----

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** **

**SECURITIES AND EXCHANGECOMMISSION****Washington, D.C.  20549**

**FORM 10-QSB**

 

| **ý** | **QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |
|------------|-----------------------------------------------------------------------------------------|

**For thequarterly period ended June 30, 2001**

**CommissionFile Number 0-11447**

**DATAKEY, INC.**

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(Exact name of small business issuer asspecified in its charter)

 

| **MINNESOTA**                    | **41-1291472**      |
|----------------------------------|---------------------|
| (State or other  jurisdiction of | (I.R.S. Employer    |
| incorporation or  organization)  | Identification No.) |

** **

| **407  WEST TRAVELERS TRAIL, BURNSVILLE, MN   55337** |
|------------------------------------------------------------|
| ****                                                       |
| Issuer’s telephone  number: ** (952) 890-6850**  |

 

----

(Former name, former address and formerfiscal year,if changed since last report)

 

Checkwhether the issuer (1) filed all reports required to be filed by Section 13 or15 (d) of the Exchange Act during the past 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

                                                                                             Yes   ý     No  o

 

APPLICABLE ONLY TO CORPORATE ISSUERS

Thenumber of shares outstanding of the issuer’s common equity, as of August 10,2001, is 9,918,273.

TransitionalSmall Business Disclosure Format (check One):

                                                                                             Yes   o     No  ý

 

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|   | PART  I.  FINANCIAL INFORMATION |
|--------|--------------------------------------|
|   | ITEM  I.  FINANCIAL STATEMENTS  |
|   | DATAKEY,  INC.                       |
|   | BALANCE  SHEETS                      |

 

|                                           | June  30,                                                                                                                              |        | December  31,        |        |
|------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------|-------------|----------------------|-------------|
|                                           | 2001                                                                                                                                   |        | 2000                 |        |
|                                           |                                                                                                                                        |        |                      |        |
|                                           | (UNAUDITED)                                                                                                                            |        |                 |        |
| ASSETS                                         |                                                                                                                                   |        |                 |        |
| CURRENT ASSETS                                 |                                                                                                                                   |        |                 |        |
|                                           | Cash and cash equivalents                                                                                                              | $           | 3,601,397            |        | $ | 1,532,558 |   |
|                                           | Trade receivables, less allowance  for doubtful accounts of  $30,000 and  $26,000                                                 | 958,546     |            | 989,020     |     |
|                                           | Inventories                                                                                                                            | 1,943,940   |                 | 513,846     |   |
|                                           | Prepaid expenses and other                                                                                                             | 68,030      |                 | 113,176     |   |
|                                           | Net assets of discontinued  operations                                                                                                 | 1,093,947   |                 | 1,561,999   |   |
|                                           |                                                                                                                                        |        |                      |        |
|                                           | Total current assets                                                                                                                   | 7,665,860   |                 | 4,710,599   |   |
|                                           |                                                                                                                                        |        |                      |        |
|                                           |                                                                                                                                   |        |                 |        |
| OTHER ASSETS                                   |                                                                                                                                   |        |                 |        |
|                                           | Prepaid licenses and  patents at cost less amortization of $845,725 and $698,517                                                       | 362,382     |            | 498,961     |     |
|                                           |                                                                                                                                   |        |                 |        |
|                                           |                                                                                                                                   |        |                 |        |
| EQUIPMENT AND  LEASEHOLD IMPROVEMENTS, at cost |                                                                                                                                   |        |                 |        |
|                                           | Production tooling                                                                                                                     | 23,650      |                 | 63,188      |   |
|                                           | Equipment                                                                                                                              | 621,816     |                 | 954,397     |   |
|                                           | Furniture and fixtures                                                                                                                 | 164,623     |                 | 284,423     |   |
|                                           | Leasehold improvements                                                                                                                 | 137,496     |                 | 224,488     |   |
|                                           |                                                                                                                                   |             |                 |             |   |
|                                           | 947,585                                                                                                                                |        | 1,526,496            |        |
|                                           | Less accumulated depreciation                                                                                                          | (746,145    | )                    | (1,300,268  | ) |
|                                           |                                                                                                                                        |        |                      |        |
|                                           | 201,440                                                                                                                                |        | 226,228              |        |
|                                           |                                                                                                                                        |        |                      |        |
|                                           |                                                                                                                                   |        |                 |        |
|                                           | $                                                                                                                                      | 8,229,682   |                 | $           | 5,435,788 |   |
|                                           |                                                                                                                                        |        |                      |        |
|                                           |                                                                                                                                   |        |                 |        |
|                                           |                                                                                                                                   |        |                 |        |
| LIABILITIES  AND SHAREHOLDERS' EQUITY          |                                                                                                                                   |        |                 |        |
| CURRENT LIABILITIES                            |                                                                                                                                   |        |                 |        |
|                                           | Accounts payable                                                                                                                       | $           | 718,564              |        | $ | 386,613 |   |
|                                           | Accrued compensation                                                                                                                   | 250,673     |                 | 226,803     |   |
|                                           | Accrued expenses-other                                                                                                                 | 58,953      |                 | 74,031      |   |
|                                           | Deferred revenue                                                                                                                       | 124,465     |                 | 63,797      |   |
|                                           | Net liabilities from discontinued  operations                                                                                          | 195,431     |                 | 480,875     |   |
|                                           |                                                                                                                                   |             |                 |             |   |
|                                           | Total current liabilities                                                                                                              | 1,348,086   |                 | 1,232,119   |   |
|                                           |                                                                                                                                        |        |                      |        |
|                                           |                                                                                                                                   |        |                 |        |
|                                           |                                                                                                                                   |        |                 |        |
| SHAREHOLDERS' EQUITY                           |                                                                                                                                   |        |                 |        |
|                                           | Convertible preferred stock,  voting, stated value $2.50 per share; authorized 400,000 shares; issued and  outstanding 150,000         | 375,000     |       | 375,000     |       |
|                                           | Common stock, par value $.05 per  share; authorized 20,000,000 shares; issued and outstanding 9,918,273 in 2001  and 8,269,173 in 2000 | 495,913     |       | 413,459     |       |
|                                           | Additional paid-in capital                                                                                                             | 18,432,802  |                 | 13,906,744  |   |
|                                           | Accumulated deficit                                                                                                                    | (12,422,119 | )                    | (10,491,534 | ) |
|                                           |                                                                                                                                   |             |                 |             |   |
|                                           | 6,881,596                                                                                                                              |        | 4,203,669            |        |
|                                           |                                                                                                                                        |        |                      |        |
|                                           |                                                                                                                                   |        |                 |        |
|                                           | $                                                                                                                                      | 8,229,682   |                 | $           | 5,435,788 |   |
|                                           |                                                                                                                                        |        |                      |        |
|                                                |                                                                                                                                        |             |                      |             |  |  |  |  |

See Notes to Financial Statements

DATAKEY, INC.STATEMENTS OF INCOME(UNAUDITED)

|                                                  | Three  Months Ended                           |          | Six  Months Ended |          |
|-------------------------------------------------------|-----------------------------------------------|---------------|-------------------|---------------|
|                                                  | June  30,                                     |          | July  1,          |          | June  30, |   | July  1, |   |
|                                                  | 2001                                          |          | 2000              |          | 2001 |   | 2000 |   |
|                                                  |                                               |          |                   |          |  |   |  |   |
|                                                  |                                          |          |              |          |   |   |   |   |
| Revenue                                               | $                                             | 1,054,909     |              | $             | 939,512 |   | $ | 2,351,547 |   | $ | 1,398,307 |   |
| Cost of goods sold                                    | 433,512                                       |          | 484,345           |          | 1,042,030 |   | 775,079 |   |
|                                                  |                                               |          |                   |          |  |   |  |   |
|                                                  |                                          |          |              |          |   |   |   |   |
|                                                  | Gross Profit                                  | 621,397       |              | 455,167       |   | 1,309,517 |   | 623,228 |   |
|                                                  |                                          |          |              |          |   |   |   |   |
|                                                  |                                          |          |              |          |   |   |   |   |
| Operating expenses:                                   |                                          |          |              |          |   |   |   |   |
|                                                  | Research, development and  engineering        | 579,520       |              | 418,221       |   | 1,179,677 |   | 869,614 |   |
|                                                  | Marketing and sales                           | 820,096       |              | 561,014       |   | 1,696,834 |   | 911,212 |   |
|                                                  | General and administrative                    | 193,345       |              | 189,361       |   | 403,767 |   | 343,595 |   |
|                                                  |                                               |          |                   |          |  |   |  |   |
|                                                  |                                          |          |              |          |   |   |   |   |
|                                                  |                                          |          |              |          |   |   |   |   |
|                                                  | Total operating expenses                      | 1,592,961     |              | 1,168,596     |   | 3,280,278 |   | 2,124,421 |   |
|                                                  |                                               |          |                   |          |  |   |  |   |
|                                                  |                                          |          |              |          |   |   |   |   |
|                                                  | Operating loss                                | (971,564      | )                 | (713,429      | ) | (1,970,761 | ) | (1,501,193 | ) |
|                                                  |                                          |          |              |          |   |   |   |   |
| Interest income                                       | 37,482                                        |          | 60,727            |          | 40,176 |   | 97,857 |   |
|                                                  |                                               |          |                   |          |  |   |  |   |
|                                                  |                                          |          |              |          |   |   |   |   |
|                                                  |                                          |          |              |          |   |   |   |   |
| Loss from continuing  operations before income taxes  | (934,082                                      | )             | (652,702          | )             | (1,930,585 | ) | (1,403,336 | ) |
| Income tax expense                                    | 0                                             |          | 0                 |          | 0 |   | 0 |   |
|                                                  |                                               |          |                   |          |  |   |  |   |
|                                                  |                                          |          |              |          |   |   |   |   |
| Net loss from  continuing operations                  | $                                             | (934,082      | )                 | $             | (652,702 | ) | $ | (1,930,585 | ) | $ | (1,403,336 | ) |
|                                                  |                                               |          |                   |          |  |   |  |   |
| Loss from operations  of discontinued segment         | 0                                             |          | (72,320           | )             | 0 |   | (29,949 | ) |
| Income (loss) from  disposal of discontinued segment  | 0                                             |          | 0                 |          | 0 |   | 0 |   |
|                                                  | Net loss attributable to common  stockholders | $             | (934,082          | )             | $ | (725,022 | ) | $ | (1,930,585 | ) | $ | (1,433,285 | ) |
|                                                  |                                               |          |                   |          |  |   |  |   |
|                                                  |                                          |          |              |          |   |   |   |   |
|                                                  |                                          |          |              |          |   |   |   |   |
|   Basic and diluted loss per share               | $                                             | (0.09         | )                 | $             | (0.09 | ) | $ | (0.20 | ) | $ | (0.19 | ) |
|                                                  |                                               |          |                   |          |  |   |  |   |
|                                                  |                                          |          |              |          |   |   |   |   |
| Weighted average  number ofcommon  shares outstanding | 9,902,730                                     |     | 8,110,533         |     | 9,486,576 |     | 7,705,281 |     |
|                                                  |                                               |          |                   |          |  |   |  |   |
|                                                       |                                               |               |                   |               |  |  |  |  |  |  |  |  |  |  |  |

See Notes to Financial Statements

DATAKEY, INC.STATEMENTS OF CASH FLOWS(UNAUDITED)

 

|                                     | Three  Months Ended                                                          |      | Six  Months Ended |       |
|------------------------------------------|------------------------------------------------------------------------------|-----------|-------------------|------------|
|                                     | June  30,                                                                    |      | July  1,          |       | June  30, |   | July  1, |   |
|                                     | 2001                                                                         |      | 2000              |       | 2001 |   | 2000 |   |
|                                     |                                                                              |      |                   |       |  |   |  |   |
|                                     |                                                                         |      |              |       |   |   |   |   |
| **CASH FLOWS FROM OPERATING ACTIVITIES** |                                                                         |      |              |       |   |   |   |   |
|                                     | Net loss                                                                     | $         | (934,082          | )          | $ | (725,022 | ) | $ | (1,930,585 | ) | $ | (1,433,285 | ) |
|                                     | Adjustments to reconcile net loss to net cash used in  operating activities: |      |              |       |   |   |   |   |   |
|                                     | Depreciation                                                                 | 90,503    |              | 100,154    |   | 159,198 |   | 181,764 |   |
|                                     | Amortization                                                                 | 90,899    |              | 99,220     |   | 151,437 |   | 154,771 |   |
|                                     | Change in assets and liabilities                                             |      |              |       |   |   |   |   |   |
|                                     | (Increase) decrease:                                                         |      |              |       |   |   |   |   |   |
|                                     | Trade receivables                                                            | 546,012   |              | (468,737   | ) | (130,021 | ) | (168,015 | ) |
|                                     | Inventories                                                                  | (806,026  | )                 | (521,858   | ) | (1,027,266 | ) | (574,541 | ) |
|                                     | Prepaid expenses and other                                                   | (36,630   | )                 | (90,752    | ) | 27,094 |   | (65,631 | ) |
|                                     | Prepaid license fees and patent                                              | (1,156    | )                 | (2,167     | ) | (1,156 | ) | (7,155 | ) |
|                                     | Increase (decrease) in:                                                      |      |              |       |   |   |   |   |   |
|                                     | Reserve for loss on discontinued  operations                                 | 167,309   |              | 0          |   | 110,148 |   | 0 |   |
|                                     | Accounts payable                                                             | 180,539   |              | (36,548    | ) | 51,092 |   | (164,844 | ) |
|                                     | Accrued expenses                                                             | (61,195   | )                 | 17,448     |   | 64,874 |   | 57,201 |   |
|                                     |                                                                         |           |              |            |   |  |   |  |   |
|                                     |                                                                         |      |              |       |   |   |   |   |
|                                     | Net cash used in operating activities                                        | (763,827  | )                 | (1,628,262 | ) | (2,525,185 | ) | (2,019,735 | ) |
|                                     |                                                                         |           |              |            |   |  |   |  |   |
|                                     |                                                                         |      |              |       |   |   |   |   |   |
|                                     |                                                                         |      |              |       |   |   |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES** |                                                                         |      |              |       |   |   |   |   |
| Purchase of tooling  and equipment       | (198                                                                         | )         | (10,564           | )          | (14,488 | ) | (75,980 | ) |
|                                     |                                                                              |      |                   |       |   |   |   |   |
|                                     |                                                                         |      |              |       |   |   |   |   |
| Net cash used in                         |                                                                         |      |              |       |   |   |   |   |
| investing activities                     | (198                                                                         | )         | (10,564           | )          | (14,488 | ) | (75,980 | ) |
|                                     |                                                                              |      |                   |       |  |   |  |   |
|                                     |                                                                         |      |              |       |   |   |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES** |                                                                         |      |              |       |   |   |   |   |
|                                     | Net proceeds from issuance of common stock                                   | (11,323   | )                 | 238,993    |   | 4,608,512 |   | 5,267,001 |   |
|                                     |                                                                         |           |              |            |   |  |   |  |   |
|                                     | Net cash provided by financing  activities                                   | (11,323   | )                 | 238,993    |   | 4,608,512 |   | 5,267,001 |   |
|                                     |                                                                              |      |                   |       |  |   |  |   |
|                                     |                                                                         |      |              |       |   |   |   |   |
|                                     | Increase(decrease) in cash and cash equivalents                              | (775,348  | )                 | (1,399,833 |   | 2,068,839 |   | 3,171,286 |   |
|                                     |                                                                         |      |              |       |   |   |   |   |
| **CASH AND CASH   EQUIVALENTS**     |                                                                         |      |              |       |   |   |   |   |
|                                     | Beginning                                                                    | 4,376,745 |              | 4,916,041  |   | 1,532,558 |   | 344,922 |   |
|                                     |                                                                              |      |                   |       |  |   |  |   |
|                                     | Ending                                                                       | $         | 3,601,397         |       | $ | 3,516,208 |   | $ | 3,601,397 |   | $ | 3,516,208 |   |
|                                     |                                                                              |      |                   |       |  |   |  |   |
|                                          |                                                                              |           |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

See Notes to Financial Statements

 

 

**DATAKEY, INC.NOTES TO FINANCIAL STATEMENTS**

** **

** **

**GENERAL**In the opinion of management, the accompanying unaudited financial statementscontain all adjustments necessary to present fairly Datakey’s financialposition as of June 30, 2001, and December 31, 2000, and results of itsoperations and cash flows for the three-month and six-month periods ended June30, 2001, and July 1, 2000.  Theadjustments that have been made are of a normal recurring nature.

Theaccounting policies followed by the Company are set forth in Note 1 to theCompany’s financial statements in the 2000 Datakey, Inc. Annual Report and inForm 10-KSB for the year ended December 31, 2000.

** **

**ACCOUNTING STANDARDS NOT YET ISSUED**In July 2001, the Financial AccountingStandards Board issued two new statements. Statement No. 141, BusinessCombinations, eliminates the pooling method of accounting for businesscombinations. Statement No. 142, Goodwill and Other Intangible Assets,eliminates the amortization of goodwill and other intangibles that aredetermined to have an indefinite life and requires, at a minimum, annualimpairment tests of goodwill and other intangible assets that are determined tohave an indefinite life. The Company has not yet completed its full assessmentof the effect of these new standards on its consolidated financial statements,but believes their impact will not be significant. The standards generally arerequired to be implemented by the Company in its 2002 financial statements.

**OPERATINGSEGMENTS**The Company has two reportable segments: Electronic Products (EP)and Integrated Systems Solutions (ISS). The Electronic Products segment produces and markets proprietary memorykeys, cards, and custom-shaped tokens and systems that utilize these productsthat serve as a convenient way to carry electronic information.  The Integrated Systems Solutions segmentproduces and markets products for the information security market, which enableuser identification and authentication, secure data exchange, and informationvalidation.

Theaccounting policies of the segments are the same as those described in thesummary of significant accounting policies. There are no intersegment transactions. The Company evaluates performance based on operating earnings of therespective segments.

 

|                           |   | *Three  Months Ended June 30, 2001* |      | *Six  Months Ended June 30, 2001* |     |
|--------------------------------|--------|-------------------------------------|-----------|-----------------------------------|----------|
| **                             |   |
| *EP*                           |   | *ISS*                               |      | *UNALLOCATED*                     |     | *TOTAL* |   | *EP* |   | *ISS* |   | *UNALLOCATED* |   | *TOTAL* |   |
|                           |   | **                                  |      |
| Revenue                        |   | $                                   | 1,049,382 |                              | $        | 1,054,909 |   | $ | – |   | $ | 2,104,291 |   | $ | 2,121,012 |   | $ | 2,351,547 |   | $ | – |   | $ | 4,472,559 |   |
| Interest  income (expense)     |   | –                              |      | –                            |     | 37,482 |   | 67,482 |   | – |   | – |   | 40,176 |   | 40,176 |   |
| Depreciation  and amortization |   | 61,527                              |      | 119,480                           |     | – |   | 181,007 |   | 106,812 |   | 213,570 |   | – |   | 320,382 |   |
| Segment  profit (loss)         |   | *167,309                            |      | (971,564                          | )        | 37,482 |   | (766,773 | ) | *110,148 |   | (1,970,761 | ) | 40,176 |   | (1,820,437 | ) |
|                           |   | **                                  | * *  |
|                           |   |                                |      |                              |     |
|                           |   | *Three  Months Ended July 1, 2000*  | * *  | *Six  Months Ended July 1, 2000*  | * * |
|                           |   | **                                  |      |
|                           |   | *EP*                                |      | *ISS*                             |     | *UNALLOCATED* |   | *TOTAL* |   | *EP* |   | *ISS* |   | *UNALLOCATED* |   | *TOTAL* | * * |
|                           |   | **                                  |      |
| Revenue                        |   | $                                   | 897,188   |                              | $        | 939,512 |   | $ | – |   | $ | 1,836700 |   | $ | 2,211,770 |   | $ | 1,398,307 |   | $ | – |   | $ | 3,610,077 |   |
| Interest  income(expense)      |   | –                              |      | –                            |     | 60,727 |   | 60,727 |   | – |   | – |   | 97,857 |   | 97,857 |   |
| Depreciation  and amortization |   | 72,303                              |      | 127,071                           |     | – |   | 199,374 |   | 126,503 |   | 210,032 |   | – |   | 336,535 |   |
| Segment  profit (loss)         |   | (72,320                             | )         | (713,429                          | )        | 60,727 |   | (725,022 | ) | (29,949 | ) | (1,501,193 | ) | 97,857 |   | (1,433,285 | ) |

 

*Thesegment profit from the EP segment during the periods is not reflected in theIncome Statement because the estimated loss from operations and disposition ofthe segment was charged to earnings in 2000.

**DISCONTINUED OPERATIONS**In February, 2001 the Company’s Board ofDirectors approved management’s plan to discontinue the operations of the EPsegment.  The plan anticipated the phasedown of the operations through December 31, 2001, although it was possible theoperations could be sold if a purchaser was found.  The financial statements have been prepared as if the operationwill be phased down.  (See SubsequentEvents).

Theestimated loss, taken in 2000, on the phase down of the EP segment included thewrite-off of inventory, patents, and equipment anticipated to remain at thedate of closedown and expenses associated with the phase down, net of estimatedoperating income through that date.  Thephase down of the segment is being accounted for as discontinued operationsand, accordingly, its net assets and net liabilities have been segregated fromcontinuing operations in the balance sheets and the results of operations havebeen excluded from continuing operations for all periods presented.  Net assets and liabilities of the EP segmentas of June 30, 2001 and December 31, 2000 are as follows:

 

|                                          | June  30, 2001 |      | Dec.  31, 2000 |   |
|-----------------------------------------------|----------------|-----------|----------------|--------|
|                                          |                |      |                |   |
| Trade receivables                             | $              | 658,776   |           | $      | 498,281 |   |
| Inventories                                   | 1,524,660      |      | 1,927,488      |   |
| Equipment and  leasehold improvements         | 224,497        |      | 344,418        |   |
| Patents and prepaid  expense                  | 77,162         |      | 72,812         |   |
| Reserve for  discontinued operations          | (1,391,148     | )         | (1,281,000     | )      |
|                                          |                |      |                |   |
| Net assets from  discontinued operations      | $              | 1,093,947 |           | $      | 1,561,999 |   |
|                                          |                |      |                |   |
|                                          |           |      |           |   |
| Accounts payable                              | $              | 76,681    |           | $      | 357,540 |   |
| Accrued expenses:                             |           |      |           |   |
|                                          | Compensation   | 87,113    |           | 90,165 |   |
|                                          | Other          | 31,637    |           | 33,170 |   |
|                                          |                |      |                |   |
| Net liabilities from  discontinued operations | $              | 195,431   |           | $      | 480,875 |   |
|                                          |                |      |                |   |

** **

**SUBSEQUENTEVENTS**On August 3, 2001 the Company completedthe sale of the EP business segment fixed assets, inventory, patents andprepaid expense along with customer lists, assignment of certain customercontracts and all intellectual property required to operate the EP businesssegment.  The Company retained certaincustomer contracts, and all EP accounts receivable, accounts payable andaccrued expense as of July 31, 2001. The Company received $550,000 in cash on the date of closing, willrealize the cash difference between accounts receivable and accounts payableand accrued expense and profit on the customer contracts retained.  In addition, the Company subleased for 35months, the remaining term under the Company’s lease, the former EP space tothe buyer.  Due to the nature of thetransaction the final accounting is not complete but the Company does notanticipate a significant gain or loss on the disposition of the EP businesssegment beyond that which was already recorded in 2000.  The reserve for discontinued operations is,therefore, not being adjusted at this time. Estimated net cash to the Company from this sale is approximately $1million.

 

**ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLANOF OPERATION**

**DATAKEY,INC.RESULTS OF OPERATIONS AND FINANCIAL CONDITION**

*** ***

***RESULTS OF OPERATIONSCONTINUING OPERATIONS***

 

             **REVENUE**– ISS revenue for the three and six-month periods ended June 30, 2001,increased by $115,000, or 12 percent, and $953,000, or 68 percent, respectivelyas compared to the same periods in 2000. The significant increase in revenue is primarily due to increasedacceptance of the Company’s information security product offering.  Management believes that revenue in 2001will continue to improve as compared to 2000 and will likely result in annualrevenue that is significantly higher than that of 2000.

             **GROSSPROFIT MARGIN** – Gross profit as a percentage of revenue increased to59 percent in the three-month period ended June 30, 2001, from 48 percent inthe three-month period ended July 1, 2000, and increased to 56 percent from 45percent in the six-month period.  Theincrease in gross profit percentage is primarily due to favorable productpricing during the three and six-month periods.  Although the Company does not expect to always obtain productpricing as favorable as that obtained in the first half of 2001, managementexpects the gross margin percentage to continue to be favorable as compared to2000 due to increased revenue and technology licensing fees.

             **OPERATINGEXPENSES** – Operating expenses increased by $424,000, or 36 percentin the three-month period ended June 30, 2001 and $1,156,000, or 54 percent, inthe six-month period ended June 30, 2001, due to redistribution of marketingand general and administrative expenses that were previously shared with ourdiscontinued operation, expenses related to opening and staffing a Europeanoffice and two additional US sales offices, increases in product promotionexpense, increases in staffing for software development and technical supportand increases in commissions on the significant increase in revenue.  Operating expenses are expected to increasegradually for the balance of the year as compared to the first half.

             **INTERESTINCOME** – Interest income, net of interest expense, decreased to$37,000 in the three-month period and to 40,000 in the six-month periodreflecting a lower balance in interest bearing accounts than in the 2000.  The Company also borrowed $500,000 from amajor shareholder during the first quarter as interim working capital as itpursued a private placement of common stock.  Interest income is expected to decrease over the balance of the year dueto a decline interest rates.

***RESULTS OF OPERATIONSDISCONTINUED OPERATIONS(Also See Subsequent Events)***

** **

**REVENUE**Revenue from discontinued operations in the three months ended June 30, 2001increased $152,000, or 19 percent, and decreased $91,000, or 4 percent, in thesix month-period as compared to the same periods in 2000 as the Companyexperienced volatility in the customer orders from the EP segment.

**GROSS MARGIN**Gross margin from discontinued operationsin the three months ended June 30, 2001 declined $76,000 or 16 percent from thecomparable period in 2000 and decreased 237,000 in the six-month period due, inpart, to lower revenue and due to unfavorable product pricing in the currentperiods.

**OPERATINGEXPENSES**Operating expenses from discontinued operations in the three-month period endedJune 30, 2001 declined $316,000 or 57 percent from the comparable period in2000 and declined 377,000 or 37 percent in the six-month period as the Company reducedstaff and scaled back operations to conserve cash while looking for a buyer forthe business segment.

**OPERATINGINCOME AND LOSS**Discontinued operations reflected a profit of $167,000 during the quartercompared to a loss of $72,000 in the second quarter of 2000 and a profit of$110,000 in the six-month period compared to a loss of $30,000 in the prioryear, primarily as a result of the substantial reduction of operatingexpenses.  This current year segment profitdid not affect reported net loss as the Company provided a loss for operationof and disposition of the discontinued business segment in 2000.

***FINANCIAL CONDITION*****–**The Company experienced adecrease in cash and cash equivalents of $775,000 in the three-month periodended June 30, 2001 as a result of the operating loss, and experienced anincrease of $2,069,000 in the six-month period as a result of the successfulprivate placement in the first quarter that raised $4,600,000, offset by theoperating loss and increases in inventory and receivables.  The statements of cash flows includediscontinued operations as well as continuing operations in the periodspresented.

             Datakey’s balance sheet reflects$6,318,000 in working capital as of June 30, 2001 and a current assets tocurrent liabilities ratio of 5.69 to 1. The Company believes that its current cash and cash equivalents inaddition to its $1 million bank line of credit will provide sufficient fundingfor at least the balance of 2001.

** **

**FORWARDLOOKING STATEMENTS AND RISK FACTORS**

TheManagement’s Discussion and Analysis contains certain forward-lookingstatements relating to the growing acceptance of the Company’s informationsecurity products, the implication that the information security productrevenue will continue to improve, that gross margins will continue to befavorable, and that the Company will be able to fund its operations for atleast the balance of 2001.  Thesestatements are subject to certain risks and uncertainties which may cause actualresults to differ materially from those projected.

Theserisks and uncertainties include: (i) that market acceptance and demand for theCompany’s information security products may not increase at the rate expectedor may decrease due to competitive or other general market conditions; (ii)that the $2.8 million in shipments in ISS products to the Canadian DND pursuantto an order obtained in June 2001 actually occur as projected; (iii) that theCompany may not be able to obtain favorable pricing; (iv) the introduction ofcompetitive information security products, (v) that the Company may not besuccessful in continuing to develop significant licensing arrangements topositively impact gross margin, (vi) the ability of the Company to attainprofitability and positive cash flows by significantly increasing ISS productrevenues while controlling expenses; and (vii) recent fluctuations in the stockmarket and general market conditions.

 

**PART II.  OTHERINFORMATION**

**ITEM4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY SHAREHOLDERS**

TheCompany held its Annual Meeting on Wednesday, May 31, 2001.

Proxiesfor the Annual Meeting were solicited pursuant to Regulation 14 under theSecurities Exchange Act of 1934.  Therewas no solicitation in opposition to management’s nominees as listed in theCompany’s proxy statement, and all nominees were elected.

By7,200,115 votes in favor, with 57,190 votes opposed, and 22,852 votesabstaining, the shareholders set the number of directors to be elected at five(5).

Thefollowing persons were elected to serve as directors of the Company, by thevotes indicated, until the next annual meeting of shareholders:

| NOMINEE              | NUMBER OF VOTES FOR | NUMBER OF VOTES  WITHHELD |
|----------------------|---------------------|---------------------------|
| Terrence  W. Glarner | 7,051,051           | 229,106                   |
| Thomas  R. King      | 6,545,467           | 734,690                   |
| Gary  R. Holland     | 7,050,801           | 229,356                   |
| Eugene  W. Courtney  | 7,055,551           | 224,606                   |
| Carl  P. Boecher     | 6,956,066           | 324,091                   |

Theshareholders approved, by a vote of 3,380,497 shares in favor, with 171,132against, 25,052 abstaining, and 3,703,476 broker non-votes, a proposal toapprove the amended and restated Bylaws to provide for a staggered election of directors, to revise procedures forthe conduct of shareholder meeting and procedures for shareholder proposals andthe incorporate certain other changes.

Theshareholders approved, by a vote of 6,261,560 in favor, with 997,917 againstand 20,650 abstaining, an increase in the shares under the 1997 Stock OptionPlan from 1,100,000 to 1,400,000

Theshareholders also ratified the appointment of McGladrey and Pullen, LLP, asindependent auditors for the Company for the fiscal year ending December 31,2001, by 7,259,936 votes in favor, 10,691 opposing and 9,530 abstaining.

**ITEM6.  EXHIBITS AND REPORTS ON FORM 8-K**

| (a)    | Reports  on Form 8-K                                                                                                                                                                               |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                               |
|   | No  reports on Form 8-K were filed during the quarter ended June 30, 2001; however,  the Company did file a form 8-K dated August 3, 2001 to report the sale of  its Electronic Products Business. |

 

**SIGNATURES**

 

Inaccordance with the requirements of the Exchange Act of 1934, the Registranthas duly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

| Dated  August 14, 2001 | Datakey,  Inc. |
|------------------------|----------------|
|                   |           |   |
|                   | By:            | /s/Carl  P. Boecher |
|                   |           |  |
|                   |           | Carl  P. Boecher |
|                   |           | President  & Chief Executive |
|                   |           | Officer |
|                   |           | (Principal  Executive Officer) |
|                   |           |   |
|                   | By:            | /s/Alan  G. Shuler |
|                   |           |  |
|                   |           | Alan  G. Shuler |
|                   |           | Vice  President & Chief Financial |
|                   |           | Officer |
|                   |           | (Principal  Financial and |
|                   |           | Accounting  Officer) |