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" in the Company's Form 10-K for the fiscal year ended September 30, 2000, and elsewhere in this report.

OVERVIEW

F5 Networks, Inc. ("F5") is a leading provider of integrated Internet traffic and content management solutions designed to improve the availability and performance of Internet-based servers and applications. Our products monitor and manage local and geographically dispersed servers and intelligently direct traffic to the server best able to handle a user's request. Our content management products enable network managers to increase access to content by capturing and storing it at points between production servers and end-users and ensure that newly published or updated files and applications are replicated uniformly across all target servers. When combined with our network management tools, these products help organizations optimize their network server availability and performance and cost-effectively manage their Internet infrastructure.

Currently, we derive approximately 57% 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 March 31, 2001, no individual customer represented more than 10% of our total revenues.

Net revenues derived from customers located outside of the United States were $9.0 million and $4.4 million for the three months ended March 31, 2001 and 2000, respectively. We plan to continue expanding our international operations, primarily in the European and the Asia Pacific markets, because we believe international markets represent 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, our limited operating history and the current economic conditions, 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.

We have recorded a total of $8.3 million of stock compensation costs since our inception through March 31, 2001. 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 $1.6 million and $470,000 for the three months ended March 31, 2001 and 2000.

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.

                                                    THREE MONTHS ENDED       SIX MONTHS ENDED
                                                        MARCH 31,                MARCH 31,
                                                    ------------------       -----------------
                                                      2001       2000        2001        2000
                                                     ------     ------       ------     ------
                                                        (UNAUDITED)             (UNAUDITED)
STATEMENT OF OPERATIONS DATA:
Net revenues:
   Products ....................................      73.0%       78.5%        72.4%      81.4%
   Services ....................................      27.0        21.5         27.6       18.6
                                                     -----       -----        -----      -----
           Total net revenues ..................     100.0       100.0        100.0      100.0
                                                     -----       -----        -----      -----
Cost of net revenues:
   Products ....................................      28.6        21.4         30.6       22.6
   Services ....................................      12.0         7.6         13.2        6.7
   Provision for excess inventory...............      18.1          --          9.4         --
                                                     -----       -----        -----      -----
           Total cost of net revenues ..........      58.7        29.0         53.2       29.3
                                                     -----       -----        -----      -----
           Gross margin ........................      41.3        71.0         46.8       70.7
                                                     -----       -----        -----      -----
Operating expenses:
   Sales and marketing .........................      47.6        35.8         51.0       33.2
   Research and development ....................      17.2        11.7         18.5       11.7
   General and administrative ..................      15.7         7.4         17.4        7.5
   Restructuring charges........................       (.4)         --          1.9         --
   Amortization of unearned compensation .......       5.9         2.0          4.2        2.3
                                                     -----       -----        -----      -----
           Total operating expenses ............      86.0        56.9         93.0       54.7
Income (loss) from operations ..................     (44.7)       14.1        (46.2)      16.0
Other income, net ..............................       1.6         3.5          0.1        3.6
Interest income (expense), net..................       2.5          --          2.6         --
                                                     -----       -----        -----      -----
Income (loss) before income taxes...............     (40.6)       17.6        (43.2)      19.6
Income tax provision............................      (8.4)         --         (9.1)        --
                                                     -----       -----        -----      -----
Net income (loss) ..............................     (32.2)%      17.6%        34.1%      19.6%
                                                     =====       =====        =====      =====

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 6.7% from $18.5 million for the three months ended March 31, 2000 to $19.8 million for the three months ended March 31, 2001. Product revenues increased 7.7% from $34.8 million for the six months ended March 31, 2000 to $37.5 million for the six months ended March 31, 2001. The increase in product revenues were due primarily to an increase in the quantity of our products sold through our international indirect 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 43.8% from $5.1 million for the three months ended March 31, 2000 to $7.3 million for the three months ended March 31, 2001. Service revenues increased 79.6% from $8.0 million for the six months ended March 31, 2000 to $14.3 million for the six months ended March 31, 2001. The increase was due primarily to an increase in the installed base of our products and the renewal of service and support contracts.

International revenues represented 32.6% and 18.48% of net revenues for the three months ended March 31, 2001 and 2000, respectively. International revenues represented 31.7% and 15.5% for the six months ended March 31, 2001 and 2000. 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.

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. This decrease may have a negative impact on our gross margin. In order to maintain our gross margin, we must continually manage our cost of revenues to offset the decrease in our average sales price.

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, an allocation of our facilities and depreciation expenses.

Cost of product revenues. Cost of product revenues increased by 53.4%, from $5.0 million for the three months ended March 31, 2000 to $7.8 million for the three months ended March 31, 2001 and increased as a percentage of product revenues from 27.3% to 39.2% for the same periods. Cost of product revenues increased by 63.7% from $9.7 million for the six months ended March 31, 2000 to $15.8 million for the six months ended March 31, 2001 and increased as a percentage of product revenues from 27.8% to 42.2% for the same periods. The increases 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.

Due to changes in current market conditions, and a revision of our sales forecast, a review was made of our inventory needs and an assessment of our future purchase commitments as of March 31, 2001. As a result, we determined a provision for excess inventory and future purchase commitments would be recorded. The provision for excess inventory was charged to cost of revenues in the amount of $3.8 million as of March 31, 2001, which consisted of a $3.0 million inventory valuation allowance and $800,000 of future purchase commitments. An additional $1.1 million was included in the provision for excess inventory in the statement of operations. The charge is associated with changes in the configuration of our EDGE-FX Cache product, which will increase the functionality of the product. These costs are associated with updating both existing inventory and product previously sold to customers, as well as costs to fulfill existing purchase commitments, have been included in cost of revenues at March 31, 2001.

Cost of service revenues. Cost of service revenues increased by 80.7%, from $1.8 million for the three months ended March 31, 2000 to $3.2 million for the three months ended March 31, 2001 and increased as a percentage of service revenues from 35.3% to 44.4% for the same periods. Cost of service revenues increased by 139.3% from $2.9 million for the six months ended March 31, 2000 to 6.8 million for the six months ended March 31, 2001 and increased as a percentage of service revenues from 35.8% to 47.7% for the same periods. The increases as a percentage of cost of service revenues was due to increased personnel costs related to hiring. The personnel associated with cost of service revenues increased from 43 as of March 31, 2000 to 95 as of March 31, 2001.

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 52.3%, from $8.5 million for the three months ended March 31, 2000 to $12.9 million for the three months ended March 31, 2001. Sales and marketing expenses increased by 86% from $14.2 million for the six months ended March 31, 2000 to $26.4 million for the six months ended March 31, 2001. These increases were due to an increase in sales and marketing and professional services personnel from 170 to 212, 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 68.5%, from $2.8 million for the three months ended March 31, 2000 to $4.7 million for the three months ended March 31, 2001. Research and development expenses increased by 92.5% from $5.0 million for the six months ended March 31, 2000 to $9.6 million for the six months ended March 31, 2001. These increases were due primarily to an increase in product development personnel from 89 to 115. Our future success is dependent in a 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 143.2% from $1.8 million for the three months ended March 31, 2000 to $4.3 million for the three months ended March 31, 2001. General and administrative expenses increased by 178.9% from $3.2 million for the six months ended March 31, 2000 to $9.0 million for the six months ended March 31, 2001. These increases were due primarily to an increase in general and administrative personnel from 48 to 67.

Restructuring charge. During the first fiscal quarter of 2001, F5 recorded a restructuring charge of $1.1 million in connection with management's decision to bring operating expenses in line with the business revenue growth model. As a result of change in the business revenue growth model, the Company terminated 96 employees throughout all divisions of the Company. In January 2001, all identified employees had been terminated. During the quarter ended March 31, 2001, the Company reversed $96,000 of the original accrual due to a revision of previous estimates. As of March 31, 2001, substantially all of the restructuring charge accrued during the first fiscal quarter of 2001, has been paid.

Stock compensation. We recorded stock compensation charges of $470,000 for the three months ended March 31, 2000 and $1.6 million for the three months ended March 31, 2001. The increase was the result of stock granted below fair market value to an executive officer. For the six months ended March 31, 2000 and 2001, stock compensation was $1.0 million and $2.2 million, respectively.

Other income, net. Other income consists primarily of earnings on our cash and cash equivalent balances. Other income, net was $818,000 for the three months ended March 31, 2000 and $1.1 million for the three months ended March 31, 2001. The decrease in other income is due to a decline in our cash and cash equivalent balances which were used for investment in the building of our corporate facilities and our global business. For the six months ended March 31, 2000 and 2001, other income, net, was $1.6 million and $1.5 million, respectively.

Income taxes. At March 31, 2001 the Company had net operating loss carryforwards of approximately $10.9 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 $10.9 million in the valuation allowance was recorded against the deferred tax assets as a result of the operating losses incurred during the six months ended March 31, 2001.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents, short-term investments, and restricted cash decreased from $53.0 million at September 30, 2000 to $30.3 million at March 31, 2001, a decrease of $22.7 million. This decrease is primarily due to increases in inventory and working capital requirements necessary to fund our operations. Inventory levels increased 69% from September 30, 2000 to March 31, 2001. 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.

Cash used in investing activities was $7.3 million for the six months ended March 31, 2001, and $3.4 million for the six months ended March 31, 2000. The increase in investing activities was primarily the result of capital expenditures associated with the completion of the new corporate facilities.

As of March 31, 2001, 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. In April 2001, we signed an agreement to sublease the second building. The sublease will substantially cover our monthly costs as the primary tenant. 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 March 31, 2001 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.