Item 2.   Management's Discussion and Analysis of Financial Condition and Results of Operations.

     The following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our Financial Statements and Notes. Our discussion contains forward-looking statements based upon current expectations. These forward-looking statements include, but are not limited to, statements about our plans, objectives, expectations and intentions and other statements that are not historical facts. Because these forward-looking statements involve risks and uncertainties, our actual results and the timing of certain events could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under "Risk Factors" and "Business" sections in the Company's Form 10-K for the fiscal year ended September 30, 2000, and elsewhere in this report.

Overview

    F5 was incorporated on February 26, 1996 and began operations in April 1996. Our fiscal year ended on September 30, 2000.

    From our inception through May 1999, we financed our operations and capital expenditures primarily through the sale of approximately $12.4 million in equity securities. In June 1999, we completed an initial public offering of 2,860,000 shares of common stock and raised approximately $25.5 million, net of offering costs. In October 1999, we completed a secondary public offering of 500,000 shares of common stock and raised approximately $31.5 million, net of offering costs.

    For the fiscal years 1998 through 2000, our net revenues were $4.9 million, $27.8 million and $108.6 million respectively. We achieved our first quarterly profit during the fourth quarter of fiscal year 1999 and our first annual profit in fiscal year 2000.

    Currently, we derive approximately 52% of our net revenues from sales of BIG-IP, and we expect to derive a significant portion of our net revenues from sales of BIG-IP in the future. For the three months ended December 31, 2000, one of our resellers, Exodus Communications, accounted for 11% of our net revenues and 5% of our accounts receivable balance at December 31, 2000.

    Net revenues derived from customers located outside of the United States were $7.6 million and $2.3 million for the three months ended December 31, 2000 and 1999, respectively. We plan to continue expanding our international operations significantly, particularly in selected countries in the

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European and Asia Pacific markets, because we believe international markets represent a significant growth opportunity.

    Customers who purchase our products have the option to receive installation services and an initial customer support contract, typically covering a 12-month period. We generally combine the software license, installation, and customer support elements of our products into a package with a single price. We allocate a portion of the sales price to each element of the bundled package based on their respective fair values as determined when the individual elements are sold separately. Customers may also purchase consulting services and renew their initial customer support contract.

    Revenues from the sale of our products and software licenses are recognized, net of allowances for estimated returns, when the product has been shipped and the reseller or end user is obligated to pay for the product. Estimated sales returns are based on historical experience by product and are recorded at the time revenues are recognized. Services revenue for installation is recognized when the product has been installed at the customer's site. Revenues for customer support are recognized on a straight-line basis over the service contract term. Consulting services are customarily billed at fixed rates, plus out-of-pocket expenses, and revenues from consulting services are recognized when completed.

    Our ordinary payment terms to our domestic customers are net 30 days, but we have extended payment terms beyond net 30 days to some customers. For these arrangements, revenue is recognized ratably over the terms of the arrangement. Our ordinary payment terms to our international customers are net 60 days.

    In view of the rapidly changing nature of our business and our limited operating history, we believe that period-to-period comparisons of net revenues and operating results are not necessarily meaningful and should not be relied upon as indicators of future performance. To achieve profitability we will need to increase our net revenues and manage operating expenses. Although we have experienced rapid growth in net revenues historically we may not be able to sustain such growth rates.

    We have recorded a total of $8.2 million of stock compensation costs since our inception through December 31, 2000. These charges represent the difference between the exercise price and the deemed fair value of certain stock options granted to our employees and outside directors. These options generally vest ratably over a four-year period. We are amortizing these costs using an accelerated method as prescribed by FASB interpretation No. 28 ("FIN No. 28") and have recorded stock compensation charges of $2.1 million, $2.5 million and $420,000 for the years ended September 30, 2000, 1999 and 1998, respectively and $576,000 and $543,000 for the three months ended December 31, 2000 and 1999.

    We expect to recognize amortization expense related to unearned compensation of approximately $2.6 million, $400,000, $60,000 and $0 during the years ended September 30, 2001, 2002, 2003 and 2004, respectively. We cannot guarantee, however, that we will not accrue additional stock compensation costs in the future or that our current estimate of these costs will prove accurate.

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Net Revenues:

    Net revenues consist of sales of our products and services, which include software licenses and services. Services include revenue from service and support agreements provided as part of the initial product sale, sales of extended service and support contracts and consulting services.

    Product revenues.   Product revenues increased by 8.9% from $16.3 million for the three months ended December 31, 1999 to $17.7 million for the three months ended December 31, 2000. This increase in product revenues was due primarily to an increase in the quantity of our products sold through our indirect sales channels and to a lesser extent to an increase of sales through our direct sales channels. This increase also reflects the addition of new customers, as well as repeat sales to existing customers.

    Service revenues.   Service revenues increased by 142.1% from $2.9 million for the three months ended December 31, 1999 to $7.0 million for the three months ended December 31, 2000. This increase was due primarily to an increase in the installed base of our products and the renewal of service and support contracts.

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    International revenues represented 31% and 12% of net revenues for the three months ended December 31, 2000 and 1999, respectively. We expect international sales will continue to represent a significant portion of net revenues, although we cannot assure you that international sales as a percentage of net revenues will remain at current levels. Substantially all sales transactions are denominated in U.S. dollars.

    As our net revenue base increases, we do not believe we can sustain percentage growth rates that we have experienced historically. We anticipate our average selling prices to decrease primarily as a result of a shift in our channel mix and to a lesser extent increased competition.

Cost of Net Revenues:

    Cost of net revenues consists primarily of out-sourced hardware components and manufacturing, fees for third-party software products integrated into our products, service and support personnel and an allocation of our facilities and depreciation expenses.

    Cost of product revenues.   Cost of product revenues increased by 74.9%, from $4.6 million for the three months ended December 31, 1999 to $8.1 million for the three months ended December 31, 2000 and increased as a percentage of product revenues to 45.6% from 28.4% for the same periods. This increase as a percentage of product revenues was due to component enhancements of our products and a decrease in our average selling price as a result of a change in our channel mix.

    Cost of service revenues.   Cost of service revenues increased by 238.4%, from $1.1 million for the three months ended December 31, 1999 to $3.6 million for the three months ended December 31, 2000 and increased as a percentage of service revenues to 51.2% from 36.6% for the same periods. This increase as a percentage of cost of service revenues was due to increased personnel costs related to hiring.

    Sales and marketing.   Our sales and marketing expenses consist primarily of salaries, commissions and related benefits of our sales and marketing staff, costs of our marketing programs, including public relations, advertising and trade shows and an allocation of our facilities and depreciation expenses. Sales and marketing expenses increased by 135.6%, from $5.7 million for the three months ended December 31, 1999 to $13.5 million for the three months ended December 31, 2000. This increase was due to an increase in sales and marketing and professional services personnel from 117 to 258, increased commissions, and increased advertising and promotional activities. We expect to continue increasing the number of commissioned sales staff in order to grow our revenues.

    Research and development.   Our research and development expenses consist primarily of salaries and related benefits for our product development personnel and an allocation of our facilities and depreciation expenses. Research and development expenses increased by 122.2%, from $2.2 million for the three months ended December 31, 1999 to $4.9 million for the three months ended December 31, 2000. This increase was due primarily to an increase in product development personnel from 69 to 128. Our future success is dependent in large part on the continued enhancement of our current products and our ability to develop new, technologically advanced products that meet the sophisticated needs of our customers. We expect research and development expenses to increase in future periods.

    General and administrative.   Our general and administrative expenses consist primarily of salaries, benefits and related costs of our executive, finance, information technology, human resource and legal personnel, third-party professional service fees, and an allocation of our facilities and depreciation expenses. General and administrative expenses increased by 221.1% from $1.5 million for the three months ended December 31, 1999 to $4.7 million for the three months ended December 31, 2000. This increase was due primarily to an increase in general and administrative personnel from 44 to 66.

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    Restructuring charge.   During the three months ended December 31, 2000 we recorded a restructuring charge of $1.1 million in connection with management's decision to realign operating expenses with revenue growth. The charge consisted primarily of costs associated with a 17% reduction in the workforce throughout all lines of the business.

    Stock compensation.   We recorded stock compensation charges of $543,000 and $576,000 for the three months ended December 31, 1999 and 2000, respectively.

    Other income, net.   Other income consists primarily of earnings on our cash and cash equivalent balances. Net other income was $741,000 for the three months ended December 31, 1999 and $437,000 for the three months ended December 31, 2000. This decrease in our cash balance was due primarily to the investment in the building of our corporate facilities and our global business.

    Income taxes.   At December 31, 2000 the Company had net operating loss carryforwards of approximately $8.0 million, which begin to expire in 2011. Until June 30, 2000, the Company had provided a full valuation allowance against deferred tax assets. Based upon available evidence, which included a review of historical operating performance, the Company determined that certain of these deferred tax assets were more likely than not realized and therefore reduced the valuation allowance related to those deferred tax assets.

    An increase from $4.9 million to $8.1 million in the valuation allowance was recorded against the deferred tax assets as a result of the operating losses incurred during the three months ended December 31, 2000.

Liquidity and Capital Resources

    Cash and cash equivalents, short-term investments, and restricted cash decreased from $53.0 million at September 30, 2000 to $36.0 million at December 31, 2000, a decrease of $17.0 million. This decrease is primarily due to increases in inventory and capital expenditures. Inventory levels increased 218% from September 30, 2000 to December 31, 2000. Inventory management remains an area of focus as we balance the need to maintain strategic inventory levels to ensure competitive lead times. Any such increases in inventory can be expected to reduce cash and cash equivalents, and short-term investments. The increase in capital expenditures is primarily associated with the completion of the new corporate facilities.

    Cash used in investing activities was $5.9 million for the three months ended December 31, 2000, and $1.3 million for the three months ended December 31, 1999. The increase in investing activities was primarily the result of capital expenditures associated with the completion of the new corporate facilities.

    As of December 31, 2000, our principal commitments consisted of obligations outstanding under operating leases. In April 2000, we entered into a lease agreement on two buildings for a new corporate headquarters. The lease commenced in July 2000 on the first building; and the lease on the second building commenced in October 2000. The lease for both buildings expires in 2012 with an option for renewal. The company established a restricted escrow account in connection with this lease agreement. Under the term of the lease, a $6 million irrevocable standby letter of credit is required through November 2012, unless the lease is terminated before then. This amount has been included on the Company's balance sheet as of December 31, 2000 as a component of restricted cash. In the future we may also require a larger inventory of products in order to provide better availability to customers and achieve purchasing efficiencies. Any such increase can be expected to reduce cash, cash equivalents and short-term investments. We expect that our existing cash balances and cash from operations will be sufficient to meet our anticipated working capital and capital expenditures for the foreseeable future.

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