1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended DECEMBER 31, 2000 ----------------- 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 0-24544 CYBERGUARD CORPORATION -------------------------------------------------------------------------------- (Exact name of Registrant as Specified in Its Charter) FLORIDA 65-0510339 -------------------------------------------------------------------------------- (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 2000 WEST COMMERCIAL BLVD., SUITE 200, FORT LAUDERDALE, FLORIDA 33309 -------------------------------------------------------------------------------- (Address of Principle Executive Offices) (Zip Code) Registrant's Telephone Number, Including Area Code 954-958-3900 ---------------------------- -------------------------------------------------------------------------------- Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report Indicate by check [X] whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), Yes [X] No [ ] and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] As of February 9, 2001, 17,736,936 shares of the Registrant's $0.01 par value Common Stock were outstanding. 2 CYBERGUARD CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2000 (UNAUDITED) PART I: FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CYBERGUARD CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (Dollars in thousands except share and per share data) Three Months Ended Six Months Ended Dec. 31, Dec. 31, Dec. 31, Dec. 31, 2000 1999 2000 1999 ----------- ----------- ----------- ----------- Revenues: Products $ 4,938 $ 3,498 $ 7,879 $ 6,763 Services 1,411 872 2,517 1,939 ----------- ----------- ----------- ----------- Total revenues 6,349 4,370 10,396 8,702 Cost of revenues: Products 1,222 849 1,880 1,387 Services 668 259 1,190 948 ----------- ----------- ----------- ----------- Total cost of revenues 1,890 1,108 3,070 2,335 ----------- ----------- ----------- ----------- Gross profit 4,459 3,262 7,326 6,367 ----------- ----------- ----------- ----------- Operating expenses: Research and development 1,113 707 2,427 1,552 Selling, general and administrative 3,529 2,407 6,759 4,896 ----------- ----------- ----------- ----------- Total operating expenses 4,642 3,114 9,186 6,448 ----------- ----------- ----------- ----------- Operating income (loss) (183) 148 (1,860) (81) ----------- ----------- ----------- ----------- Other income (expense) Interest expense, net (240) (319) (438) (662) Gain on sale of assets 0 24 13 0 Other income (expense) (62) 85 (60) 98 ----------- ----------- ----------- ----------- Total other income (expense) (302) (210) (485) (564) Loss before cumulative effect of change in accounting principle $ (485) $ (62) $ (2,345) $ (645) ----------- ----------- ----------- ----------- Cumulative effect of change in accounting principle (129) 0 (129) 0 Net Loss $ (614) $ (62) $ (2,474) $ (645) =========== =========== =========== =========== Basic and fully-diluted loss per common share: Before cumulative effect of change in accounting principle $ (0.05) $ (0.01) $ (0.24) $ (0.07) Cummulative effect of change in accounting principle $ (0.01) $ -- $ (0.01) $ -- ----------- ----------- ----------- ----------- Net Loss $ (0.06) $ (0.01) $ (0.25) $ (0.07) =========== =========== =========== =========== Weighted average number of common shares outstanding 9,907,451 9,148,283 9,878,423 9,118,481 =========== =========== =========== =========== See accompanying notes to condensed consolidated financial statements 1 3 CYBERGUARD CORPORATION CONDENSED CONSOLIDATED BALANCE SHEET (Unaudited) (Dollars in thousands) Dec. 31, June 30, 2000 2000 ---------- ---------- ASSETS Cash and cash equivalents $ 2,332 $ 2,497 Restricted cash 703 800 Accounts receivable, less allowance for uncollectible accounts of $98 at Dec. 31, 2000 and $52 at June 30, 2000 5,015 3,614 Inventories, net 279 159 Other current assets 1,895 1,255 ---------- ---------- Total current assets 10,224 8,325 Property and equipment at cost, less accumulated depreciation of $1,431 at Dec. 31, 2000 and $1,181 at June 30, 2000 1,299 1,086 Capitalized sofware, net 1,150 1,142 Non-compete agreements, net 140 280 Other assets 171 163 ---------- ---------- Total assets $ 12,984 $ 10,996 ========== ========== LIABILITIES AND SHAREHOLDERS' DEFICIT Line of credit and note payable 1,230 1,575 Accounts payable 2,674 1,424 Deferred revenue 3,386 2,912 Accrued expenses and other liabilities 3,430 1,942 ---------- ---------- Total current liabilities 10,720 7,853 Note Payable 650 650 Convertible debenture, net 5,479 4,445 ---------- ---------- Total liabilities 16,849 12,948 ---------- ---------- Shareholders' deficit Common stock par value $0.01 authorized 50,000,000 shares issued and outstanding 9,941,820 at Dec. 31, 2000 and 9,799,321 at June 30, 2000 99 98 Additional paid-in capital 75,773 75,290 Accumulated deficit (79,923) (77,451) Accumulated other comprehensive income 186 111 ---------- ---------- Total shareholders' deficit (3,865) (1,952) ---------- ---------- ---------- ---------- Total liabilities and shareholders' deficit $ 12,984 $ 10,996 ========== ========== See accompanying notes to condensed consolidated financial statements 2 4 CYBERGUARD CORPORATION CONDENSED CONSOLIDATED STATEMENT OF CASH FLOW (Unaudited) (Dollars in thousands) Six Months Ended Dec. 31, Dec. 31, 2000 1999 ---------- ---------- Cash flows from operating activities: Net loss $ (2,474) $ (645) Adjustment to reconcile net loss to net cash used by operating activities: Depreciation 361 188 Amortization 569 244 Interest on retirement of convertible debt -- 240 Interest on new convertible debt -- 95 Provision for uncollectible accounts receivable 46 (266) Provision for inventory reserve (1) -- Modification to stock options 68 -- Beneficial conversion feature on Aug. 1999 and Dec. 2000 convertible debt 162 -- Changes in assets and liabilities: Accounts receivable (1,447) 205 Other current assets (640) (141) Inventories (120) 91 Accounts payable 1,250 (1,723) Accrued expenses and other liabilities 1,488 (1,511) Deferred revenue 475 952 Other, net 66 78 ---------- ---------- Net cash used in operating activities (197) (2,193) ---------- ---------- Cash flows used in investing activities: Capitalized software costs (360) (350) Additions/deletions to Property & Equipment (574) (130) ---------- ---------- Net cash used in investing activities (934) (480) ---------- ---------- Cash flows provided by financing activities: Change in restricted cash 97 258 Issuance of new convertible debt 1,000 4,314 Retirement of existing convertible debt -- (1,125) Notes Payable (214) (610) Revolving line of credit (132) (55) Proceeds from stock options exercised 109 -- Proceeds from sale of securities -- -- Proceeds from sale of common stock 106 196 ---------- ---------- Net cash provided by financing activities 966 2,978 ---------- ---------- Net increase (decrease) in cash (165) 305 Cash and cash equivalents at beginning of period 2,497 2,622 ---------- ---------- Cash and cash equivalents at end of period $ 2,332 $ 2,927 ========== ========== Supplemental disclosure of cash flow information Cash paid for interest 364 482 ========== ========== Cash paid for income taxes -- -- ========== ========== Supplemental disclosure of non-cash information Modification to stock options - on November 27, 2000, the Compensation Committee of the Board of Directors of the Company resolved that the February 4, 2001 expiration date of each of the options to purchase shares of the Company's common stock granted on February 4, 1996 would be extended by three years. All 129,100 shares granted on February 4, 1996 will now expire in their entirety on February 4, 2004. This modification required the Company to record compensation expense during the quarter of approximately $68,000. Beneficial conversion feature on Aug. 1999 and Dec. 2000 convertible debt - at the November 2000 meeting, The Emerging Issues Task Force (EITF) reached a consensus opinion on Issue 00-27 regarding the "Aplication of EITF Issue 98-5, "Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios," to Certain Convertible Instruments". The consensus opinion required the Company to use an effective conversion price to determmine a convertible instrument's beneficial conversion feature. The change is effective retroactively to transactions for which a commitment date occurs prior to November 16, 2000. As a result, the Company recognized $129,000 as a cumulative effect of a change in accounting principle associated with the convertible debt issued in August 1999. The change is effective prospectively to transactions for which a commitment date occurs after November 16, 2000. As a result, the Company recognized $33,000 in interest expense associated with the convertible debt issued in December 2000. See accompanying notes to condensed consolidated financial statements 3 5 CYBERGUARD CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2000 (UNAUDITED) 1. BASIS OF PRESENTATION The Company has prepared the consolidated financial statements included herein, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission with respect to Form 10-Q. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures made are adequate so as to make the information contained not misleading. These interim financial statements and the notes should be read in conjunction with the financial statements and the notes included in the Company's 10-K for the year ended June 30, 2000. In the Company's opinion, all adjustments (consisting only of normal recurring adjustments) necessary for fair presentation of the information shown have been included. Generally accepted accounting standards also requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and disclose contingent assets and liabilities at the date of the financial statements. Significant estimates include those made for software development costs, reserve for inventories, the allowance for uncollectible accounts, and contingencies. Actual results could differ from those estimates. The results of operations for the six months ended December 31, 2000 presented are not necessarily indicative of the results of operations that may be expected for the year ending June 30, 2001. Basic loss per share is calculated by dividing net loss by the weighted average number of common shares outstanding during the year. Diluted per share data includes the dilutive effect of options, warrants and convertible securities. Since the effects of the outstanding options, warrants and convertible securities are anti-dilutive, they are not included in the calculation of diluted loss per share. The Company's operating results and financial condition may be impacted by a number of factors including, but not limited to the following, any of which could cause actual results to vary materially from current and historical results or the Company's anticipated future results. A portion of the Company's revenue is derived from its international operations and sources. As a result, the Company's operations and financial results could be affected by international factors such as changes in foreign currency exchange rates or weak economic conditions in the international markets in which the Company distributes its products. The network security industry is highly competitive and competition is expected to intensify. There are numerous companies competing in segments of the market in which the Company does business. Competitors include organizations significantly larger and with more development, marketing and financial resources than the Company. In addition, the Company is subject to risks and uncertainties which include, but are not limited to, the timely development of and acceptance of new products, impact of competitive products, competition for and retention of key management and technology employees, regulation, inventory obsolescence, the ultimate outcome of certain litigation matters, and cash balances in excess of federally insured limits. 2. CHANGE IN ACCOUNTING PRINCIPLE At the November 2000 meeting, The Emerging Issues Task Force (EITF) reached a consensus opinion on Issue 00-27 regarding the "Application of EITF Issue 98-5, "Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios," to Certain Convertible Instruments". The consensus opinion required the Company to use an effective conversion price to determine a convertible instrument's beneficial conversion feature. The change is effective retroactively to transactions for which a commitment date occurs prior to November 16, 2000. As a result, the 4 6 CYBERGUARD CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2000 (UNAUDITED) Company recognized $129,000 as a cumulative effect of a change in accounting principle associated with the convertible debt issued in August 1999. The change is effective prospectively to transactions for which a commitment date occurs after November 16, 2000. As a result, the Company recognized $33,000 in interest expense associated with the convertible debt issued in December 2000. 3. LITIGATION On August 24, 1998, the Company announced, among other things, that due to a review of its revenue recognition practices relating to distributors and resellers, it would restate prior financial results. After the August 24, 1998 announcement, twenty-five purported class action lawsuits were filed by alleged shareholders against the Company and certain former officers and directors. Pursuant to an order issued by the Court, these actions have been consolidated into one action, styled Stephen Cheney, et al. v. CyberGuard Corporation, et al., Case No. 98-6879-CIV-Gold, in the United States District Court, Southern District of Florida. On August 23, 1999, the plaintiffs filed a Consolidated and Amended Class Action Complaint. This action seeks damages purportedly on behalf of all persons who purchased or otherwise acquired the Company's common stock during various periods from November 7, 1996 through August 24, 1998. The complaint alleges, among other things, that as a result of accounting irregularities relating to the Company's revenue recognition policies, the Company's previously issued financial statements were materially false and misleading and that the defendants knowingly or recklessly published these financial statements which caused the Company's common stock prices to rise artificially. The action alleges violations of Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act") and SEC Rule 10b-5 promulgated thereunder and Section 20(a) of the Exchange Act. Subsequently, the defendants, including the Company, filed their respective motions to dismiss the amended complaint. On July 31, 2000, the Court issued a ruling denying the Company's and Robert L. Carberry's (the Company's CEO from June 1996 through August 1998) motions to dismiss. The court granted the motions to dismiss with prejudice for defendants William D. Murray (the Company's CFO from November 1997 through August 1998), Patrick O. Wheeler (the Company's CFO from April 1996 through October 1997), C. Shelton James (former Audit Committee Chairman), and KPMG Peat Marwick LLP ("KPMG"). On August 14, 2000, the plaintiffs filed a motion for reconsideration of that order. The Company filed an answer to the plaintiffs' complaint on August 24, 2000. The Company's obligation to indemnify its officers and directors under the aforementioned lawsuit is insured to the extent of the limits of the applicable insurance policies. The Company has notified its insurance carrier of the existence of the lawsuit, and the carrier has sent the Company a reservation of rights letter. The Company intends to vigorously defend this action, and believes that in the event that it is unsuccessful, insurance coverage will be available to defray a portion, or substantially all, of the expense of defending and settling the lawsuit or paying a judgment. However, the Company is unable to predict the ultimate outcome of the litigation. There can be no assurance that the Company will be successful in defending the lawsuit or if unsuccessful, insurance will be available to pay all or any portion of the expense of the lawsuit. If the Company is unsuccessful in defending the lawsuit and the insurance coverage is unavailable or insufficient, the resolution of the lawsuit could have an effect on the Company's consolidated financial position, results of operations, and cash flows. The Company's consolidated financial statements do not include any adjustments related to these matters. In August 1998, the Securities and Exchange Commission ("SEC") commenced an informal inquiry into certain accounting and financial reporting practices of the Company and its officers, directors and employees. On March 25, 1999, the SEC issued a formal order of investigation (which the Company learned of on September 27, 1999) into certain accounting and financial reporting practices of the 5 7 CYBERGUARD CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2000 (UNAUDITED) Company and its officers, directors and employees. The SEC's investigation is ongoing. On September 16, 1999, the Company filed a lawsuit against KPMG and August A. Smith, the KPMG engagement partner. The lawsuit is pending in the Circuit Court of the 17th Judicial Circuit in and for Broward County, Case No. 00-004102-CACE-14. On May 1, 2000, the Company filed the First Amended Complaint, alleging that KPMG failed to properly audit the Company's financial statements and provided inaccurate advice on accounting matters for fiscal years 1996, 1997 and 1998. The action alleges professional malpractice, breach of fiduciary duty, breach of contract and breach of implied duty of good faith, and seeks damages in excess of $10 million. KPMG and Mr. Smith filed motions to dismiss, which were denied. In August 2000, KPMG and Mr. Smith filed their answers and KPMG filed counterclaims against the Company, alleging the Company's breach of contract, negligent misrepresentation and abuse of process, and seeks an unspecified amount of damages consisting of unpaid service fees and legal fees and costs. The Company is involved from time to time in other litigation on various matters relating to the conduct of its business. The Company believes that these other litigation matters, single or collective, will not have a material adverse effect on its consolidated financial position, results of operations or cash flows. 4. CONVERTIBLE DEBT On December 29, 2000, the Company completed an additional $1 million financing transaction with Fernwood Partners II LLC, which was constructed as an add-on to the earlier Fernwood Financing (see Part 1, Item 2). The additional note is convertible into the Company's common stock at $1.51 per share and carries a warrant to purchase an additional 333,877 shares of the Company's common stock at $2.51 per share. The additional convertible note bears interest at 11.5% per annum with no principal payments due until June 30, 2002. The Fernwood Financing is subordinated to senior debt and is collateralized by the assets of the Company. At the November 2000 meeting, The Emerging Issues Task Force (EITF) reached a consensus opinion on Issue 00-27 regarding the "Application of EITF Issue 98-5, "Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios," to Certain Convertible Instruments". The consensus opinion required the Company to use an effective conversion price to determine a convertible instrument's beneficial conversion feature. In applying the consensus opinion, the Company recognized $33,000 in interest expense. 5. MODIFICATION OF STOCK OPTIONS On November 2, 2000, the Board of Directors resolved that upon Mr. Terrence Zielinski's, the Company's Chief Financial Officer ("CFO"), retirement date, full vesting of all options held by Mr. Zielinski to purchase the Company's common stock ("Options"), with the Options remaining exercisable through June 30, 2003, or the Options' expiration, whichever comes first. There was no accounting effect as a result of this resolution. On November 17, 2000, the Compensation Committee of the Board of Directors of the Company resolved that upon the termination of David R. Proctor as the Company's Chief Executive Officer ("CEO") and President, Mr. Proctor's "Officer Options" shall become fully vested to the extent such Officer Options have not yet fully vested and shall remain exercisable for a period of two years from the 6 8 CYBERGUARD CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2000 (UNAUDITED) termination date. Upon his termination date the Company will record associated compensation expense of approximately $20,000. On November 27, 2000, the Compensation Committee of the Board of Directors of the Company resolved that the February 4, 2001 expiration date of each of the options to purchase shares of the Company's common stock granted on February 4, 1996 would be extended by three years. All 129,100 shares granted on February 4, 1996 will now expire in their entirety on February 4, 2004. This modification required the Company to record compensation expense during the quarter of approximately $68,000. 6. RELATED PARTY TRANSACTIONS On August 26, 1999, certain directors, officers and employees participated in the Fernwood Financing, contributing a total of $614,000. The interest rate on the convertible debt is 11.5% per annum. The debt can be converted into approximately 614,000 shares of common stock at a conversion price equal to $1.00 per share. In addition, the Company issued approximately 614,000 warrants to purchase the Company's common stock at $2.00 per share. The warrants are exercisable any time before August 2004. Subsequently, certain directors and officers elected to convert approximately $0.428 million of convertible debt and interest on that debt into approximately 428,000 shares of common stock at $1.00 per share. Certain directors also elected to exercise warrants for the purchase of approximately 110,000 shares of the Company's common stock for approximately $0.220 million in cash (see note 7). 7. SUBSEQUENT EVENTS On January 2, 2001, Scott J. Hammack was appointed the CEO of the Company. David R. Proctor, who had been serving as the Company's President, CEO and Chairman of the Board, will continue as Chairman of the Board. On January 18, 2001, Patrick J. Clawson was appointed the President of the Company. On January 24, 2001, in connection with the Fernwood Financing, approximately $5.7 million of convertible debt and the interest accrued on that debt was converted into approximately 4.6 million shares of common stock at $1.00 per share and approximately 668,000 million shares of common stock at $1.51 per share. In connection with the Fernwood Financing, approximately $252,000 in convertible debt and interest accrued on that debt is still outstanding. During January 2000, in connection with the Fernwood Financing, warrants for the purchase of approximately 2.4 million shares of the Company's common stock were exercised at a total of approximately $4.8 million in cash. In connection with the Fernwood Financing, approximately 1.9 million warrants are still outstanding. During January 2000, newly appointed CEO Scott J. Hammack invested $500,000 to purchase at the market value 142,857 shares of common stock at $1.75 share and 62,500 shares of common stock at $4.00 per share. In conjunction with the purchase of the 142,857 shares of common stock, Mr. Hammack was granted an equal number of warrants to purchase the Company's common stock at $1.75 per share. The warrants are exercisable any time before December 25, 2005. 7 9 CYBERGUARD CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2000 (UNAUDITED) The pro-forma balance sheet below reflects the effect of the above transactions had they occurred prior to December 31, 2000: CYBERGUARD CORPORATION CONDENSED PRO-FORMA CONSOLIDATED BALANCE SHEET (Unaudited) (Dollars in thousands) Dec. 31, Proforma Dec. 31, 2000 2000 ---------- ----------------- ASSETS Cash and cash equivalents $ 2,332 $ 7,636 Restricted cash 703 703 Accounts receivable, less allowance for uncollectible accounts of $98 at Dec. 31, 2000 5,015 5,015 Inventories, net 279 279 Other current assets 1,895 1,895 ---------- ---------- Total current assets 10,224 15,528 Property and equipment at cost, less accumulated depreciation of $1,431 at Dec. 31, 2000 1,299 1,299 Capitalized sofware, net 1,150 1,150 Non-compete agreements, net 140 140 Other assets 171 171 ---------- ---------- Total assets $ 12,984 $ 18,288 ========== ========== LIABILITIES AND SHAREHOLDERS' DEFICIT Line of credit and note payable 1,230 1,230 Accounts payable 2,674 2,674 Deferred revenue 3,386 3,386 Accrued expenses and other liabilities 3,430 3,313 ---------- ---------- Total current liabilities 10,720 10,603 Note Payable 650 650 Convertible debenture, net 5,479 240 ---------- ---------- Total liabilities 16,849 11,493 ---------- ---------- Shareholders' deficit Common stock par value $0.01 authorized 50,000,000 shares issued and outstanding 9,941,820 at Dec. 31, 2000 99 178 Additional paid-in capital 75,773 86,655 Accumulated deficit (79,923) (80,223) Accumulated other comprehensive income 186 186 ---------- ---------- Total shareholders' deficit (3,865) 6,795 ---------- ---------- ---------- ---------- Total liabilities and shareholders' deficit $ 12,984 $ 18,288 ========== ========== See accompanying notes to condensed consolidated financial statements On February 13, 2001, Michael Matte was appointed CFO of the Company. Terrence A. Zielinski, who had been serving as the Company's CFO since August 1998, has retired. On February 13, 2001, the Board of Directors nominated Richard L. Scott to the Board of Directors. 8 10 CYBERGUARD CORPORATION DECEMBER 31, 2000 (DOLLARS IN MILLIONS, EXCEPT SHARE AND PER SHARE DATA) ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company provides a full suite of products and services for the network security industry. The products offered by the Company include the CyberGuard(R) Firewall, proprietary and third-party technology (such as Virtual Private Network, authentication, virus scanning, encryption, advanced reporting, high availability and centralized management), and consulting, support, and installation services. RESULTS OF OPERATIONS THE QUARTER ENDED DECEMBER 31, 2000 COMPARED TO THE QUARTER ENDED DECEMBER 31, 1999 NET REVENUES Net revenues consist primarily of network security products and services including third party security products and service and support related to security products. For the quarter ended December 31, 2000, net revenues were $6.349 million compared to $4.370 million for the quarter ended December 31, 1999. The increase was comprised of an increase of $1.440 million in network security product revenues and an increase of $0.539 million in service revenues. The increase in network security product revenues was primarily the result of continued acceptance of the Company's family of appliance products, particularly in Europe and Asia. The increase in service revenue corresponds to the growth in the Company's customer base. Network security products accounted for 77.8% of revenues during the quarter ended December 31, 2000 as compared to 80.0% of revenues during the quarter ended December 31, 1999. Support services for network security products accounted for 22.2% of revenues during the quarter ended December 31, 2000 as compared to 20.0% of revenues during the quarter ended December 31, 1999. GROSS PROFIT Gross Profit as a percentage of revenues decreased to 70.2% from 74.64% for the quarter ended December 31, 2000 as compared to the quarter ended December 31, 1999. The decrease is attributable to the increase in the hardware component of cost of revenues associated with the appliance family of products. OPERATING EXPENSES, OTHER INCOME AND EXPENSE AND NET LOSS Overall, operating expenses increased $1.528 million for the quarter ended December 31, 2000 to $4.642 million when compared to December 31, 1999. This is due to increased compensation and related employee costs, the initial investment in a new marketing and branding campaign and litigation expenses. Total Other Income and Expense increased $0.092 million for the quarter ended December 31, 2000 to ($0.302) million. This was in part due to a decrease in the interest expense associated with the Fernwood Financing and a foreign currency transaction expense for the Company's foreign subsidiary. Cumulative effect of change in accounting principle increased $0.129 million for the quarter ended December 31, 2000 to ($0.129) million. The Emerging Issues Task Force (EITF) reached a consensus opinion regarding the "Application of EITF Issue 98-5, "Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios," to Certain Convertible Instruments". The consensus opinion required the Company to use an effective conversion price to 9 11 CYBERGUARD CORPORATION DECEMBER 31, 2000 (DOLLARS IN MILLIONS, EXCEPT SHARE AND PER SHARE DATA) determine a convertible instrument's beneficial conversion feature, which resulted in the recognition of additional expense associated with the convertible debt issued in August 1999. The expense is reported as a cumulative effect on prior periods of a change in accounting principle. Net loss for the quarter ended December 31, 2000 was $0.614 million compared to $0.062 million for the quarter ended December 31, 1999. The Company did not provide for income taxes due to the significant net operating loss carryforwards available. THE SIX-MONTH PERIOD ENDED DECEMBER 31, 2000 COMPARED TO THE SIX-MONTH PERIOD ENDED DECEMBER 31, 1999 NET REVENUES For the six-month period ended December 31, 2000, net revenues were $10.396 million when compared $8.702 million for the six-month period ended December 31, 1999. The increase was comprised of an increase of $1.116 million in network security product revenues and an increase of $0.578 million in service revenues. The increase in both product and service revenue is directly attributed to the market's acceptance of the Company's appliance family of products and the Company's growing customer base. Network security products accounted for 75.79% of revenues during the six-month period ended December 31, 2000 as compared to 77.72% of revenues during the six-month period ended December 31, 1999. Support services for network security products accounted for 24.21% of revenues during the six-month period ended December 31, 2000 as compared to 22.28% of revenues during the six-month ended December 31, 1999. GROSS PROFIT Gross Profit as a percentage of revenues decreased to 70.47% from 73.17% for the six-month period ended December 31, 2000 when compared to the six-month period ended December 31, 1999. This is attributable to the increase in the hardware component of cost of revenues associated with the appliance family of products. OPERATING EXPENSES, OTHER INCOME AND EXPENSE AND NET LOSS Overall, operating expenses increased $2.738 million for the six-month period ended December 31, 2000 to $9.186 million. There was a $1.863 million increase in selling, general and administrative expenses that was the result of increased staffing, marketing expenditures relating to the Company's branding and advertising campaign and litigation expenses associated with the KPMG lawsuit. There was also a $0.875 million increase in research and development directly related to increased staffing. Total Other Income and Expense decreased slightly by $0.079 million for the six-month period ended December 31, 2000 to ($0.485). This was due to a decrease in the interest expense associated with the Fernwood Financing and a foreign currency transaction expense for the Company's foreign subsidiary. Cumulative effect of a change in accounting principle increased $0.129 million for the six-month period ended December 31, 2000 to ($0.129) million. The Emerging Issues Task Force (EITF) reached a consensus opinion regarding the "Application of EITF Issue 98-5, "Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios," to Certain Convertible Instruments". The consensus opinion required the Company to use an effective conversion price to determine a convertible instrument's beneficial conversion feature, which resulted in the recognition of 10 12 CYBERGUARD CORPORATION DECEMBER 31, 2000 (DOLLARS IN MILLIONS, EXCEPT SHARE AND PER SHARE DATA) additional expense associated with the convertible debt issued in August 1999. The expense is reported as a cumulative effect on prior periods of a change in accounting principle. Net loss for the six-month period ended December 31, 2000 was $2.474 million compared to $0.645 million for the six-month period ended December 31, 1999. The Company did not provide for income taxes due to the significant net operating loss carryforwards available. LIQUIDITY AND CAPITAL RESOURCES The Company has experienced losses since its inception as a network security company. The Company's historical uses of cash have been to fund net losses from operations, establish inventory stocking levels, and fund capital expenditures for property, equipment and software. For the quarter ended December 31, 2000, the Company incurred a net loss of approximately $0.614 million on revenues of approximately $6.349 million. For the quarter ended December 31, 1999, the Company incurred a net loss of approximately $0.062 million on revenues of approximately $4.370 million. In August 1998, the Company and certain former officers and directors were named in twenty-five shareholder lawsuits. The plaintiffs sued for unspecified compensatory damages, legal fees, and litigation costs. The Company is unable to predict the ultimate outcome or potential financial impact of this litigation. The consolidated financial statements do not include any adjustments relating to the realization of assets and the recognition and satisfaction of liabilities that might be necessary as a result of the matters described in this Item 2 or Part II, Item 1 of this report. At December 31, 2000, the Company had cash and cash equivalents on hand of $2.332 million representing a decrease of $0.165 million from $2.497 million as of June 30, 2000. Accounts payable and accrued liabilities increased by $2.738 million, accounts receivable increased by $1.401 million, property and equipment increased $0.213 million, and inventory levels increased by $0.120 million compared to June 30, 2000. The Company's principal sources of liquidity at December 31, 2000, consisted of cash, accounts receivable, a revolving line of credit with Coast Business Credit, and vendor trade credit. The revolving line of credit with Coast Business Credit is based on available eligible account receivables and inventory. The line of credit decreased $.132 million, from $1.316 million to $1.184 million compared to June 30, 2000. On August 26, 1999, the Company entered into a financing transaction with Fernwood Partners II, LLC ("Fernwood") and certain officers, directors and employees of the Company, through which the Company obtained a total amount of $4,313,484 (the "Fernwood Financing"). In the Fernwood Financing, Fernwood provided $3,699,484 and certain other directors, executive officers and employees of the Company provided $614,000. All of the financing consisted of promissory notes convertible into the Company's Common Stock at $1.00 per share and warrants to purchase an equivalent number of shares of the Company's Common Stock at $2.00 per share. The Fernwood Financing bears interest at a rate of 11.5% per annum and is secured by a lien on all of the Company's assets. Interest is payable quarterly, except that interest accruing from the date of issuance through July 1, 2000, which was added to the principal amount of the note. Part of the proceeds from this financing was used to repay a $1,125,000 loan and accrued interest to Fernwood Partners, LLC, a limited liability company that provided financing to the Company in December 1998. 11 13 CYBERGUARD CORPORATION DECEMBER 31, 2000 (DOLLARS IN MILLIONS, EXCEPT SHARE AND PER SHARE DATA) On December 29, 2000, the Company completed an additional $1 million financing transaction with Fernwood, which was constructed as an add-on to the earlier Fernwood Financing. The additional note is convertible into the Company's common stock at $1.51 per share and carries a warrant to purchase an additional 333,877 shares of the Company's common stock at $2.51 per share. The additional convertible note bears interest at 11.5% per annum with no principal payments due until June 30, 2002. The Fernwood Financing is subordinated to senior debt and is collateralized by the assets of the Company. On January 24, 2001, in connection with the Fernwood Financing, approximately $5.7 million of convertible debt and the interest accrued on that debt was converted into approximately 4.6 million shares of common stock at $1.00 per share and approximately 668,000 million shares of common stock at $1.51 per share. In connection with the Fernwood Financing, approximately $252,000 in convertible debt and interest accrued on that debt is still outstanding. During January 2000, in connection with the Fernwood Financing, warrants for the purchase of approximately 2.4 million shares of the Company's common stock were exercised at a total of approximately $4.8 million in cash. In connection with the Fernwood Financing, approximately 1.9 million warrants are still outstanding. The Company uses the U.S. Dollar as its reporting currency for financial statement purposes. The Company conducts business in numerous countries around the world through its international subsidiary that uses the local currency to denominate its transactions. Therefore, the Company is subject to certain risks associated with fluctuating foreign currencies. The resulting changes in the financial statements do not indicate any underlying changes in the financial position of the international subsidiary, but merely reflect the adjustment in the carrying value of the net assets of this subsidiary at the current U.S. dollar exchange rate. Due to the long-term nature of the Company's investment in this subsidiary, the translation adjustments resulting from these exchange rate fluctuations are excluded from the results of operations and recorded in a separate component of consolidated stockholders' equity. The Company monitors its currency exposure but does not hedge its translation exposure due to the high economic costs of such a program and the long-term nature of its investment in its European subsidiary. Based upon information currently available to the Company, including the Company's current level of sales, its margins on sales, its expected levels of expense, opportunities for selling additional network security products and the availability of additional equity and debt financing, the Company believes that it has an opportunity to execute on its business plans and achieve profitability in the long term. There can be no assurance, however, that the Company will be able to execute on its business plans, or that it will not be required to obtain additional financing or capital infusions. There can be no assurance that the Company will be able to secure additional financing or that such additional financing will be on terms and conditions acceptable to the Company. Any additional financing may involve dilution of the interests of the Company's then existing shareholders. The future liquidity of the Company will be affected by numerous factors, including sales volumes, gross margins, the levels of selling, general and administrative expenses, levels of required capital expenditures and access to external sources of financing. Other recent and possible future events that could also materially impact the Company's ability to successfully execute on its business plans are described in Information Relating to Forward Looking Statements of this Report on Form 10-Q. 12 14 CYBERGUARD CORPORATION DECEMBER 31, 2000 (DOLLARS IN MILLIONS, EXCEPT SHARE AND PER SHARE DATA) RISK RELATED TO YEAR 2000 PROBLEM The Year 2000 problem stems from the use of a two-digit date to represent the year (e.g., 85 = 1985) in computer software and firmware. It was thought that many currently installed computer systems were not capable of distinguishing dates beginning with the year 2000 from dates prior to the year 2000. Computer systems or applications used by many companies in a wide variety of industries could experience operating difficulties unless the systems or applications were modified to adequately process information related to the date change. A degree of uncertainty still exists in the software and other industries concerning the scope and magnitude of problems associated with the century change. Many industry experts believe that the extent of Year 2000 issues may not be realized until after March 31, 2001. While the Company believes its Year 2000 risk management initiative's scope covered both the Company's information technology (IT) systems and non-IT systems and addressed all areas of the Year 2000 issues as defined by the Information Technology Association of America (ITAA), and to date there have been no Year 2000 issues detected, there can be no assurance that the Company has identified and remedied all Year 2000 problems, and that such problems will not have a material adverse affect on the Company's business. INFORMATION RELATING TO FORWARD LOOKING STATEMENTS Statements regarding future products, future prospects, future profitability, business plans and strategies, future revenues and revenue sources, future liquidity and capital resources, computer network security market directions, future acceptance of the Company's products, possible growth in markets, as well as all other statements contained in this Report on Form 10-Q that are not purely historical are forward-looking statements. These statements are based upon assumptions and analyses made by the Company in light of current conditions, future developments and other factors the Company believes are appropriate in the circumstances, or information obtained from third parties and are subject to a number of assumptions, risks and uncertainties. Readers are cautioned that forward-looking statements are not guarantees of future performance and that the actual results might differ materially from those suggested or projected in the forward-looking statements. Accordingly, there can be no assurance that the forward-looking statements will occur, or that results will not vary significantly from those described in the forward-looking statements. Some of the factors that might cause future actual events to differ from those predicted or assumed include: future advances in technologies and computer security; the Company's history of annual net operating losses and the financing of these losses through the sale of assets and newly issued Company securities; risks related to the early stage of the Company's existence and its products' development; the Company's ability to execute on its business plans; the Company's dependence on outside parties such as its key customers and alliance partners; competition from major computer hardware, software, and networking companies; risk and expense of government regulation and effects on changes in regulation; the limited experience of the Company in marketing its products; uncertainties associated with product performance liability; risks associated with growth and expansion; risks associated with obtaining patent and intellectual property right protection; uncertainties in availability of expansion capital in the future and other risks associated with capital markets. In addition, certain events that have occurred also are factors that might cause future actual events to differ from those predicted or assumed, including: the impact of the restatement of financial results for the Company's fiscal year ended June 30, 1997 and quarters ended September 30, 1997, December 31, 1997 and March 31, 1998; the completion of the numerous organizational changes and the assembly of a new management 13 15 CYBERGUARD CORPORATION DECEMBER 31, 2000 (DOLLARS IN MILLIONS, EXCEPT SHARE AND PER SHARE DATA) team for CyberGuard; the outcome of a purported class action lawsuit against the Company and former CEO, Mr. Robert L. Carberry, relating to the restatement of financial results for the fiscal periods noted above and an SEC investigation regarding these matters; and the de-listing of the Company from the NASDAQ National Market. In addition, the forward-looking statements herein involve assumptions, risks and uncertainties, including, but not limited to economic, competitive, operational, management, governmental, regulatory, litigation and technological factors affecting the Company's operations, liquidity, capital resources, markets, strategies, products, prices and other factors discussed elsewhere herein and in the other documents filed by the Company with the Securities and Exchange Commission. Many of the foregoing factors are beyond the Company's control. The Company's future success is based largely on its ability to develop and sell increasingly technologically advanced network security solutions in sufficient volume and at sufficient prices to become profitable on a consistent basis. In addition, the network security market is characterized by extremely rapid technological change, requiring rapid product development. The velocity of technological change has accelerated and the Company believes that it is important to its future that it keeps pace with these changes. The Company believes that competition will continue to intensify in the rapidly evolving markets in which the Company is involved, and that the continued development of technologically advanced products will be necessary to keep its products current. In addition, the competition for and retention of key management and technology employees is a critical challenge. The Company believes that its ability to generate adequate cash flow from operations will also be critical to its future. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES CONCERNING MARKET RISK We have limited exposure to financial market risks, including changes in interest rates. The fair value of our investment portfolio or related income would not be significantly impacted by a 100 basis point increase or decrease in interest rates due mainly to the short-term nature of the major portion of our investment portfolio. A fluctuation in interest rates would not significantly affect interest expense on debt obligations since a significant portion of the debt obligation is at a fixed rate of interest. PART II: OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On August 24, 1998, the Company announced, among other things, that due to a review of its revenue recognition practices relating to distributors and resellers, it would restate prior financial results. After the August 24, 1998 announcement, twenty-five purported class action lawsuits were filed by alleged shareholders against the Company and certain former officers and directors. Pursuant to an order issued by the Court, these actions have been consolidated into one action, styled Stephen Cheney, et al. v. CyberGuard Corporation, et al., Case No. 98-6879-CIV-Gold, in the United States District Court, Southern District of Florida. On August 23, 1999, the plaintiffs filed a Consolidated and Amended Class Action Complaint. This action seeks damages purportedly on behalf of all persons who purchased or otherwise acquired the Company's common stock during various periods from November 7, 1996 through August 24, 1998. The complaint alleges, among other things, that as a result of accounting irregularities relating to the Company's revenue recognition policies, the Company's previously issued financial statements were materially false and misleading and that the defendants knowingly or recklessly published these financial statements which caused the Company's common stock prices to rise artificially. The action alleges violations of Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act") and SEC Rule 10b-5 promulgated thereunder and Section 20(a) of the Exchange Act. 14 16 CYBERGUARD CORPORATION DECEMBER 31, 2000 (DOLLARS IN MILLIONS, EXCEPT SHARE AND PER SHARE DATA) Subsequently, the defendants, including the Company, filed their respective motions to dismiss the amended complaint. On July 31, 2000, the Court issued a ruling denying the Company's and Robert L. Carberry's (the Company's CEO from June 1996 through August 1998) motions to dismiss. The court granted the motions to dismiss with prejudice for defendants William D. Murray (the Company's CFO from November 1997 through August 1998), Patrick O. Wheeler (the Company's CFO from April 1996 through October 1997), C. Shelton James (former Audit Committee Chairman), and KPMG Peat Marwick LLP ("KPMG"). On August 14, 2000, the plaintiffs filed a motion for reconsideration of that order. The Company filed an answer to the plaintiffs' complaint on August 24, 2000. On September 16, 1999, the Company filed a lawsuit against KPMG and August A. Smith, the KPMG engagement partner. The lawsuit is pending in the Circuit Court of the 17th Judicial Circuit in and for Broward County, Case No. 00-004102-CACE-14. On May 1, 2000, the Company filed the First Amended Complaint, alleging that KPMG failed to properly audit the Company's financial statements and provided inaccurate advice on accounting matters for fiscal years 1996, 1997 and 1998. The action alleges professional malpractice, breach of fiduciary duty, breach of contract and breach of implied duty of good faith, and seeks damages in excess of $10 million. KPMG and Mr. Smith filed motions to dismiss, which were denied. In August 2000, KPMG and Mr. Smith filed their answers and KPMG filed counterclaims against the Company, alleging the Company's breach of contract, negligent misrepresentation and abuse of process, and seeks an unspecified amount of damages consisting of unpaid service fees and legal fees and costs. In August 1998, the Securities and Exchange Commission ("SEC") commenced an informal inquiry into certain accounting and financial reporting practices of the Company and its officers, directors and employees. On March 25, 1999, the SEC issued a formal order of investigation (which the Company learned of on September 27, 1999) into certain accounting and financial reporting practices of the Company and its officers, directors and employees. The SEC's investigation is ongoing. The Company is unable to predict the ultimate outcome of the litigation and investigation described above in this Part II, Item 1. The resolution of such matters could have a material adverse affect on the Company's results of operations and financial position. The Company's financial statements do not include any adjustments related to these matters. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On December 6, 2000, the Company held its Annual Meeting of Shareholders at the Marriott by Courtyard at Cypress Creek, in Fort Lauderdale, Florida. John V. Tiberi and David T. Vandewater were nominated as members to the Board of Directors for a period of three years. Mr. Tiberi received 8,821,206 votes in favor of his appointment, while 47,489 shares were withheld and Mr. Vandewater received 8,821,206 votes in favor of his appointment, while 47,489 shares were withheld. David L. Manning, David R. Proctor and William G. Scott will continue on in their current capacity as Board members. 15 17 CYBERGUARD CORPORATION DECEMBER 31, 2000 (DOLLARS IN MILLIONS, EXCEPT SHARE AND PER SHARE DATA) Two other matters were brought for vote during the annual meeting: the ratification of the CyberGuard Corporation 2000 Employee Stock Purchase Plan and the ratification of Grant Thornton LLP as the Company's independent public accountants for the fiscal year ending June 30, 2001. The amendment to ratify the Employee Stock Purchase Plan was passed with 2,428,923 votes in favor, 205,915 votes against and 40,821 abstentions. The ratification of Grant Thornton LLP was passed with 8,744,241 votes in favor, 32,241 votes against, and 22,846 abstentions. ITEM 5. OTHER INFORMATION None ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: Exhibit Nr. Exhibit Description ----------- ------------------- 10.1 Amendment to Employment Agreement between the Company and Mike Wittig dated December 13, 2000. 10.2 Amendment No.1 to Loan Agreement between the Company and Fernwood Partners II, LLC dated December 29, 2000. 10.3 Agreements dated January 24, 2001 relating to the conversion of promissory notes and exercise of warrants issued under (i) the Loan Agreement, as amended, between the Company and Fernwood Partners II, LLC, and (ii) the Loan Agreement between the Company and certain officers, directors and employees of the Company. 10.4 Employment Agreement between the Company and Scott J. Hammack effective as of January 2, 2001. 10.5 Agreement between the Company and Scott J. Hammack dated December 26, 2000. 10.6 Agreement between the Company and Scott J. Hammack dated January 17, 2001. 10.7 Employment Agreement between the Company and Patrick J. Clawson dated January 18, 2001. (b) Reports filed on Form 8-K during the quarter ended December 31, 2000: During the quarter ended December 31, 2000, the Company filed one report on Form 8-K on November 2, 2000. The report furnished information relating to the Company's appeal to list the Company's securities on the NASDAQ Small-Cap Market. 16 18 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: February 13, 2001 CYBERGUARD CORPORATION By: /s/ Scott Hammack -------------------------------------- Chief Executive Officer By: /s/ Terrence A. Zielinski -------------------------------------- Vice President of Finance and Chief Financial Officer (Principal Financial and Accounting Officer) 17