.  The decline in revenue in APAC for 2009 compared to 2008 was primarily due to the combination of decreases in average net revenue per unit in the UTM, SCM and SSL product categories, offset by increases in the units sold in the UTM product category.

Revenue in the Americas included sales from regions outside the United States and Canada of $5.6 million and $3.0 million for 2008 and 2007, respectively. The increase in revenue in the Americas for 2008 compared to 2007 was primarily due to increases in sales of software license and subscription services in the UTM and SSL product categories, offset by the combination of decreases in the units sold in the UTM, SCM and CDP product categories and average net revenue per unit in the UTM product category.  The increase in revenue in EMEA for 2008 compared to 2007 was primarily due to the combination of increased sales of software license and subscription services in the UTM, SCM and SSL product categories and average net revenue per unit in the UTM product category, offset by decreases in the units sold in the UTM product category.  The increase in revenue in APAC for 2008 compared to 2007 was primarily due to the combination of increased sales of software license and subscription services in the UTM and SSL product categories and average net revenue per unit in the UTM product category, offset by decreases in the units sold in the UTM and CDP product categories.

Product and License and Service Revenue (in thousands, except for percentage data)
 
   
Year Ended December 31,
   
Dollar Change
   
Percent Change
 
   
2009
   
2008
   
2007
   
2009 vs. 2008
   
2008 vs. 2007
   
2009 vs. 2008
   
2008 vs. 2007
 
Product
  $ 73,847     $ 90,857     $ 98,936     $ (17,010 )   $ (8,079 )     (19%)       (8%)  
% of total revenue
    37%       42%       50%                                  
License and service
    126,728       127,787       100,263       (1,059 )     27,524       (1%)       27%  
% of total revenue
    63%       58%       50%                                  
Total revenue
  $ 200,575     $ 218,644     $ 199,199     $ (18,069 )   $ 19,445       (8%)       10%  
 
Product Revenue

We shipped approximately 174,000, 182,000, and 196,000 total units, respectively, during fiscal 2009, 2008, and 2007.

The decrease in product revenue in 2009 compared to 2008 was primarily due to the combination of decreases in units sold in all product categories and average net revenue per unit in UTM and SSL product categories.

The decrease in product revenue in 2008 compared to 2007 was primarily due to decreases in units sold in all product categories, offset by increases in average net revenue per unit in the UTM and SSL product categories.
 
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License and Service Revenue
 
License and service revenue includes revenue from subscription service licenses, technical support services and perpetual software licenses.

The decline in license and service revenue in 2009 compared to 2008 was primarily due to (1) a decrease in sales of software licenses associated with our UTM solution, and (2) a decrease in sales of subscription services associated with our SCM solutions.  These decreases were offset by (1) an increase in sales of subscription services associated with our UTM solutions, and (2) an increase in sales of software licenses associated with our SSL and CDP solutions.

The increase in license and service revenue in 2008 compared to 2007 was primarily due to (1) an increase in sales of software licenses associated with our SSL solution; and (2) an increase in sales of subscription services associated with our UTM and SCM solutions.  These increases were offset by a decrease in sales of software licenses associated with our UTM and SCM solutions.

 Cost of Revenue and Gross Profit

The following table shows the cost of revenue for product and the cost of revenue for license and service (in thousands, except for percentage data):

   
Year Ended December 31,
   
Percent Variance
 
   
2009
   
2008
   
2007
   
2009 vs. 2008
   
2008 vs. 2007
 
Product
 
$
39,038
   
$
43,507
   
$
40,555
     
(10%)
     
7%
 
License and service
   
15,857
     
20,102
     
15,894
     
(21%)
     
26%
 
Amortization of purchased technology
   
3,017
     
3,017
     
2,232
     
-
     
35%
 
Total cost of revenue
 
$
57,912
   
$
66,626
   
$
58,681
     
(13%)
     
14%
 

Note – Effect of amortization of purchased technology has been excluded from product and license and service gross profit discussions below.

The following table shows the gross profit for product and the gross profit for license and service (in thousands, except for percentage data):

   
Year Ended December 31,
 
   
Gross Profit Amount
   
Gross Margin
 
   
2009
   
2008
   
2007
   
2009
   
2008
   
2007
 
Product
 
$
34,809
   
$
47,350
   
$
58,381
     
47%
     
52%
     
59%
 
License and service
   
110,871
     
107,685
     
84,369
     
87%
     
84%
     
84%
 
Amortization of purchased technology
   
(3,017
)
   
(3,017
)
   
(2,232
)
                       
Total gross profit
 
$
142,663
   
$
152,018
   
$
140,518
     
71%
     
70%
     
71%
 

Cost of Product Revenue and Gross Profit/Margin
 
Cost of product revenue includes costs associated with the production of our products, including cost of materials, manufacturing and assembly costs paid to contract manufacturers, freight, related fulfillment cost, and overhead costs associated with our manufacturing operations.  Additionally, warranty costs and inventory provisions or write-downs are included in cost of product revenue.

In 2009 compared to 2008, the cost of product revenue decreased in all product categories.  The 10% decline was primarily due to the combination of a 2% decrease in the units sold from the UTM product category, a 42% decrease in units sold from the SCM product category, a 22% decrease in units sold from the SSL product category, a 33% decrease in units sold from the CDP product category and a 5% decrease in the average production cost per unit in the UTM product category, offset by a 21% increase in the average production cost per unit in the CDP product category.  Compared to 2008, 2009 average production cost per unit for all product categories decreased by approximately 6%.
 
Page 43 of 103


In 2008 compared to 2007, the cost of product revenue increased in the UTM product category, but decreased in the SCM, SSL, and CDP product categories.  The 7% increase was primarily due to a 23% increase in the average production cost per unit in the UTM product category, offset by a 6% decrease in the units sold in the UTM product category, a 38% decrease in the SCM product category and a 28% decrease in the CDP product category. Compared to 2007, 2008 average production cost per unit for all product categories increased by approximately 16%.

In 2009 compared to 2008, gross profit and gross profit percentage from product sales decreased in all four product categories. In the UTM product category, an 18% decline in gross profit was primarily due to the combination of a 10% decrease in the average net revenue per unit and a 2% decrease in the units sold, offset by a 5% decrease in the average production cost per unit.  In the SCM product category, a 59% decline in gross profit was due to the combination of a 9% decrease in the average net revenue per unit and a 42% decrease in the units sold.  In the SSL product category, a 55% decline in gross profit was primarily due to the combination of a 32% decrease in the average net revenue per unit and a 22% decrease in the units sold.  In the CDP product category, a 40% decline in gross profit was due to the combination of a 33% decrease in the units sold and a 21% increase in the average production cost per unit.

In 2008 compared to 2007, gross profit and gross profit percentage from product sales decreased in the UTM, SCM and CDP product categories. In the UTM product category, a 19% decline in gross profit was primarily due to the combination of a 23% increase in the average production cost per unit and a 6% decrease in the units sold, offset by a 1% increase in the average net revenue per unit.  In the SCM product category, a 52% decline in gross profit was due to the combination of a 7% decrease in the average net revenue per unit, a 38% decrease in the units sold, and a 5% increase in the average production cost per unit.  In the CDP product category, a 31% decline in gross profit was due to the combination of a 28% decrease in the units sold and a 6% increase in the average production cost per unit.

We expect future product gross profit to erode to the extent that we experience downward pressure on product pricing or upward pressure on production costs.  A change in the mix of product sold could also change product gross profit and gross profit percentage.

Cost of License and Service Revenue and Gross Profit
 
Cost of license and service revenue includes costs associated with the production and delivery of our license and service offerings, including technical support costs related to our service contracts, royalty costs related to certain subscription offerings, personnel costs related to the delivery of training, consulting, and professional services; and cost of packaging materials and related costs paid to contract manufacturers.

In 2009 compared to 2008, gross profit from license and service increased in the UTM, SSL and CDP product categories and gross profit percentage from license and service increased in all product categories.  These increases were primarily due to decreased costs. Cost of license and service revenue decreased by 21% in 2009 compared to 2008.  This decrease was primarily due to decreased technical support costs.  In 2007, the Company started a process to “in-source” a portion of our technical support delivery to centers located in the United States and India.  That phase of the “in-sourcing” process was completed in mid 2008 and has resulted in a decline in our technical support costs for 2009 compared to 2008. The Company has also completed the implementation of a second phase of technical support “in sourcing” activity for certain other regions in the fourth quarter of 2009.

In 2008 compared to 2007, gross profit from license and service increased in all product categories and gross profit percentage from license and service increased in the UTM and SCM product categories.  These increases were primarily due to a 28% increase in net revenue, offset by a 27% increase in the cost of license and service revenue. The increase in the cost of license and service was primarily due to the technical support costs associated with a larger base of license and subscription service customers. In addition, in 2007, the Company started a process to “in-source” a portion of our technical support delivery to centers located in the United States and India.  That phase of the “in-sourcing” process was completed in mid 2008.  The planning and other ramp up costs associated with these centers, without a corresponding decrease in costs associated with existing third party service providers, resulted in duplicate or redundant technical support expenses for a period of time.
 
Page 44 of 103

 
Amortization of Purchased Technology

   
Year Ended December 31,
 
   
2009
   
2008
   
2007
 
   
(in thousands)
 
Expenses
 
$
3,017
   
$
3,017
   
$
2,232
 
% of total revenue
   
2%
     
1%
     
1%
 
Year over year change in dollars
   
-
     
785
         
Year over year change in percent
   
-
     
35%
         

Amortization of purchased technology represents the amortization of existing technology acquired in our business combinations accounted for using the purchase method.  Purchased technology is being amortized over the estimated useful lives of four to eight years.  The increase in amortization for the year ended December 31, 2008 as compared to the same period last year is primarily due to the timing difference of the amortization of the purchased technology from Aventail.

The amounts for the year ended December 31, 2009, 2008 and 2007 represent amortization of purchased intangibles associated with our acquisitions of enKoo, Lasso Logic, MailFrontier, and Aventail.

Future amortization to be included in cost of revenue based on the current balance of purchased technology absent any additional investment is as follows (in thousands):

Fiscal Year
 
Amortization Amount to Cost of Revenue
 
2010
 
$
2,374
 
2011
   
1,382
 
2012
   
1,382
 
2013
   
803
 
2014
   
225
 
Thereafter
   
206
 
Total
 
$
6,372
 

Our gross profit has been and will continue to be affected by a variety of factors, including competition, the mix of products and services, new product introductions and enhancements, fluctuations in manufacturing volumes, and the cost of components and manufacturing labor.

Operating Expenses

Research and Development

   
Year Ended December 31,
 
   
2009
   
2008
   
2007
 
   
(in thousands)
 
Expenses
 
$
37,858
   
$
44,176
   
$
39,410
 
% of total revenue
   
19%
     
20%
     
20%
 
Year over year change in dollars
   
(6,318
)
   
4,766
         
Year over year change in percent
   
(14%)
     
12%
         

Research and development expenses primarily consist of personnel costs, contract consultants, outside testing services and equipment and supplies associated with enhancing existing products and developing new products.
 
During 2009, the decrease in research and development costs in comparison to the same period last year was primarily due to the following: (1) a decrease in personnel costs, including salaries, contract labor, variable compensation and benefit expenses of approximately $3.9 million; (2) a decrease in contract services of $0.5 million; (3) a decrease in share-based compensation expense related to employee stock options and rights granted under the Employee Stock Purchase Program (“ESPP”) of approximately $0.5 million; (4) a decrease in travel related costs of approximately $0.4 million; and (5) a decrease in information service and facilities costs allocated to product development of approximately $0.7 million.
 
Page 45 of 103


During 2008, the increase in research and development costs in comparison to the same period last year was primarily due to the following: (1) an increase in salary, variable compensation and benefit expenses of approximately $3.1 million resulting primarily from increased headcount related to the Aventail acquisition; and (2) an increase in information service and facilities costs allocated to product development of approximately $2.7 million. These increases in research and development expenses were partially offset by a decrease in share-based compensation expense related to employee stock options and rights granted under the ESPP of approximately $1.4 million.

We believe that our future performance will depend in large part on our ability to maintain and enhance our current product line, develop new products that achieve market acceptance, maintain technological competitiveness, and meet an expanding range of customer requirements.  We plan to maintain our investments in current and future product development and enhancement efforts, and incur expenses associated with these initiatives, such as prototyping expense and non-recurring engineering charges associated with the development of new products and technologies.

Sales and Marketing

   
Year Ended December 31,
 
   
2009
   
2008
   
2007
 
   
(in thousands)
 
Expenses
 
$
70,000
   
$
82,348
   
$
77,741
 
% of total revenue
   
35%
     
38%
     
39%
 
Year over year change in dollars
   
(12,348
)
   
4,607
         
Year over year change in percent
   
(15%)
     
6%
         

Sales and marketing expenses primarily consist of personnel costs, including commissions, costs associated with the development of our business and corporate identification, costs related to customer support, travel, tradeshows, promotional and advertising costs, and related facilities costs.

During 2009, the decrease in sales and marketing expenses compared to the same period in 2008 is primarily due to (1) a decrease in personnel costs, including salaries, contract labor, and other related employee benefits, of approximately $5.9 million; (2) a decrease in share-based compensation expense related to employee stock options and rights granted under the ESPP of approximately $0.5 million; (3) a decrease of $1.4 million in travel related costs; (4) a decrease in marketing program, advertising, channel marketing and promotional costs of approximately $4.0 million; and (5) a decrease of approximately $0.3 million in expenses associated with our sales and marketing facilities including rent, maintenance costs, telephone, and internet connectivity.

During 2008, the increase in sales and marketing expenses compared to the same period in 2007 is primarily due to (1) increased personnel costs, including commissions, contract labor, and other related employee benefits, of approximately $3.7 million resulting from the acquisition of Aventail and the “in-sourcing” of our technical support services; (2) an increase of approximately $3.9 million in expenses associated with our sales and marketing facilities including rent, maintenance costs, telephone, and internet connectivity primarily due to the “in-sourcing” of our technical support services; and (3) an increase of approximately $0.3 million in travel related expenses. These increases in sales and marketing expenses were partially offset by (1) a decrease in marketing program, advertising, channel marketing and promotional costs of approximately $2.2 million; and (2) a decrease in the cost of share-based compensation expense related to employee stock options and rights granted under the ESPP of approximately $1.0 million.

We expect to direct our sales and marketing expenses toward the expansion of domestic and international markets, introduction of new products and establishment and expansion of new distribution channels.
 
Page 46 of 103

 
General and Administrative

   
Year Ended December 31,
 
   
2009
   
2008
   
2007
 
   
(in thousands)
 
Expenses
 
$
17,134
   
$
18,613
   
$
21,473
 
% of total revenue
   
9%
     
9%
     
11%
 
Year over year change in dollars
   
(1,479
)
   
(2,860
)
       
Year over year change in percent
   
(8%)
     
(13%)
         

General and administrative expenses consist primarily of personnel costs, business insurance, corporate governance costs, professional fees, travel expense, and related facilities costs.

During 2009, the decrease in G&A expenses was primarily related to (1) a decrease in share-based compensation expense related to employee stock options and rights granted under the ESPP of approximately $0.4 million; (2) a decrease of approximately $0.2 million in personnel costs; (3) a decrease in accounting related expenses of approximately $0.7 million; (4) a decrease in bad debt expenses of approximately $0.2 million; and (5) a decrease of approximately $0.1 million in office supplies expenses.  These decreases were partially offset by an increase in litigation related expenses of approximately $0.4 million.

During 2008, the decrease in G&A expenses was primarily related to (1) a decrease in personnel costs of approximately $1.2 million primarily due to decreased performance based bonus expenses; (2) a decrease in share-based compensation expense related to employee stock options and rights granted under the ESPP of approximately $1 million; (3) a decrease of approximately $0.4 million in allocated facilities expenses including rent, maintenance costs, depreciation, telephone, and internet connectivity; (4) a decrease in litigation related expenses of approximately $0.3 million; and (5) a decrease of approximately $0.1 million in travel related expenses.

We believe that general and administrative expenses will increase in absolute dollars and remain relatively stable as a percentage of total revenue as we incur costs related to corporate governance matters and the pursuit of various corporate opportunities.

Amortization of Purchased Intangible Assets Included in Operating Expenses

   
Year Ended December 31,
 
   
2009
   
2008
   
2007
 
   
(in thousands)
 
Expenses
 
$
1,095
   
$
1,114
   
$
715
 
% of total revenue
   
0.5%
     
0.5%
     
0.4%
 
Year over year change in dollars
   
(19
)
   
399
         
Year over year change in percent
   
(2%)
     
56%
         

Amortization of purchased intangibles included in operating expenses represents the amortization of assets arising from contractual or other legal rights acquired in business combinations and excludes for amortization of acquired developed technology which is included in cost of revenue.  Purchased intangible assets are being amortized over their estimated useful lives of three to eight years.

The reduction in amortization expense included in operating expenses in 2009 compared to 2008 was the result of the completion of the amortization of certain intangibles associated with the acquisition of MailFrontier.

The increase in amortization expense included in operating expense in 2008 compared to 2007 was the result of an increase in the amortization of intangibles associated with the acquisition of Aventail.  This increase was partially offset by a decrease in the amortization of intangibles associated with the acquisition of MailFrontier.
 
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Future amortization to be included in operating expenses based on current balance of purchased intangibles absent any additional investment is as follows (in thousands):

Fiscal Year
 
Amortization Amount to Operating Expenses
 
2010
 
$
1,095
 
2011
   
1,095
 
2012
   
1,008
 
2013
   
990
 
2014
   
990
 
Thereafter
   
495
 
Total
 
$
5,673
 
 
Restructuring Charges

   
Year Ended December 31,
 
   
2009
   
2008
   
2007
 
   
(in thousands)
 
Expenses
 
$
-
   
$
1,683
   
$