##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-QSB

(X)      QUARTERLY REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934



| | For the quarterly period ended September 28, 2002
| | -------------------------------------------------



| | Commission File Number 0-11447
| | ------------------------------

DATAKEY, INC.
(Exact name of small business issuer as specified in its charter)

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

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



---

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

Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15 (d) of the Exchange Act during the past 12 months (or for such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.

Yes X No

APPLICABLE ONLY TO CORPORATE ISSUERS

The number of shares outstanding of the issuers common equity, as of
October 23, 2002, is 10,082,750.

Transitional Small Business Disclosure Format (check One):

Yes  No X





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TABLE OF CONTENTS



|                                                                  |  |  |  |  |  |  |  | 
|----------------------------------------------------------------- |  |  |  |  |  |  |  | 
|PART I. FINANCIAL INFORMATION                                    
|ITEM I. FINANCIAL STATEMENTS                                     
|BALANCE SHEETS                                                   
|STATEMENTS OF INCOME                                             
|STATEMENTS OF CASH FLOWS                                         
|NOTES TO FINANCIAL STATEMENTS                                    
|ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
|RESULTS OF OPERATIONS AND FINANCIAL CONDITION                    
|FORWARD LOOKING STATEMENTS AND RISK FACTORS                      
|ITEM 3. CONTROLS AND PROCEDURES                                  
|PART II. OTHER INFORMATION                                       
|ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K                         
|SIGNATURES                                                       
|CERTIFICATION OF CHIEF EXECUTIVE OFFICER                         
|CERTIFICATION OF CHIEF FINANCIAL OFFICER                         



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

|                                              |                                                                                                                                       |                          |                                      |             |               |           |           |              |   |           | 
|--------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------- | ------------------------ | ------------------------------------ | ----------- | ------------- | --------- | --------- | ------------ | - | --------- | 
|                                              |                                                                                                                                       |                          |                                      |             | September 28, |           |           | December 31, |  
|                                              |                                                                                                                                       |                          |                                      |             | 2002          |           |           | 2001         |  
|                                              |                                                                                                                                       |                          |                                      |             |               |           |           |              |  
|                                              |                                                                                                                                       |                          |                                      |             | (UNAUDITED)   |           |           |              |   |          
|                                              |                                                                                                                                       | ASSETS                   |                                      |             |               |           |           |              |   |          
|CURRENT ASSETS                                |                                                                                                                                       |                          |                                      |             |               |           |           |             
|                                              | Cash                                                                                                                                  |                          | $                                    | 3,275,086   |               |           | $         | 4,112,264    |  
|                                              | Trade receivables, less allowance for
doubtful accounts of $55,000 and $28,000                                                        |                          |                                      | 1,568,108   |               |           |           | 2,154,723    |  
|                                              | Inventories, less reserves for obsolescence
of $267,000 and $185,000                                                                  |                          |                                      | 1,019,295   |               |           |           | 926,028      |  
|                                              | Prepaid expenses and other                                                                                                            |                          |                                      | 85,645      |               |           |           | 84,433       |  
|                                              | Net assets of discontinued operations                                                                                                 |                          |                                      | 0           |               |           |           | 82,077       |  
|                                              |                                                                                                                                       |                          |                                      |             |               |          
|                                              |                                                                                                                                       |                          | Total current assets                 |             |               | 5,948,134 |           |              |   | 7,359,525 | 
|                                              |                                                                                                                                       |                          |                                      |             |               |          
|OTHER ASSETS                                  |                                                                                                                                       |                          |                                      |             |               |           |           |             
|                                              | Prepaid licenses and patents at cost less amortization                                                                                |                          |                                      | 233,381     |               |           |           | 191,839      |  
|                                              |                                                                                                                                       | of $907,831 and $832,374 |                                      |             |               |           |           |              |   |          
|EQUIPMENT AND LEASEHOLD IMPROVEMENTS, at cost |                                                                                                                                       |                          |                                      |             |               |           |           |             
|                                              | Production tooling                                                                                                                    |                          |                                      | 23,650      |               |           |           | 23,650       |  
|                                              | Equipment                                                                                                                             |                          |                                      | 740,267     |               |           |           | 701,326      |  
|                                              | Furniture and fixtures                                                                                                                |                          |                                      | 166,520     |               |           |           | 166,520      |  
|                                              | Leasehold improvements                                                                                                                |                          |                                      | 310,912     |               |           |           | 302,809      |  
|                                              |                                                                                                                                       |                          |                                      |             |               |          
|                                              |                                                                                                                                       |                          | 1,241,349                            |             |               |           | 1,194,305 |             
|                                              | Less accumulated depreciation                                                                                                         |                          |                                      | (898,352    | )             |           |           | (803,548     | )
|                                              |                                                                                                                                       |                          |                                      |             |               |          
|                                              |                                                                                                                                       |                          | 342,997                              |             |               |           | 390,757   |             
|                                              |                                                                                                                                       |                          |                                      |             |               |          
|                                              |                                                                                                                                       | $                        | 6,524,512                            |             |               | $         | 7,942,121 |             
|                                              |                                                                                                                                       |                          |                                      |             |               |          
|                                              |                                                                                                                                       |                          | LIABILITIES AND SHAREHOLDERS EQUITY |             |               |           |           |              |   |           | 
|CURRENT LIABILITIES                           |                                                                                                                                       |                          |                                      |             |               |           |           |             
|                                              | Accounts payable                                                                                                                      |                          | $                                    | 427,935     |               |           | $         | 566,345      |  
|                                              | Accrued compensation                                                                                                                  |                          |                                      | 358,361     |               |           |           | 313,098      |  
|                                              | Accrued expenses-other                                                                                                                |                          |                                      | 246,139     |               |           |           | 118,119      |  
|                                              | Deferred revenue                                                                                                                      |                          |                                      | 232,332     |               |           |           | 474,897      |  
|                                              |                                                                                                                                       |                          |                                      |             |               |          
|                                              |                                                                                                                                       |                          | Total current liabilities            |             |               | 1,264,767 |           |              |   | 1,472,459 | 
|                                              |                                                                                                                                       |                          |                                      |             |               |          
|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
10,082,750 in 2002 and 9,974,012 in 2001 |                          |                                      | 504,137     |               |           |           | 498,701      |  
|                                              | Additional paid-in capital                                                                                                            |                          |                                      | 18,921,150  |               |           |           | 18,580,288   |  
|                                              | Accumulated deficit                                                                                                                   |                          |                                      | (14,540,540 | )             |           |           | (12,984,327  | )
|                                              |                                                                                                                                       |                          |                                      |             |               |          
|                                              |                                                                                                                                       |                          | 5,259,747                            |             |               |           | 6,469,662 |             
|                                              |                                                                                                                                       |                          |                                      |             |               |          
|                                              |                                                                                                                                       | $                        | 6,524,514                            |             |               | $         | 7,942,121 |             
|                                              |                                                                                                                                       |                          |                                      |             |               |          

See Notes to Financial Statements

2



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##### Table of Contents






DATAKEY, INC.
STATEMENTS OF INCOME
(UNAUDITED)

|                                                     |                                                             |                                              |            |                    |           |   |                   |         |           |               |             |           |               |   |             |           |             |  
|---------------------------------------------------- | ----------------------------------------------------------- | -------------------------------------------- | ---------- | ------------------ | --------- | - | ----------------- | ------- | --------- | ------------- | ----------- | --------- | ------------- | - | ----------- | --------- | ----------- | -
|                                                     |                                                             |                                              |            | Three Months Ended |           |   | Nine Months Ended |        
|                                                     |                                                             |                                              |            |                    |           |   |                   |        
|                                                     |                                                             |                                              |            | September 28,      |           |   | September 29,     |         |           | September 28, |             |           | September 29, |  
|                                                     |                                                             |                                              |            | 2002               |           |   | 2001              |         |           | 2002          |             |           | 2001          |  
|                                                     |                                                             |                                              |            |                    |           |   |                   |         |           |               |             |           |               |  
|Revenue                                              |                                                             | $                                            | 1,387,781  |                    |           | $ | 2,714,470         |         |           | $             | 5,750,197   |           |               | $ | 5,066,017   |          
|Cost of goods sold                                   |                                                             |                                              | 558,606    |                    |           |   | 1,191,933         |         |           |               | 2,885,358   |           |               |   | 2,233,963   |          
|                                                     |                                                             |                                              |            |                    |           |   |                   |         |           |               |             |          
|                                                     |                                                             | Gross Profit                                 |            |                    | 829,175   |   |                   |         | 1,522,537 |               |             |           | 2,864,839     |   |             |           | 2,832,054   |  
|Operating expenses:                                  |                                                             |                                              |            |                    |           |   |                   |         |           |               |             |           |               |   |             |          
|                                                     | Research, development, technical support
and engineering    |                                              |            | 578,427            |           |   |                   | 552,119 |           |               |             | 1,750,556 |               |   |             | 1,731,796 |            
|                                                     | Marketing and sales                                         |                                              |            | 762,878            |           |   |                   | 932,979 |           |               |             | 2,439,904 |               |   |             | 2,629,813 |            
|                                                     | General and administrative                                  |                                              |            | 223,625            |           |   |                   | 223,554 |           |               |             | 619,052   |               |   |             | 627,421   |            
|                                                     |                                                             |                                              |            |                    |           |   |                   |         |           |               |             |          
|                                                     |                                                             | Total operating expenses                     |            |                    | 1,564,930 |   |                   |         | 1,708,652 |               |             |           | 4,809,512     |   |             |           | 4,989,030   |  
|                                                     |                                                             |                                              |            |                    |           |   |                   |         |           |               |             |          
|                                                     |                                                             | Operating loss                               |            |                    | (735,755  | ) |                   |         | (186,115  | )             |             |           | (1,944,673    | ) |             |           | (2,156,976  | )
|Interest income                                      |                                                             |                                              | 12,692     |                    |           |   | 23,437            |         |           |               | 37,415      |           |               |   | 63,613      |          
|                                                     |                                                             |                                              |            |                    |           |   |                   |         |           |               |             |          
|Loss from continuing operations
before income taxes  |                                                             |                                              | (723,063   | )                  |           |   | (162,678          | )       |           |               | (1,907,258  | )         |               |   | (2,093,363  | )        
|Income tax expense                                   |                                                             |                                              | 0          |                    |           |   | 0                 |         |           |               | 0           |           |               |   | 0           |          
|                                                     |                                                             |                                              |            |                    |           |   |                   |         |           |               |             |          
|Net loss from continuing operations                  |                                                             |                                              | ($723,063  | )                  |           |   | ($162,678         | )       |           |               | ($1,907,258 | )         |               |   | ($2,093,363 | )        
|                                                     |                                                             |                                              |            |                    |           |   |                   |         |           |               |             |          
|Profit from operations of discontinued segment       |                                                             |                                              | 0          |                    |           |   | 0                 |         |           |               | 0           |           |               |   | 0           |          
|Gain(loss) from disposal of discontinued segment     |                                                             |                                              | 0          |                    |           |   | (528,000          | )       |           |               | 351,045     |           |               |   | (528,000    | )        
|                                                     |                                                             |                                              |            |                    |           |   |                   |         |           |               |             |          
|                                                     |                                                             | Net loss attributable to common stockholders |            |                    | ($723,063 | ) |                   |         | ($690,678 | )             |             |           | ($1,556,213   | ) |             |           | ($2,621,363 | )
|                                                     |                                                             |                                              |            |                    |           |   |                   |         |           |               |             |          
|                                                     | Basic and diluted loss per share
from continuing operations |                                              |            | ($0.07             | )         |   |                   | ($0.02  | )         |               |             | ($0.19    | )             |   |             | ($0.22    | )          
|                                                     |                                                             |                                              |            |                    |           |   |                   |         |           |               |             |          
|                                                     | Basic and diluted
loss per share                            |                                              |            | ($0.07             | )         |   |                   | ($0.07  | )         |               |             | ($0.15    | )             |   |             | ($0.27    | )          
|                                                     |                                                             |                                              |            |                    |           |   |                   |         |           |               |             |          
|Weighted average number of
common shares outstanding |                                                             |                                              | 10,082,750 |                    |           |   | 9,918,273         |         |           |               | 10,072,138  |           |               |   | 9,631,004   |          
|                                                     |                                                             |                                              |            |                    |           |   |                   |         |           |               |             |          

See Notes to Financial Statements

3



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DATAKEY, INC.
STATEMENTS OF CASH FLOWS
(UNAUDITED)

|                                     |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |               |   |         |               |             |        |         |            |  
|------------------------------------ | --------------------------------------------------------------------------- | ------------------------------------------------------------------------------------- | -------------------------------------------------------------- | --------------------------------------------------- | - | ------------------ | -------- | --------- | ----------------- | ------ | -------- | ------------- | - | ------- | ------------- | ----------- | ------ | ------- | ---------- | -
|                                     |                                                                             |                                                                                       |                                                                |                                                     |   | Three Months Ended |          |           | Nine Months Ended |       
|                                     |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |       
|                                     |                                                                             |                                                                                       |                                                                |                                                     |   | September 28,      |          |           | September 29,     |        |          | September 28, |   |         | September 29, |            
|                                     |                                                                             |                                                                                       |                                                                |                                                     |   | 2002               |          |           | 2001              |        |          | 2002          |   |         | 2001          |            
|                                     |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |               |   |         |               |            
|CASH FLOWS FROM                      |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |               |   |         |               |            
|OPERATING ACTIVITIES                 |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |               |   |         |               |            
|                                     | Net loss                                                                    |                                                                                       |                                                                | ($723,063                                           | ) |                    |          | ($690,678 | )                 |        |          | ($1,556,213   | ) |         |               | ($2,621,363 | )     
|                                     | Adjustments to reconcile net loss
to net cash used in operating activities: |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |               |   |         |               |             |       
|                                     |                                                                             | Loss on sale of business unit net of changes in
net assets of discontinued operations |                                                                |                                                     | 0 |                    |          |           | (114,829          | )      |          |               | 0 |         |               |             | (4,681 | )      
|                                     |                                                                             |                                                                                       | Depreciation                                                   |                                                     |   | 56,701             |          |           |                   | 37,557 |          |               |   | 119,436 |               |             |        | 196,755 |           
|                                     |                                                                             |                                                                                       | Amortization                                                   |                                                     |   | 21,799             |          |           |                   | 80,285 |          |               |   | 75,457  |               |             |        | 241,465 |           
|                                     |                                                                             |                                                                                       | Change in assets and liabilities
(Increase)decrease in assets: |                                                     |   |                    |          |           |                   |        |          |               |   |         |               |             |        |         |           
|                                     |                                                                             |                                                                                       |                                                                | Trade receivables                                   |   |                    | 212,002  |           |                   |        | (989,878 | )             |   |         | 668,692       |             |        |         | (1,119,899 | )
|                                     |                                                                             |                                                                                       |                                                                | Inventories                                         |   |                    | 49,225   |           |                   |        | 850,284  |               |   |         | (93,267       | )           |        |         | (176,982   | )
|                                     |                                                                             |                                                                                       |                                                                | Prepaid expenses and other                          |   |                    | (103,892 | )         |                   |        | (32,847  | )             |   |         | (118,212      | )           |        |         | (16,652    | )
|                                     |                                                                             |                                                                                       |                                                                | Increase (decrease) in:                             |   |                    |          |           |                   |        |          |               |   |         |               |             |        |         |            |  
|                                     |                                                                             |                                                                                       |                                                                | Accounts payable                                    |   |                    | 39,090   |           |                   |        | (197,435 | )             |   |         | (138,410      | )           |        |         | (146,343   | )
|                                     |                                                                             |                                                                                       |                                                                | Accrued expenses                                    |   |                    | 171,168  |           |                   |        | 175,794  |               |   |         | 173,282       |             |        |         | 180,100    |  
|                                     |                                                                             |                                                                                       |                                                                | Deferred revenue                                    |   |                    | (127,119 | )         |                   |        | 144,472  |               |   |         | (242,565      | )           |        |         | 205,140    |  
|                                     |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |              
|                                     |                                                                             |                                                                                       |                                                                | Net cash provided by (used in)
operating activities |   |                    | (404,089 | )         |                   |        | (737,275 | )             |   |         | (1,111,800    | )           |        |         | (3,262,460 | )
|                                     |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |              
|CASH FLOWS FROM INVESTING
ACTIVITIES |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |               |   |         |               |            
|                                     | Proceeds from sale of business unit                                         |                                                                                       |                                                                | 0                                                   |   |                    |          | 550,000   |                   |        |          | 0             |   |         |               | 550,000     |       
|                                     | Purchase of equipment and leasehold
improvements                            |                                                                                       |                                                                | (1,653                                              | ) |                    |          | (229,835  | )                 |        |          | (71,676       | ) |         |               | (244,323    | )     
|                                     |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |              
|                                     |                                                                             |                                                                                       |                                                                | Net cash used in
investing activities               |   |                    | (1,653   | )         |                   |        | 320,165  |               |   |         | (71,676       | )           |        |         | 305,677    |  
|                                     |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |              
|CASH FLOWS FROM FINANCING
ACTIVITIES |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |               |   |         |               |            
|                                     | Net proceeds from issuance of
common stock                                  |                                                                                       |                                                                | 0                                                   |   |                    |          | 0         |                   |        |          | 346,298       |   |         |               | 4,608,512   |       
|                                     |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |              
|                                     |                                                                             |                                                                                       |                                                                | Net cash provided by (used in)
financing activities |   |                    | 0        |           |                   |        | 0        |               |   |         | 346,298       |             |        |         | 4,608,512  |  
|                                     |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |              
|                                     |                                                                             |                                                                                       |                                                                | Increase (decrease) in cash                         |   |                    | (405,742 | )         |                   |        | (417,110 | )             |   |         | (837,178      | )           |        |         | 1,651,729  |  
|CASH AND CASH EQUIVALENTS            |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |               |   |         |               |            
|                                     | Beginning                                                                   |                                                                                       |                                                                | 3,680,828                                           |   |                    |          | 3,601,397 |                   |        |          | 4,112,264     |   |         |               | 1,532,558   |       
|                                     |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |              
|                                     | Ending                                                                      |                                                                                       | $                                                              | 3,275,086                                           |   |                    | $        | 3,184,287 |                   |        | $        | 3,275,086     |   |         | $             | 3,184,287   |       
|                                     |                                                                             |                                                                                       |                                                                |                                                     |   |                    |          |           |                   |        |          |              

See Notes to Financial Statements

4



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##### Table of Contents






DATAKEY, INC.
NOTES TO FINANCIAL STATEMENTS

GENERAL

In the opinion of management, the accompanying unaudited financial statements
contain all adjustments necessary to present fairly Datakeys financial position
as of September 28, 2002, and December 31, 2001, and results of its operations
and cash flows for the three-month and nine-month periods ended September 28,
2002, and September 29, 2001. The adjustments that have been made are of a
normal recurring nature.

The accounting policies followed by the Company are set forth in Note 1 to the
Companys financial statements in the 2001 Datakey, Inc. Annual Report and in
Form 10-KSB for the year ended December 31, 2001.

INVENTORY AND RECEIVABLE RESERVES

During the nine-month period ended September 28, 2002 the Company added
approximately $82,000 to the reserve for inventory obsolescence and
approximately $27,000 to the reserve for doubtful accounts. An assessment of the
age and market value of inventory items revealed that a certain portion of the
products had been replaced by newer models and the ultimate value was greatly
diminished, suggesting that an additional charge for obsolete inventory was
warranted. The addition to the reserve for doubtful accounts was in connection
to a potential write off of an account from a foreign reseller whose
collectibility is uncertain.

OPERATING SEGMENTS

Through July 31, 2001, the Company had two reportable segments: Electronic
Products (EP) and Information Security Solutions (ISS). As discussed in the
following notes, the EP segment has been shown as discontinued operations
beginning in December 2000. The Electronic Products segment produced and
marketed proprietary memory keys, cards, and custom-shaped tokens and systems
that utilize these products that serve as a convenient way to carry electronic
information. The assets related to the ongoing business of the EP business
segment were sold in August 2001. The Information Security Solutions segment
produces and markets products for the information security market, which enable
user identification and authentication, secure data exchange, and information
validation.

The accounting policies of the segments are the same as those described in the
summary of significant accounting policies. There are no inter-segment
transactions. The Company evaluates performance based on operating earnings of
the respective segments.

|                              |  |                                       |   |  |                                      |   |           |             |  |  |        |  |  |    |           |   |     |   |         |             |  |   |            |   |  |   |        |  |  |   |            |  
|----------------------------- |  | ------------------------------------- | - |  | ------------------------------------ | - | --------- | ----------- |  |  | ------ |  |  | -- | --------- | - | --- | - | ------- | ----------- |  | - | ---------- | - |  | - | ------ |  |  | - | ---------- | -
|                              |  | Three Months Ended September 28, 2002 |   |  | Nine Months Ended September 28, 2002 |  
|                              |  |                                       |   |  |                                      |  
|                              |  | EP                                    |   |  | ISS                                  |   |           | UNALLOCATED |  |  | TOTAL  |  |  | EP |           |   | ISS |   |         | UNALLOCATED |  |   | TOTAL      |  
|                              |  |                                       |   |  |                                      |   |           |             |  |  |        |  |  |    |           |   |     |   |         |             |  |   |            |  
|Revenue                       |  | $                                     | 0 |  |                                      | $ | 1,387,782 |             |  |  |        |  |  | $  | 1,387,782 |   |     | $ | 870,051 |             |  | $ | 5,570,198  |   |  | $ |        |  |  | $ | 6,440,249  |  
|Interest income
(expense)     |  |                                       |   |  |                                      |   |           |             |  |  | 12,692 |  |  |    | 12,692    |   |     |   |         |             |  |   |            |   |  |   | 37,415 |  |  |   | 37,415     |  
|Depreciation
and amortization |  |                                       | 0 |  |                                      |   | 78,500    |             |  |  |        |  |  |    | 78,500    |   |     |   | 0       |             |  |   | 194,893    |   |  |   |        |  |  |   | 194,893    |  
|Segment profit
(loss)         |  |                                       | 0 |  |                                      |   | (735,755  | )           |  |  | 12,692 |  |  |    | (723,063  | ) |     |   | 351,045 |             |  |   | (1,944,673 | ) |  |   | 37,415 |  |  |   | (1,556,213 | )

|                              |  |                                       |           |   |                                      |   |           |             |  |  |        |  |  |    |           |   |     |   |           |             |  |   |            |   |  |   |        |  |  |   |            |  
|----------------------------- |  | ------------------------------------- | --------- | - | ------------------------------------ | - | --------- | ----------- |  |  | ------ |  |  | -- | --------- | - | --- | - | --------- | ----------- |  | - | ---------- | - |  | - | ------ |  |  | - | ---------- | -
|                              |  | Three Months Ended September 29, 2001 |           |   | Nine Months Ended September 29, 2001 |  
|                              |  |                                       |           |   |                                      |  
|                              |  | EP                                    |           |   | ISS                                  |   |           | UNALLOCATED |  |  | TOTAL  |  |  | EP |           |   | ISS |   |           | UNALLOCATED |  |   | TOTAL      |  
|                              |  |                                       |           |   |                                      |   |           |             |  |  |        |  |  |    |           |   |     |   |           |             |  |   |            |  
|Revenue                       |  | $                                     | 247,119   |   |                                      | $ | 2,714,470 |             |  |  |        |  |  | $  | 2,961,590 |   |     | $ | 2,368,132 |             |  | $ | 5,066,017  |   |  | $ |        |  |  | $ | 7,434,149  |  
|Interest income
(expense)     |  |                                       |           |   |                                      |   |           |             |  |  | 23,437 |  |  |    | 23,437    |   |     |   |           |             |  |   |            |   |  |   | 63,613 |  |  |   | 63,613     |  
|Depreciation
and amortization |  |                                       | 5,403     |   |                                      |   | 112,439   |             |  |  |        |  |  |    | 117,842   |   |     |   | 139,927   |             |  |   | 298,293    |   |  |   |        |  |  |   | 438,220    |  
|Segment profit
(loss)         |  |                                       | *(642,829 | ) |                                      |   | (186,115  | )           |  |  | 23,437 |  |  |    | (805,507  | ) |     |   | *(532,681 | )           |  |   | (2,156,976 | ) |  |   | 63,613 |  |  |   | (2,626,044 | )

|                                                                                                                                                                                             
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*A portion of the EP profit(loss) during the first nine months of 2001
was not reflected in the income statement because a provision for loss
on disposal of $1,281,000 was provided in 2000.

5



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##### Table of Contents



DISCONTINUED OPERATIONS

In February 2001 the Companys Board of Directors approved managements plan to
discontinue the operations of the EP segment. The plan anticipated the phase
down of the operations through December 31, 2001, although the Company continued
to pursue the possibility of selling the operations. (See Sale of Discontinued
Business Segment).

The estimated loss, taken in 2000, on the phase down of the EP segment included
the write-off of inventory, patents, and equipment anticipated to remain at the
date of closedown and expenses associated with the phase down, net of estimated
operating income through that date. The phase down of the segment was accounted
for as discontinued operations and, accordingly, its net assets and net
liabilities have been segregated from continuing operations in the balance
sheets and the results of operations have been excluded from continuing
operations for all periods presented. Net assets of the EP segment as of
September 28, 2002 and December 31, 2001 are as follows:

|                                        |  |               |   |  |               |   |        | 
|--------------------------------------- |  | ------------- | - |  | ------------- | - | ------ | 
|                                        |  | Sep. 28, 2002 |   |  | Dec. 31, 2001 |  
|                                        |  |               |   |  |               |  
|Trade receivables                       |  | $             | 0 |  |               | $ | 82,077 | 
|Net assets from discontinued operations |  | $             | 0 |  |               | $ | 82,077 | 
|                                        |  |               |   |  |               |  

SALE OF DISCONTINUED BUSINESS SEGMENT

On August 3, 2001, the Company completed the sale of the EP business segment
fixed assets, inventory, patents and prepaid expense along with customer lists,
assignment of certain customer contracts and all intellectual property required
to operate the EP business segment. The Company retained certain customer
contracts, and all EP accounts receivable, accounts payable and accrued expense
as of July 31, 2001. The Company received $550,000 in cash on the date of
closing, and recorded the cash difference between accounts receivable and
accounts payable and accrued expense and profit on the customer contracts
retained. Due to the nature of the transaction, the Company recorded a loss of
$492,000 during the year ended December 31, 2001 from the disposal of
discontinued operations because the loss on disposal of the selected assets and
the loss from discontinued operations exceeded the $1,281,000 reserve that was
established for these losses in 2000.

Under terms of the primary contract retained upon sale of the EP segment, the
customer was required to provide certain components that are necessary to
complete the manufacture and shipment of the final product, provide necessary
test fixtures and must also approve the final test results prior to shipping the
product. Due to a delay in delivery of the customer provided materials and a
delay in providing the necessary test fixtures, the completion date of the
contract extended beyond the date that was initially expected at the time the EP
segment was sold.

During the second quarter of 2002 the Company completed the final delivery under
the contract retained at the time of sale of the EP segment and realized a
profit of $361,767. This amount was reflected on the Income Statement as gain on
disposition of discontinued operation. This completed the sale of the EP segment
and no further gain or loss from discontinued operations is expected.

6



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##### Table of Contents









ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
DATAKEY, INC.
RESULTS OF OPERATIONS AND FINANCIAL CONDITION

RESULTS OF OPERATIONS
CONTINUING OPERATIONS

REVENUE

ISS revenue for the three-month period ended September 28, 2002, decreased by
$1,327,000, or 49 percent, as compared to the same period in 2001. Revenue in
the nine-month period ended September 28, 2002, increased by $684,000, or 14
percent, over the comparable period in 2001. The significant decrease in revenue
in the three-month period resulted from delays in our customers production
delivery schedules created by the slowdown in IT spending and budgetary issues.
The increase in revenue in the nine-month period resulted from increasing
acceptance of and demand for the Companys smart token based information
security products.

GROSS PROFIT MARGIN

Gross profit, as a percentage of revenue, increased to 60 percent in the
three-month period ended September 28, 2002, from 56 percent in the three-month
period ended September 29, 2001. The gross profit decreased to 50 percent from
56 percent when comparing the nine-month period of 2002 to that of 2001. The
increase in gross profit percentage in the three-month period related primarily
to a favorable product mix during the quarter. The reduction in percentage in
the nine-month period was primarily due to a significant portion of the first
quarter 2002 revenue consisting of USB tokens that are re-sold by Datakey and
carry a much lower margin than Datakeys standard products. The gross margin
percentage for the balance of 2002 is expected to remain in the mid to high 50
percent range as the Company expects to ship products with more software content
and works to reduce the cost of products that are expected to be re-sold.

OPERATING EXPENSES

Operating expenses decreased by $144,000 in the three-month period ended
September 28, 2002, and decreased by $180,000 in the nine-month period, as
management continued to control discretionary spending. Operating expenses
during the balance of 2002 are expected to increase modestly.

INTEREST INCOME

Interest income, net of interest expense, decreased to $13,000 from $23,000 in
the three-month period and decreased to $37,000 from $64,000 in the nine-month
period, reflecting a lower rate of interest. Interest income is expected to
decrease slightly over the balance of the year due to an expected decrease in
cash.

OUTLOOK

There is evidence of a worldwide slowdown in IT spending in the commercial
market as well as in the government market which has resulted in a
stretching-out of our customers production delivery schedules. This stretching
out of delivery schedules was first observed during the first quarter and
continued in recent months to a greater extent than we thought would occur only
a few months ago, and we are uncertain as to when more traditional delivery
schedules will resume. Accordingly, we are revising our revenue guidance for the
year to a range between $7 million and $8 million, and we will not be profitable
in the fourth quarter of 2002.

7



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RESULTS OF OPERATIONS
DISCONTINUED OPERATIONS
(Also See Sale of Discontinued Business Segment In Notes to Financial Statements)

REVENUE

Revenue from discontinued operations in the nine-month period ended September
28, 2002 was $852,000, compared to $2,368,000 during the same period in 2001.
The majority of the discontinued business was sold in August 2001. The Company
completed the final delivery under the final contract retained upon sale of the
discontinued operation during the second quarter and will not report any revenue
from discontinued operations going forward.

OPERATING INCOME AND LOSS

Discontinued operations reflected a gain of $351,000 in the nine-month period
ended September 28, 2002. The Company does not expect to report any additional
gain or loss from the sale of the EP business segment in the future.

LIQUIDITY AND FINANCIAL CONDITION

The Company experienced a decrease in cash of $406,000 in the three-month period
ended September 28, 2002 and a decrease in cash of $837,000 in the nine-month
period. The decrease in cash during the nine-month period ended September 28,
2002 related to the operating loss and an increase in inventory. This decrease
was offset by a $669,000 decrease in trade receivables and $346,000 in proceeds
received from the sale of common stock upon the exercise of certain warrants and
pursuant to the employee stock purchase plan during the first quarter. The
statements of cash flows include discontinued operations as well as continuing
operations in the periods presented.

Accounts receivable declined $669,000 during the nine-month period ended
September 28, 2002 primarily as a result of lower revenue in the quarter ended
September 28, 2002. Accounts payable, likewise, declined $138,000 during the
nine-month period as a result of a reduction in inventory purchases in the
quarter ended September 28, 2002. Inventory increased by $93,000 during the
nine-month period ended September 28, 2002 as the Company acquired additional
parts and finished goods in preparation for an expected increase in revenue
during the second half of 2002 which did not materialize.

Deferred revenue decreased $243,000 during the nine-month period ended September
28, 2002 as the amortization of deferred revenue during the nine-month period
exceeded the additional deferred revenue booked. Deferred revenue consists of
extended maintenance contracts from which the Company typically receives a
percentage of revenue from the sale of products, and are amortized over the term
of the contracts.

Datakeys balance sheet reflects $4,683,000 in working capital as of September
28, 2002 and a current assets to current liabilities ratio of 4.7 to 1. The
Company believes that its current level of cash will provide sufficient
liquidity to fund operations for at least the next twelve months.

CONTRACTUAL CASH OBLIGATIONS

The Company presently has no long-term debt outstanding and its only contractual
cash obligations are those from operating lease obligations. These lease
obligations total $571,000 as shown below:

|           |  |   |         |                          |  |  |  | 
|---------- |  | - | ------- | ------------------------ |  |  |  | 
|2002       |  | $ | 81,000  | (remaining three months)
|2003       |  |   | 307,000 |                          |  |  |  | 
|*2004      |  |   | 154,000 |                          |  |  |  | 
|thereafter |  |   | 29,000  |                          |  |  |  | 

|                                                                   
|-------------------------------------------------------------------
|*The lease on the Companys primary facility expires June 30, 2004.

8



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##### Table of Contents






FORWARD LOOKING STATEMENTS AND RISK FACTORS

The Managements Discussion and Analysis contains certain forward-looking
statements including that: (i) annual revenues in 2002 will range between $7
million and $8 million; (ii) gross margins will range between 55 and 60 percent;
and (iii) the Company will have sufficient financial resources to fund its
operations for at least 12 months. These statements are subject to certain risks
and uncertainties which may cause actual results to differ materially from those
projected. These risks and uncertainties include that: (i) market acceptance and
demand for the Companys information security products may not increase at the
rate expected or may decrease due to economic, competitive or other market
conditions; (ii) that the Companys sales may continue to be negatively
impacted, and perhaps to a greater extent, due to the overall slowdown in the
Information Technology market; (iii) that the Companys sales may not continue
to reflect a favorable product mix seen in the past quarter, and the Companys
expected sales of products with more software content may not materialize
depending on the actual demand and timing of its customers; and (iv) the
Companys overall funding depends on actual sales given the state of the economy
as well as its ability to effectively control expenses.




ITEM 3. CONTROLS AND PROCEDURES

In response to recent legislation and additional requirements, we reviewed our
internal control structure and our disclosure controls and procedures. As a
result of such review we implemented changes primarily to formalize and document
the procedures. We have designed our disclosure controls and procedures to
ensure that material information related to Datakey is made known to our
principal executive officer and principal financial officer on a regular basis,
in particular during the period in which the quarterly reports are being
prepared. As required, we will evaluate the effectiveness of these disclosure
controls and procedures on a quarterly basis, and did so on October 16, 2002, a
date within 90 days prior to the filing of this quarterly report. We believe as
of that date, such controls and procedures are operating effectively as
designed.

We presented the results of our most recent evaluation to our independent
auditors, McGladrey & Pullen, and the Audit Committee of the Board of Directors.
Based on such evaluation, the Companys management concluded that the Companys
disclosure controls and procedures are adequate to ensure the clarity and
material completeness of the Companys disclosure in its periodic reports
required to be filed with the SEC and there are no significant deficiencies or
material weaknesses in the design or operation of internal controls which could
significantly affect our ability to record, process, summarize and report
financial data.

9



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##### Table of Contents






PART II. OTHER INFORMATION




ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K



|(a) |  | Reports on Form 8-K
|--- |  | -------------------
|   
|    |  | None.              
|   
|(b) |  | Exhibits           
|   
|    |  | None               

10



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##### Table of Contents






SIGNATURES

In accordance with the requirements of the Exchange Act, the Registrant has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.

|                        |  |               |  |                                             
|----------------------- |  | ------------- |  | --------------------------------------------
|Dated: October 23, 2002 |  | Datakey, Inc. |  |                                             
|                        |  |               |  |                                             
|                        |  | By:           |  | /s/ Carl P. Boecher                         
|                        |  |               |  |                                             
|                        |  |               |  | Carl P. Boecher                             
|                        |  |               |  | Chief Executive Officer                     
|                        |  |               |  | (Principal Executive Officer)               
|                        |  |               |  |                                             
|                        |  |               |  |                                             
|                        |  | By:           |  | /s/Alan G. Shuler                           
|                        |  |               |  |                                             
|                        |  |               |  | Alan G. Shuler                              
|                        |  |               |  | Vice President & Chief Financial Officer    
|                        |  |               |  | (Principal Financial and Accounting Officer)

11



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##### Table of Contents






CERTIFICATION OF CHIEF EXECUTIVE OFFICER

In connection with this Quarterly Report of Datakey, Inc. Inc. (the
Company) on Form 10-QSB for the quarter ended September 28, 2002 as filed with
the Securities and Exchange Commission (the Report), I, Carl P. Boecher, Chief
Executive Officer of the Company, certify, pursuant to §302(a) of the
Sarbanes-Oxley Act of 2002 and related rules, that:



|1. |  | I have reviewed this quarterly report on Form 10-QSB of Datakey, Inc. for the period ended September 28,
2002;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|2. |  | Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;                                                                                                                                                                                                                                                                                                                                     
|  
|3. |  | Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the Company as of, and for, the periods presented in this
quarterly report;                                                                                                                                                                                                                                                                                                                                                           
|  
|4. |  | The Companys other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d -14) for the Company and have:                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|  
|   |  | a) designed such disclosure controls and procedures to ensure that material
information relating to the Company, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared; b) evaluated the effectiveness of the Companys disclosure
controls and procedures as of a date within 90 days prior to the filing
date of the quarterly report (the Evaluation Date); c) presented in this
quarterly report our conclusions about the effectiveness of the disclosure
controls and procedures based on our evaluation as of the Evaluation Date;
|  
|5. |  | The Companys other certifying officer and I have disclosed, based on our
most recent evaluation, to the Companys auditors and the audit committee
of the Companys board of directors:                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|  
|   |  | a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the Companys ability to record,
process, summarize and report financial data and have identified for the
Companys auditors any material weaknesses in internal controls;
and b) any
fraud, whether or not material, that involves management or other employees
which have a significant role in the Companys internal controls; and                                                                                                                                                                                                               
|  
|6. |  | The Companys other certifying officer and I have indicated in this
quarterly report whether there were significant changes in the internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.                                                                                                                                                                                                                                                                                 





---



##### Table of Contents



Additionally, pursuant to §906 of the Sarbanes-Oxley Act of 2002 and related
rules, I, Carl P. Boecher, certify that:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities
Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations of the
Company.

|                       |  |            |     |                        
|---------------------- |  | ---------- | --- | -----------------------
|Date: October 23, 2002 |  | Signature: | /s/ | Carl P. Boecher        
|                       |  |            |     |                        
|                       |  |            |     | Carl P. Boecher        
|                       |  |            |     | Chief Executive Officer





---



##### Table of Contents






CERTIFICATION OF CHIEF FINANCIAL OFFICER

In connection with this Quarterly Report of Datakey, Inc. Inc. (the
Company) on Form 10-QSB for the quarter ended September 28, 2002 as filed with
the Securities and Exchange Commission (the Report), I, Alan G. Shuler, Chief
Financial Officer of the Company, certify, pursuant to §302(a) of the
Sarbanes-Oxley Act of 2002 and related rules, that:



|1. |  | I have reviewed this quarterly report on Form 10-QSB of Datakey, Inc. for the period ended September 28,
2002;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|2. |  | Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;                                                                                                                                                                                                                                                                                                                                     
|  
|3. |  | Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the Company as of, and for, the periods presented in this
quarterly report;                                                                                                                                                                                                                                                                                                                                                           
|  
|4. |  | The Companys other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d -14) for the Company and
have:                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|  
|   |  | a) designed such disclosure controls and procedures to ensure that
material information relating to the Company, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared; b) evaluated the effectiveness of the Companys
disclosure controls and procedures as of a date within 90 days prior to
the filing date of the quarterly report (the Evaluation
Date); c)
presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
|  
|5. |  | The Companys other certifying officer and I have disclosed, based on
our most recent evaluation, to the Companys auditors and the audit
committee of the Companys board of directors:                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|  
|   |  | a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the Companys ability to record,
process, summarize and report financial data and have identified for
the Companys auditors any material weaknesses in internal controls;
and b) any fraud, whether or not material, that involves management or
other employees which have a significant role in the Companys internal
controls; and                                                                                                                                                                                                               
|  
|6. |  | The Companys other certifying officer and I have indicated in this
quarterly report whether there were significant changes in the internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.                                                                                                                                                                                                                                                                                 





---



##### Table of Contents



Additionally, pursuant to §906 of the Sarbanes-Oxley Act of 2002 and related
rules, I, Alan G. Shuler, certify that:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities
Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations of the
Company.

|                       |  |            |     |                        
|---------------------- |  | ---------- | --- | -----------------------
|Date: October 23, 2002 |  | Signature: | /s/ | Alan G. Shuler         
|                       |  |            |     |                        
|                       |  |            |     | Alan G. Shuler         
|                       |  |            |     | Vice President         
|                       |  |            |     | Chief Financial Officer