ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Statements in this report concerning future events or future performance, financial results or achievements of F5, or other statements which are not statements of historical facts are forward-looking statements. These statements may be identified by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts", "potential" or "continue" or the negative of such terms or comparable terms. These statements are subject to a number of known and unknown risks, uncertainties and other factors which may cause F5's actual results, performance or achievements to differ from those expressed or implied by those statements. Relevant risks and uncertainties include among others: the Company's limited operating history; variability of the Company's operating results; market acceptance of the Company's Internet traffic and content management products; the Company's timely development of new products and features; the company's ability to manage its growth; the Company's ability to maintain and develop distribution relationships; competition in the Internet traffic and content management market; the company's ability to expand in the international markets; unpredictability of the Company's sales cycle and other risk factors referenced in the Company's public filings with the Securities and Exchange Commission, and in particular, those set forth under the heading "Risk Factors" in the company's Annual Report on Form 10-K filed with the SEC on December 28, 1999. These forward-looking statements speak only as of the date of this report. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained in this report to reflect any change in our expectations with regard to such statements or any change in events, conditions or circumstances on which any statement is based.

The following information should be read in conjunction with the "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 15 through 27 of our annual report on Form 10-K.

OVERVIEW

F5 is a leading provider of integrated Internet traffic and content management solutions designed to improve the availability and performance of mission-critical Internet-based servers and applications. We were incorporated on February 26, 1996 and began operations in April 1996. During the period from February 26, 1996 through September 30, 1996, we were a development stage enterprise and had no product revenues. Our operating activities during this period related primarily to developing our initial product, recruiting personnel, building our corporate infrastructure and raising capital.

In July, 1997, we released our first version of our BIG/ip(R) Controller, and began to expand our operations. We continue to commit a significant amount of resources to research and development, marketing programs, domestic and international sales channels, customer support and services and our general and administrative infrastructure. As of December 31, 1999, we have:

o hired more than 230 employees;

o hired sales, professional services and customer support personnel nation-wide;

o released several upgrades to BIG/ip;

o released three new products: our 3DNS(TM) Controller, our see/IT(TM) Network Manager and our global/SITE(TM) Controller;

o engaged sales representatives in the European and Asia Pacific markets; and

o established distributor relationships with nine international resellers.

Our net revenues grew from $2.7 million for the three months ended December 31, 1998 to $19.2 million for the three months ended December 31, 1999. Currently, we derive approximately 72% of our net revenues from sales of BIG/ip. One of our resellers, Exodus Communications, accounted for 24.3% of our net revenues for the three months ended December 31, 1999 and 15.4% of our accounts receivable balance at December 31, 1999. We expect to continue to derive a significant portion of our net revenues from sales of BIG/ip in the future.

Net revenues derived from customers located outside of the United States were $26,000 and $2,260,000 for the three months ended December 31, 1998 and 1999, respectively. We plan to expand our international operations significantly, particularly in selected countries in the European and Asia Pacific markets, because we believe international markets represent a significant growth opportunity. The expansion of our international operations will be subject to a variety of risks that could significantly harm our business and results of operations.

Customers who purchase our products receive installation services and an initial customer support contract, typically covering a 12-month period. We generally combine the software license, hardware, installation, and customer support elements of our products into a package for a single price. We allocate a portion of the sales price to each element of the bundled package based on their respective fair values when the individual elements are sold separately. Revenues from the license of software are recognized, net of allowances for estimated returns, when the product has been shipped and the customer is obligated to pay for the product. Installation revenue 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. Our ordinary payment terms to our customers are net 30 days, but we have extended payment terms beyond net 30 days to some customers. Estimated sales returns are based on historical experience by product and are recorded at the time revenues are recognized. Consulting services are customarily billed at fixed rates, plus out-of-pocket expenses. Customers may also purchase consulting services and renew their initial customer support contract. Based on our limited operating history, it is difficult to predict what our rate of renewals will be in the future.

As of December 31, 1999, we had an accumulated deficit of $5.6 million. Our success in growing net revenues depends on increasing our customer base and expanding our product line as well as continued growth of the emerging Internet traffic and content management market. Accordingly, we intend to continue to invest heavily in sales and marketing, promotion of the F5 brand, customer service and support, research and development, operating infrastructure and general and administrative staff to support our growth. As a result of these investments, we expect that our operating expenses will continue to increase significantly. Despite growing revenues, we have only begun to generate profits during our two most recent quarters ended September 30, 1999 and December 31, 1999.

We have recorded a total of $6.2 million of unearned compensation costs since our inception through December 31, 1999. 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 over the vesting period of the options and have recorded unearned compensation charges of $368,000 and $543,000 for the three months ended December 31, 1998 and 1999, respectively.

We expect to recognize amortization expense related to unearned compensation of approximately $1.8 million, $965,000, $411,000 and $60,000 during the years ended September 30, 2000, 2001, 2002 and 2003, respectively. We cannot guarantee, however, that we will not accrue additional unearned compensation costs in the future.

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 indications of future performance. To maintain profitability we will need to increase our net revenues significantly. Although we have experienced rapid growth in net revenues in recent periods, we may not be able to sustain these growth rates to maintain profitability.

                                                                             THREE MONTHS ENDED
                                                                                 DECEMBER 31,
                                                                         ---------------------------
                                                                             1999          1998
                                                                         ------------  -------------
                                                                                 (unaudited)
STATEMENT OF OPERATIONS DATA:
Net revenues:
    Products ........................................................         84.9%        84.7%
    Services ........................................................         15.1         15.3
                                                                         ------------  -------------
             Total net revenues .....................................        100.0        100.0
                                                                         ------------  -------------
Cost of net revenues:
    Products ........................................................         24.1         23.2
    Services ........................................................          5.5          7.3
                                                                         ------------  -------------
             Total cost of net revenues .............................         29.6         30.5
                                                                         ------------  -------------
             Gross margin ...........................................         70.4         69.5
                                                                         ------------  -------------
Operating expenses:
    Sales and marketing .............................................         30.0         82.2
    Research and development ........................................         11.6         37.9
    General and administrative ......................................          7.7         19.5
    Amortization of unearned compensation ...........................          2.8         13.6
                                                                         ------------  -------------
             Total operating expenses ...............................         52.1        153.2
                                                                         ------------  -------------
Income (loss) from operations .......................................         18.3        (83.7)
                                                                         ------------  -------------
Interest income, net ................................................          3.8          2.2
                                                                         ------------  -------------
Net income (loss) ...................................................         22.1%       (81.5)%
                                                                         ============  =============

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 613.5% from $2.3 million for the three months ended December 31, 1998 to $16.3 million for the three months ended December 31, 1999. 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 600.0% from $413,000 for the three months ended December 31, 1998 to $2.9 million for the three months ended December 31, 1999. This increase was due primarily to an increase in the installed base of our products and the renewal of service and support contracts.

As our net revenue base increases, we do not believe we can sustain the percentage growth rates of net revenues that we have experienced historically.

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, manufacturing and service and support personnel and an allocation of our facilities and depreciation expenses.

Cost of product revenues. Cost of product revenues increased by 641.0%, from $624,000 for the three months ended December 31, 1998 to $4.6 million for the three months ended December 31, 1999 and increased as a percentage of product revenues to 28.4% from 27.3% for the same periods. The increase in product cost was due primarily to increased product revenues. In addition, this increase, and the decrease in our gross product margin, reflects a significant increase in component costs primarily related to increases in memory cost and certain changes to our configuration which require more memory use.

Cost of service revenues. Cost of service revenues increased by 440.3%, from $196,000 for the three months ended December 31, 1998 to $1.1 million for the three months ended December 31, 1999 and decreased as a percentage of service revenues to 36.6% from 47.5% for the same periods. The increase in cost of service revenues in absolute dollars was due primarily to increased personnel costs, including training and consulting expenses related to hiring, as well as additional salaries. The decrease in cost of service revenues as a percentage of service revenues was primarily due to increased economies of scale achieved from increased service revenues.

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 159.1%, from $2.2 million for the three months ended December 31, 1998 to $5.7 million for the three months ended December 31, 1999. This increase was due to an increase in sales and marketing and professional services personnel from 49 to 117, increased commissions, and increased advertising and promotional activities. We expect to continue increasing sales and marketing expenses in order to grow net revenues and expand our brand awareness.

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 117.9%, from $1.0 million for the three months ended December 31, 1998 to $2.2 million for the three months ended December 31, 1999. This increase was due primarily to an increase in product development personnel from 34 to 69 and costs related to such increase. 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 181.5% from $525,000 for the three months ended December 31, 1998 to $1.5 million for the three months ended December 31, 1999. This increase was due primarily to an increase in general and administrative personnel from 21 to 44 and costs associated with being a public company. We expect general and administrative expenses to increase as we expand our staff and further develop our information systems.

Unearned compensation. We recorded unearned compensation charges of $368,000 and $543,000 for the three months ended December 31, 1998 and 1999, respectively.

Interest income, net. Interest income consists of earnings on our cash and cash equivalent balances offset by interest expense associated with debt obligations. Net interest income was $58,000 for the three months ended December 31, 1998 and $741,000 for the three months ended December 31, 1999. This increase was due primarily to the investment of the proceeds received from our initial and secondary public offerings in June and October 1999, respectively.

Income taxes. There was no provision for federal or state income taxes for any period as we have incurred operating losses since inception. As of September 30, 1999, we had approximately $7.8 million of net operating loss carryforwards for federal income tax purposes. Utilization of the net operating loss carryforwards may be subject to annual limitations due to the ownership change limitations contained in the Internal Revenue Code of 1986 and similar state provisions. Annual limitations may result in the expiration of the net operating losses before we can utilize them. The federal net operating loss carryforwards will expire at various dates beginning in 2011 through 2019 if we do not use them.

LIQUIDITY AND CAPITAL RESOURCES

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.

Cash provided by (used in) our operating activities was $(1.6) million for the three months ended December 31, 1998, and $3.0 million for the three months ended December 31, 1999. These net cash inflows (outflows) resulted from operating income (losses) as well as increases in accounts receivable due to increased sales and other current assets and were partially offset by increases in accounts payable, accrued liabilities and deferred revenues. In the future we may offer financing to certain resellers and to the extent such financing is offered, cash used in operating activities would increase to fund the increase in outstanding receivables.

Cash used in investing activities was $331,000 for the three months ended December 31, 1998, and $1.3 million for the three months ended December 31, 1999, substantially all of which was used for the purchase of property and equipment. We expect capital expenditures to continue to increase through the end of 2000, due to the costs of expansion and expenditures for information systems and test equipment.

As of December 31, 1999, our principal commitments consisted of obligations outstanding under operating leases. In March 1999 we began leasing approximately 20,000 square feet in a facility located in Seattle, Washington for a term of 60 months. In June 1999, we agreed to lease an additional 8,000 square feet in this facility for a term of 84 months. In December 1999 we began leasing approximately 13,000 square feet in an additional facility located in Seattle, Washington for a term of eleven months. The annual cost of these leases is approximately $854,000, subject to annual adjustments. We have also signed a lease for approximately 84,000 square feet of new office space in Seattle, Washington in a building which is currently under construction. This lease will commence on approximately June 1, 2000 with a term of 12 years. The annual cost of this lease is approximately $2,000,000, subject to annual adjustments. Our obligation under this lease is collateralized by a secured letter of credit in the amount of $2.5 million. Although we have no other material commitments, we anticipate a substantial increase in our capital expenditures and lease commitments consistent with our anticipated growth in our operations, infrastructure and personnel. In the future we may also require a larger inventory of products in order to provide better availability to customers and achieve purchasing efficiencies. 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.

YEAR 2000 COMPLIANCE

We have completed our corporate-wide Year 2000 project. As a result of these efforts, we have experienced no significant problems at the turn of the century with either our own technology or that of our infrastructure providers. Contingency plans to manage all identified areas of perceived risk will remain in place throughout 2000. The costs incurred by the Company in connection with our Year 2000 compliance program have been and are expected to remain immaterial to our financial position, results of operations and cash flows.