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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 March 31, 2004 Commission File Number 0-11447 DATAKEY, INC. 
  MINNESOTA
(State or other jurisdiction of
incorporation or organization)
    
    41-1291472
(I.R.S. Employer
Identification No.)
 407 WEST TRAVELERS
TRAIL, MINNEAPOLIS, MN 55337 
  Issuers telephone number: (952) 890-6850   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 Issuer 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 April
29, 2004 is 11,767,254. Transitional Small Business Disclosure Format (check One): Yes (  ) No (X)




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INDEX
Datakey, Inc. PART I. FINANCIAL INFORMATION
    
    
    
    
    
    Page No.Item 1. Financial StatementsBalance Sheets  March 31, 2004 and December 31, 2003.
    
    
    
    
    
    
    3Statements of Operations  Three months ended March 31, 2004 and March 31, 2003.
    
    
    
    
    
    
    4Statements of Cash Flows  Three months ended March 31, 2004 and March 31, 2003.
    
    
    
    
    
    
    5Notes to Financial Statements.
    
    
    
    
    
    
    6Item 2. Managements Discussion and Analysis or Plan of Operation.
    
    
    
    
    
    
    6Item 2. Changes in securities and small business issuer purchases of equity securities
    
    
    
    
    
    
    13Item 3. Controls and Procedures.
    
    
    
    
    
    
    14PART II. OTHER INFORMATIONItems 1, 2, 3, 4 and 5 have been omitted since all items are inapplicable or answers
negative.Item 6. Exhibits and Reports on Form 8-K
    
    
    
    
    
    
    14Signature
    
    
    
    
    
    
    15Exhibit Index
    
    
    
    
    
    
    16Employment AgreementNonqualified Stock Option AgreementNonqualified Stock Option AgreementNonqualified Stock Option AgreementLease Extension and Space Reduction AgreementCertification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO Pursuant to Section 906
  We have registered DATAKEY® as a trademark with the U.S. Patent and Trademark
Office. We also use the trademarks Rapid Deploy Technology, Model 330J Java
Card, Datakey Axis, Datakey CIP, and Datakey CMS. All other
trademarks used in this report are the property of their respective owners. 2




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PART I. FINANCIAL INFORMATION 
 ITEM 1. Financial Statements Datakey, Inc. 
 Balance Sheets
 March 31,
    
    December 31, 20032004
    
    2003(Unaudited)
    
    (see Note)AssetsCurrent AssetsCash and cash equivalents
    
    $
    1,595,192
    
    
    $
    2,702,222Trade receivables, net
    
    
    1,665,050
    
    
    
    930,183Inventories
    
    
    526,336
    
    
    
    442,775Prepaid expenses and other
    
    
    144,398
    
    
    
    68,296Total current assets
    
    
    3,930,976
    
    
    
    4,143,476Other AssetsLicenses
    
    
    472,268
    
    
    
    445,739All other, less accumulated amortization
    
    
    57,641
    
    
    
    80,852529,909
    
    
    
    526,591Equipment and Leasehold Improvements, at costTooling, equipment, fixtures and leasehold improvements
    
    
    1,244,863
    
    
    
    1,233,030Less accumulated depreciation
    
    
    (1,117,341
    )
    
    
    (1,085,555
    )127,522
    
    
    
    147,475Total assets
    
    $
    4,588,407
    
    
    $
    4,817,542Liabilities and Stockholders EquityCurrent LiabilitiesNotes payable
    
    $
    1,672,131
    
    
    $
    1,522,951Accounts payable
    
    
    393,157
    
    
    
    413,864Accrued expenses
    
    
    587,063
    
    
    
    371,973Deferred revenue
    
    
    862,331
    
    
    
    306,324Total current liabilities
    
    
    3,514,682
    
    
    
    2,615,112Commitments and Contingencies
Stockholders EquityConvertible preferred stock, voting, liquidation value $2.50 per share;
authorized 400,000 shares; issued and outstanding 150,000
    
    
    375,000
    
    
    
    375,000Common stock, par value $0.05 per share; authorized 20,000,000 shares;
issued and outstanding 11,767,254 and 11,732,708
    
    
    588,363
    
    
    
    586,635Additional paid-in capital
    
    
    20,639,747
    
    
    
    20,621,092Accumulated deficit
    
    
    (20,529,385
    )
    
    
    (19,380,297
    )Total stockholders equity
    
    
    1,073,725
    
    
    
    2,202,430Total liabilities and stockholders equity
    
    $
    4,588,407
    
    
    $
    4,817,542
 Note: See Notes to Financial Statements. 3




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Datakey, Inc. 
 Statements of Operations
- Unaudited
 For the Three Months EndedMarch 31,2004
    
    2003Net sales
    
    $
    1,501,024
    
    
    $
    794,368Costs and expenses:Costs of goods sold
    
    
    543,685
    
    
    
    605,873Research and development, engineering and technical support
    
    
    496,802
    
    
    
    548,558Marketing and sales
    
    
    993,048
    
    
    
    775,717General and administrative
    
    
    422,565
    
    
    
    418,293Total costs and expenses
    
    
    2,456,100
    
    
    
    2,348,441Operating loss
    
    
    (955,076
    )
    
    
    (1,554,073
    )Interest income (expense), net
    
    
    (194,010
    )
    
    
    4,997Loss from continuing operations before income taxes
    
    
    (1,149,086
    )
    
    
    (1,549,076
    )
Income tax expense
    
    
    
    
    
    
    Net loss
    
    $
    (1,149,086
    )
    
    $
    (1,549,076
    )Loss per share:Basic and diluted loss per share
    
    $
    (0.10
    )
    
    $
    (0.15
    )Weighted-average common shares:Basic and diluted
    
    
    11,760,423
    
    
    
    10,114,491
 See Notes to Financial Statements. 4




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Datakey, Inc. 
 Statements of Cash Flows
- Unaudited
 For the Three Months EndedMarch 31,2004
    
    2003Cash Flows From Operating ActivitiesNet loss
    
    $
    (1,149,086
    )
    
    $
    (1,549,076
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation
    
    
    38,500
    
    
    
    40,383Amortization
    
    
    172,391
    
    
    
    7,047Changes in operating assets and liabilities:Trade receivable
    
    
    (734,867
    )
    
    
    993,381Inventories
    
    
    (83,561
    )
    
    
    210,470Prepaid expenses and licenses
    
    
    (102,631
    )
    
    
    (82,040
    )Accounts payable
    
    
    (20,707
    )
    
    
    (204,440
    )Accrued expenses
    
    
    215,090
    
    
    
    56,200Deferred revenue
    
    
    556,009
    
    
    
    78,751Net cash used in operating activities
    
    
    (1,108,862
    )
    
    
    (449,324
    )Cash Flows from Investing ActivitiesPurchases of equipment
    
    
    (18,551
    )
    
    
    (6,409
    )Net cash used in investing activities
    
    
    (18,551
    )
    
    
    (6,409
    )Cash Flows from Financing ActivitiesNet proceeds from issuance of common stock
    
    
    20,383
    
    
    
    51,161Net cash provided by financing activities
    
    
    20,383
    
    
    
    51,161Decrease in cash and cash equivalents
    
    
    (1,107,030
    )
    
    
    (404,572
    )
Cash and Cash EquivalentsBeginning
    
    
    2,702,222
    
    
    
    2,562,611Ending
    
    $
    1,595,192
    
    
    $
    2,158,039
 See Notes to Financial Statements. 5




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DATAKEY, INC. 
 NOTES TO FINANCIAL STATEMENTS
 Note 1. NATURE OF
BUSINESS
Datakey, Inc. develops and markets software products that are designed to
simplify and strengthen user authentication for the information security
market. The Company also distributes smart cards, tokens and readers for use
with its line of access and identity software solutions. Note 2. BASIS OF PRESENTATION
In the opinion of management, the accompanying unaudited financial statements
contain all adjustments necessary to present fairly Datakeys financial
position as of March 31, 2004, and December 31, 2003, and results of its
operations and cash flows for the three-month periods ended March 31, 2004, and
March 31, 2003. The adjustments that have been made are of a normal recurring
nature. The balance sheet at December 31, 2003 has been derived from the audited
financial statements at that date, but does not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements. The accounting policies followed by the Company are set forth in Note 1 to the
Companys financial statements in the 2003 Datakey, Inc. Annual Report on Form
10-KSB for the year ended December 31, 2003. Note 3.STOCK BASED COMPENSATION
The Company regularly grants options to its employees under various plans. As
permitted under accounting principles generally accepted in the United States
of America, these grants are accounted for following APB Opinion No. 25 and
related interpretations. Accordingly, compensation cost has been recognized for
those grants whose exercise price is less than the fair market value of the
stock on the date of grant. No compensation expense was recorded for employee
grants for the quarters ended March 31, 2004 and March 31, 2003. The Company
also periodically grants options and warrants to non-employees for goods and
services and in conjunction with certain agreements. These grants are accounted
for under FASB Statement No. 123 based on the grant date fair values. Had compensation cost for all of the stock-based compensation grants and
warrants issued been determined based on the fair values at the grant date
consistent with the provisions of Statement No. 123, the Companys net loss and
net loss per basic and diluted common share would have been as indicated below. Quarters Ended
    
    March 31, 2004
    
    March 31, 2003Net loss, as reported
    
    ($
    1,149,086
    )
    
    ($
    1,549,076
    )Deduct total
stock-based employee compensation expense determined under the fair value-based method for all awards
    
    
    (145,673
    )
    
    
    (192,793
    )Net loss, pro forma
    
    ($
    1,294,759
    )
    
    ($
    1,741,869
    )
Basic and diluted loss per share, as reported
    
    ($
    .10
    )
    
    ($
    .15
    )Basic and diluted loss per share, pro forma
    
    ($
    .11
    )
    
    ($
    .17
    )
 The above pro forma effects on net loss and net loss per basic and diluted
common share are not likely to be representative of the effects on reported net
loss or net loss per common share for future years because options vest over
several years and additional awards generally are made each year. Note 4. CORPORATE
LIQUIDITY
The Company anticipates that its working capital, including cash of $1.6
million, will provide sufficient liquidity to fund 2004 operations. Should the
$2,000,000 note not be converted into common stock, the Company plans to raise
additional capital during 2004 to enable it to repay the note together with
$200,000 of interest due in October 2004. The Company is reviewing multiple
avenues of future funding, but does not have any commitments for such funding
at this time. 6




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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION The following discussion and analysis of our financial condition or plan of
operation should be read together with our financial statements and related
notes appearing the 2003 Datakey, Inc. Annual Report on Form 10-KSB for the
year ended December 31, 2003. This discussion and analysis contains
forward-looking statements that involve risks, uncertainties and assumptions.
The actual results may differ materially from those anticipated in these
forward-looking statements as a result of many factors, including but not
limited to those set forth under Factors That Could Affect Future Results and
elsewhere in this report on Form 10-QSB. Overview We develop, manufacture and market products and services based on our
technologies for the information and security market. For information security
solutions based on PKI, our product and service offerings include Datakey CIP
and CMS; and for authentication solutions, our product and service offering is
Datakey Axis and its management center software. Both product lines may use
either or both our 330 smart card and iKey USB token. We are currently
developing improvements to our Axis and CIP product offerings, which are
expected to add greater functionality of features and extend its compatibility
with non-Windows based operating systems. We operate within a single business
segment, the information security market. Our revenue is reported as a single
component, which is comprised of four elements, including (1) net sales of
hardware products manufactured by third parties, (2) software products
developed or licensed by us and reproduced by third parties, (3) product
support and maintenance service fees we have earned from end users of our
products, and (4) license fees paid by an original equipment manufacturer on
the use of our smart card and token-based operating system that they
incorporate into their products. Revenue from the sale of smart card and token-based products and systems based
on our technologies; maintenance, support and technical support fees from
agreements with end users, and from custom system integration consulting; and
license fees on a per seat basis from the sale of our smart card and
token-based operating system and CIP software to an original equipment
manufacturer for incorporation into their products will fluctuate from quarter
to quarter and from year to year depending on, among other factors, demand by
end users and original equipment manufacturers for the products and services we
offer, and new product and service introductions. The table below summarizes changes in selected operating indicators, showing
certain income, cost and expense items as a percentage of total revenue from
continuing operations for the first quarters of 2004 and 2003. Inflation has
not been a significant factor in our operations to date. Percentage of Total RevenueFiscal Quarter Ended March 31
    
    2004
    
    2003Revenue
    
    
    100
    %
    
    
    100
    %Cost of goods sold
    
    
    36
    
    
    
    76Gross margin
    
    
    64
    
    
    
    24Cost and Expenses:Research and development, engineering and
technical support
    
    
    33
    
    
    
    69Marketing and sales
    
    
    66
    
    
    
    98General and administrative
    
    
    28
    
    
    
    53Total cost and expenses
    
    
    127
    
    
    
    220Operating loss
    
    
    (63
    )
    
    
    (196
    )Interest income (expense), net
    
    
    (13
    )
    
    
    Loss before income taxes
    
    
    (76
    )
    
    
    (196
    )Income taxes
    
    
    
    
    
    
    Net loss
    
    
    (76
    )%
    
    
    (196
    )%
 7




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Critical Accounting Policies and Estimates The following discussion and analysis of our financial condition and results of
operations are based upon our financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States.
The preparation of our financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues and
expenses, and related disclosure of contingent assets and liabilities. On an
on-going basis, we evaluate our estimates, including those related to bad
debts, inventories, income taxes, and contingencies and litigation. We base our
estimates on historical experience and on various other assumptions that we
believe to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results may differ
from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our financial
statements. Revenue Recognition: We recognize revenue in accordance with the Securities and
Exchange Commissions Staff Accounting Bulletin No. 104, or SAB 104, Revenue
Recognition in Financial Statements. SAB 104 requires that four basic
criteria must be met before revenue can be recognized: (1) persuasive evidence
of an agreement exists; (2) delivery has occurred or services rendered; (3) the
fee is fixed and determinable; and (4) collectibility is reasonably assured. In
addition, SAB 104 requires that revenue arrangements with multiple elements
should be divided into separate units of accounting if the deliverables in the
arrangement have value to the customer on a standalone basis, if there is
objective and reliable evidence of the fair value of the undelivered elements,
and as long as there are no rights of return or additional performance
guarantees by the Company. The Company also applies the provisions of Statement
of Position 97-2 and related guidance. Revenue from products and systems sold
is recognized upon shipment to the customer as we have no future obligation for
support, upgrades or other services. Revenue from maintenance and support
obligations under a product and system sale agreement that are not separately
valued from the product and system sold are valued based on those maintenance
and support agreements that are separately valued, and recognized over the term
of the contract. Revenue from maintenance and support agreements, as well as
any technical consulting fees, is deferred and recognized over the term of the
agreement or when the services have been rendered and are complete. Revenue
from license fees is recognized at time of delivery to our customer, an
original equipment manufacturer. We separately allocate and defer revenue
recognition on the fair value of support and maintenance services provided as
part of the bundled price on the sale of some of our software products. Software Development Costs: We expense all of our software development costs as
incurred, due to uncertainties about the market acceptance of our products and
significant risks of rapid and continual changes in available technology that
could result in our software products becoming obsolete. We may capitalize such
costs in the future as market acceptance of our products becomes determinable. Valuation of Licenses: We utilize technology in our products, which is licensed
from third parties. License payments we make to third parties are stated at
cost on our balance sheets. The cost of these licenses is amortized to cost of
goods sold as the product incorporating the licensed units is sold or over the
term of the underlying license agreement. We review this asset category for
impairment and record impairment expense if warranted, based on the number of
licensed units sold and the underlying replacement value of the license. We
recognized impairment expense of $84,000 in the fiscal quarter ended March 31,
2003 and included this expense in cost of goods sold. We did not incur
impairment expense in the fiscal quarter ended March 31, 2004. Valuation of Deferred Income Taxes.The carrying value of our net deferred tax
assets is based on our ability to generate sufficient taxable income in the
United States. We are generating operating losses and, therefore, are not a
taxpayer, nor are we able to demonstrate when we may be a taxpayer based on
future profitability. As a result, we have established reserves $9,800,000 and
$9,375,000, at March 31, 2004 and December 31, 2003, respectively, to reduce
the carrying value of our deferred tax assets to zero. 8




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Reserves for Doubtful Accounts and Obsolete/Excess Inventory.Based on our
judgment, we review our accounts receivable and inventory to establish reserves
that adjust the carrying value to the estimated net realizable value. Factors
we consider in establishing these reserves include economic conditions,
customer financial strength, product mix, sales levels and customer acceptance
of our products. As a result, we established reserves for doubtful accounts
receivable of $30,000 and $31,000 at March 31, 2004 and December 31, 2003,
respectively, and reserves for slow moving and obsolete inventories of $137,000
and $119,000 at March 31, 2004 and December 31, 2003, respectively. Results of Operations Comparison of Three Month Periods Ended March 31, 2004 and 2003 Total revenue:Net sales of our products and services for the first quarter of
2004 were $1,501,000, compared to $794,000 for the same period of 2003. The
increase of $707,000 in net sales for the first quarter of 2004 resulted from
(1) a substantial increase in spending by certain financial and governmental
customers of Datakey CIP and CMS products, (2) service revenues that we earned
from completing a task order as part of a system integration analysis project
for a government customer and (3) licensing revenue from an original equipment
manufacturer. During the first quarter of 2004, we announced (1) the signing a
multi-year sales agreement with a U.S. financial services organization for
delivery of Datakey CIP and Datakey CMS authentication solutions, which
contributed to revenue in the quarter and is expected to contribute
approximately $2.6 million in revenue through 2006 and (2) a new revenue
opportunity for adding biometric authentication to a smart ID badge deployment
for the U.S. State Department, which contributed to revenue in the quarter and
is expected to contribute to revenue during the second half of 2004. Our
ability to increase total revenues in subsequent quarters will depend to a
large extent on the acceptance of and demand for Datakey Axis, which we
introduced in 2003, and the continued improvement in the market for Datakey CIP
and CMS. With these factors in mind, we currently expect total revenues in 2004
to increase significantly over 2003 levels because (1) we expect that demand
for our PKI enabled products will increase and (2) we anticipate our broader
sales and marketing efforts in 2004 to establish a market for Datakey Axis. We believe that 2004 is unfolding in a positive manner with 95 new customers
added during the quarter and our pipeline of sales opportunities continues to
grow. We define our pipeline of sales opportunities as the estimated sales
value of qualified customer interest in purchasing authentication solutions,
which could result in a sale for us or one of our competitors. For the current
quarter, we estimate our pipeline at approximately $13.0 million over the next
4 quarters, which is an increase of more than 50% from the fourth quarter of
last year. Datakey Axis is an important reason for the growth in our pipeline. Gross margins: Our gross margins increased to 64% of revenue in the first
quarter of 2004 from 24% of revenue in the same period of 2003 principally due
to our product sales mix, which consisted of a greater percentage of higher
gross margin software products, as well as high margin service and licensing
revenues earned during the quarter. In addition, gross margins in the first
quarter of 2003 were negatively affected by an $84,000 impairment expense
related to a revaluation of certain prepaid licenses. We expect gross margins
to vary from quarter to quarter during 2004 depending on the proportion of
lower margin hardware products in our product sales mix, but on an annual basis
we expect gross margins to be higher than full year 2003 gross margins as
revenues from our new product, Datakey Axis, start to comprise a larger
percentage of total revenue. Research and development, engineering and technical support: We incurred
research and development, engineering and technical support expense of
$497,000, or 33% of revenue, in the first quarter of 2004, compared to
$549,000, or 69% of revenue, in the same period of 2003. The decrease of
$52,000 in research and development, engineering and technical support expense
is primarily due to a reduction in payroll costs associated with a head count
reduction that occurred after the first quarter of 2003. We expect research and
development, engineering and technical support expense for full-year 2004 to be
slightly higher than 2003 due to personnel additions we are planning. Marketing and sales: We incurred marketing and sales expense of $993,000, or
66% of revenue, in the first quarter of 2004, compared to $776,000, or 98% of
revenue, in the same period of 2003. The increase of $217,000 in marketing and
sales expense in the first quarter of 2004 is primarily attributable to an
increase in commission expense on higher levels of commissionable sales and
higher payroll costs associated with head count additions that occurred in the
second half of 2003. We expect marketing and sales expense for full-year 2004
to be higher than 2003 due to broader efforts intended to establish and/or grow
the market for our authentication solutions. 9




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General and administrative:We incurred general and administrative expense of
$423,000, or 28% of revenue, in the first quarter of 2004, compared to
$418,000, or 53% of revenue, in the same period of 2003. The nominal increase
in general and administrative expense in the first quarter of 2004 resulted
from higher professional fees and amortization of debt service costs related to
the convertible promissory notes, which were largely offset by lower severance
costs attributable to the departure of an officer. We expect general and
administrative expense for full-year 2004 to be slightly higher than 2003 due
to costs related to the replacement of an officer during the first quarter of
2004 in addition to ongoing obligations to a previous officer. Interest income (expense), net:We incurred net interest expense of $194,000,
or 13% of revenue, in the first quarter of 2004, compared to net interest
income of $5,000 in the same period of 2003. Our net interest expense increased
by $199,000 in the first quarter of 2004 due to the $2,000,000 convertible
promissory notes payable, which were issued on October 17, 2003. In subsequent
quarters, interest expense and warrant amortization expense related to the
convertible promissory notes will accrue at approximately $200,000 per quarter
and is payable on the October 17, 2004 maturity date. Liquidity and Capital Resources We have financed our operations to date primarily through private and public
sales of equity securities, the issuance of convertible promissory notes and
revenues from the sale of our products and services. Working capital, which is defined as current assets less current liabilities,
decreased by $1,112,000 from $1,528,000 at December 31, 2003 to $416,000 at
March 31, 2004. Cash decreased by $1,107,000 from $2,702,000 at December 31,
2003 to $1,595,000 at March 31, 2004. We used $1,109,000 of cash to fund
operating activities, which closely approximates our net loss for the quarter.
The adjustments to reconcile our cash flow from operations consist primarily of
an increase in trade receivables due to higher levels of sales late in the
quarter, an increase in inventories to support higher levels of sales and an
increase in other assets resulting from insurance renewals and contractual
commitments to acquire additional licenses, which are more than offset by non
cash charges for depreciation and amortization, and higher levels of accrued
expenses and deferred revenue. The largest single component of our working
capital is the convertible promissory notes payable of $1,672,000 and related
accrued interest expense of $91,000, which are classified as current
liabilities due to the contractual maturity date of October 17, 2004. We believe that our cash and cash equivalents, together with expected revenues
from operations, will be sufficient to meet our anticipated working capital
requirements into the first quarter of 2005. However, we will require
additional funds to support our working capital requirements in the fourth
quarter of 2004 should the convertible promissory note holders opt not to
convert the notes into our common stock or not to extend the maturity of the
notes beyond the scheduled maturity date of October 17, 2004. Should the
convertible promissory note holders decide not to convert their notes into our
common stock during 2004, we will need to raise additional funds through public
or private equity financings or from other sources in order to ultimately repay
the notes and fund working capital in the future. Even if the convertible
promissory note holders convert their notes into our common stock, we will
require additional financing in 2005 to fund operations. We cannot be certain
that additional financing will be available on terms favorable to us, or at
all, or that any additional financing will not be dilutive. Contractual Cash Obligations The Company presently has no long-term debt outstanding and its only
contractual cash obligations are those from operating lease obligations and the
convertible promissory notes payable. Lease obligations for the next three
quarters of 2004 total $141,000 and debt and related accrued interest
associated with the convertible promissory notes could total $2,200,000 on
October 17, 2004. Approximately $93,000 of our total lease obligations of
$141,000 relate to our office and warehouse lease, which expires on December
31, 2004. 10




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Backlog Our customers typically require prompt delivery of our products and as such,
our product revenue is generally booked and shipped in the same quarter.
However, in the first quarter of 2004, we were unable to ship $226,000 of
product due to a shortage of a hardware product required to fulfill the
customers order. The customer requested that we invoice them for the products
even though we do not expect to ship the products until sometime in the second
quarter. As a result, we recorded this backlog as deferred revenue in the
quarter. Generally, our backlog is not material at any point in time and is not
indicative of future revenue. The timing and volume of customer orders are
difficult to forecast and are typically made pursuant to standard purchase
orders that can be rescheduled, reduced or cancelled prior to shipment without
significant penalty. Factors That Could Affect Future Results Certain statements made in this Quarterly Report on Form 10-QSB are
forward-looking statements based on our current expectations, assumptions,
estimates and projections about our business and our industry. These
forward-looking statements involve risks and uncertainties. Our business,
financial condition and results of operations could differ materially from
those anticipated in these forward-looking statements as a result of certain
factors, as more fully described below and elsewhere in this Form 10-QSB. You
should consider carefully the risks and uncertainties described below, which
are not the only ones facing our company. Certain forward-looking statements relate to increased revenues based on our
belief that users of network services will increase their usage of smart cards
and tokens; government agencies and financial service organizations worldwide
will continue to implement PKI-based security infrastructures; and our
strategic relationships will provide market leverage and higher value solutions
to new and existing customers. Such expectations are also supported by the
anticipation of adding $2.6 million in revenues through 2006 under a contract
with a U.S. financial services organization and revenue from an expected
biometric authentication project for the U.S. State Department smart ID badge
deployment that would add revenue in the second half of 2004. Our expected
pipeline of $13.0 million in sales opportunities over the next four quarters,
however, is not guaranteed, and we may not be successful in booking these sales
opportunities due to competition from others or due to other market conditions.
Other forward-looking statements reflect our specific expectations that
research and development, engineering and technical support expenses in 2004
will increase due to planned personnel additions; our marketing and sales
expenses in 2004 will increase due to broader efforts intended to establish
and/or grow the market for our authentication solutions and increase revenue
growth over the next several years; and our general and administrative expenses
in 2004 will increase to support the increased marketing efforts as well as
resulting from management personnel changes. Due in part to an expected
increased demand for the Axis Product, which we expect to carry a higher
margin, we expect our gross margins to improve in 2004; and we believe our cash
and cash equivalents together with expected revenues from operations should be
sufficient to meet anticipated working capital requirements into the first
quarter of 2005 (assuming the outstanding convertible debt due in October 2004
is converted to capital stock or the maturity date is extended). Additional
factors that may cause actual results to differ from our assumptions and
expectations include our sales terms, which allow a customer to cancel an order
at anytime prior to shipment of that order without penalty, as well as the
factors that follow. All forward-looking statements are qualified by, and
should be considered in conjunction with, these cautionary statements. Our past losses and expected future losses cast doubt on our ability to operate
profitably.
The last time we reported net income was for our fiscal year ended December 31,
1995. Since December 31, 1995 and through March 31, 2004, we have incurred
losses in the aggregate of $26,338,000. Our ability to improve our operating
performance is primarily dependent on a significantly improved market for smart
card-based information security products for PKI applications and the
successful acceptance and demand of our new product, Datakey Axis, which offers
information security and convenience without requiring the use of PKI. We
cannot make assurances that our CIP and CMS product offerings will ever find
greater acceptance among those enterprises adopting or that have adopted PKI
for information security, nor can we make assurances that our Datakey Axis
product will receive market acceptance. Our ability to achieve or sustain
profitability thereafter is uncertain. 11




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We Rely On Third Parties To Market, Distribute And Sell Our Products And Those
Third Parties May Not Perform.
Our reseller partners market and sell the products that we develop and
distribute. The marketing and sales organizations of our reseller partners may
be unsuccessful, or they may assign a lower level of priority to the marketing
of our products that is different from our priorities. Further, they may
discontinue marketing our products. Our gross margins may fail to grow as
expected if one or more of our reseller partners fail to pursue the marketing
of our products as planned, or if we are required to incur higher levels of
selling expense in an effort to mitigate the impact of such failure by one or
more of our reseller partners. We can make no assurances that our strategy to
mitigate the failure by one or more of our reseller partners to market our
products will be successful. If We Do Not Enter Into Initial And Extended Maintenance And Support Agreements
with Users Of Our Software, Our Revenues And Gross Margins Will Be Lower.
Generally, users of our software solutions pay us to provide them with
technical assistance for problems they may encounter with our products during a
specified technical support period, which typically is based on a one-year
contract. If these users do not extend their maintenance and support
agreements past the initial one-year period, or new users do not purchase the
initial one-year maintenance and support contract, our revenues and gross
margins may fail to grow as expected or may decline. Raising the required capital to conduct our operations and develop our products
is time critical.
We may require substantial capital resources in order to conduct our operations
and to further develop and market our products, including our new product
Datakey Axis. We believe that our available cash and expected revenue is
sufficient to finance operations through the first quarter of 2005, provided we
are able to extend the maturity of the convertible promissory notes for at
least an additional six months or obtain new financing to repay the convertible
promissory notes at the scheduled maturity date of October 17, 2004. We will
owe the convertible promissory note holders approximately $2.2 million,
including interest, on the scheduled maturity date of October 17, 2004. There
is no assurance that we will be able to obtain the necessary financing to repay
this loan at favorable or acceptable terms, if at all, nor is there any
assurance that the convertible promissory note holders will extend the maturity
date of this loan. If we are unsuccessful in extending the maturity date of the
note payable or in obtaining new financing to repay the note payable, our
ability to continue to operate in our current form would be in doubt. Even if
we are successful, any new financing or term extensions of the existing note
payable will likely result in significant additional dilution to current
shareholders. Our Common Stock is traded on the OTC Bulletin Board, which may affect its
market price and liquidity.
In order to maintain the listing of our common stock on the Nasdaq Stock
Market, we had to continue to meet certain financial tests (including, but not
limited to, a minimum bid price of our common stock of $1.00). Except for a few
days, our common stock consistently traded below the $1.00 minimum level from
March 3, 2003 through November 12, 2003. In addition, the National Association
of Securities Dealers has a minimum listing requirement of $2.5 million of net
equity, unless either the market value of a companys securities exceeds $35
million or the company has net income of at least $500,000. As of June 30, 2003, we no longer met such minimum net equity requirement or
alternative requirements; and, on August 6, 2003, we received notice from
Nasdaq that it was reviewing our eligibility for continued listing on Nasdaq.
Despite the Companys diligent efforts to meet the requirements, our common
stock was delisted from the Nasdaq Stock Market on November 12, 2003. Our
common stock was then immediately eligible for quotation on the OTC Bulletin
Board and began trading on the OTC Bulletin Board as of the open of business on
November 13, 2003. Because our common stock now trades on the OTC Bulletin
Board, trading may be more difficult because of lower trading volumes,
transaction delays and reduced security analyst and news media coverage of
Datakey. These factors could contribute to lower prices and larger spreads in
the bid and ask prices for our common stock. The SEC has rules relating to penny stock. If our common stock becomes
characterized as penny stock as a result of being delisted by Nasdaq or
otherwise, broker-dealers dealing in our common stock will be subject to the
disclosure rules for transactions involving penny stocks. The additional
burdens imposed upon broker-dealers may
discourage them from effecting transactions in penny stocks, which could
further have a material adverse effect on the trading market of our common
stock and further reduce the liquidity of our stock. 12




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Success of our new product, Datakey Axis, depends on commercial acceptance and
demand.
We believe our new Datakey Axis product, which we introduced in 2003, offers
significant advantages to our customers. Datakey Axis is substantially less
complex and costly than authentication solutions based on PKI technology, while
continuing to offer the security and convenience demanded within the market.
The product has only recently reached the market and we continue to work toward
engaging necessary resellers in North America and Europe. For these reasons and
because substantial funds are necessary to effectively market the product,
there is no assurance that this product will be accepted by our potential
customers or that it will generate a successful financial return. If the
introduction of our Datakey Axis product is unsuccessful, our ability to
survive would not be certain. The price of our Common Stock has significantly decreased since January 2003.
The market price of our common stock has decreased over the sixteen months,
from a high of $1.92 on January 7, 2003 to a low of $0.57 on December 18, 2003.
On March 31, 2004, the last sale price quoted on the OTC Bulletin Board was
$0.71 per share. On April 26, 2004, the last sales price quoted on the OTC
Bulletin Board was $0.72 per share. The overall decrease over this period is
due in part to a decrease in the market for technology related stocks during
this time period, the delisting of our common stock by the Nasdaq Stock Market
on November 12, 2003 and our decreased revenues and working capital during
2003. Other factors that could adversely affect our stock price include:  
    
    availability of alternative future sources of financing;
    
    fluctuations in our operating results;
    
    announcements of technological collaborations, innovations or new products by us or our competitors;
    
    developments in patent or other proprietary rights owned by us or others;
    
    litigation;
    
    decisions by our strategic partners relating to the products incorporating our technologies; and
    
    general market conditions. We face the risks related to rapid technological change.
In the information security market, we face continuing significant risks due to
the rapid and continual changes in available technology. Alternative
technologies may be developed that are superior to ours and may result in our
products becoming obsolete. We face significant price competition.
Even if our technology can demonstrate a higher level of features and functions
than many of the current competitive products, there are no assurances that
competitive pressures will not force us to accept reduced margins to compete in
the future. Large companies with significantly greater resources have
recognized the need for information security and will likely enter this market
as competitors with much greater financial resources. Our success is highly dependent on our ability to retain our management team
and technical expertise.
Our ability to succeed in the highly competitive information security business
depends upon the efforts and abilities of our management team, our sales
personnel, our software engineers and other technical personnel. Our inability
to retain such highly skilled persons, due either to our current economic
circumstances or the intense competition faced in the market for such persons,
would substantially limit our ability to further our efforts in this business. We may not be able to adequately enforce or protect our intellectual property
rights or to protect ourselves against infringement claims by others.
Although we have filed an application with the U.S. Patent and Trademark Office
for a patent covering the technology underlying our Datakey Axis product, we
cannot assure you that a patent concerning this technology will be issued or
that any resulting patent will be of sufficient breadth to deter competitors
from attempting to replicate our technology. Whether or not we receive a patent
covering our Datakey Axis technology, our continued success will depend in part
on our ability to protect our manufacturing processes, preserve our trade
secrets and operate without infringing the proprietary rights of third parties.
We cannot assure you that the scope of any patent protection under the patent
that is under pending application or any other patents will exclude competitors
or provide competitive advantages to us. Furthermore, we cannot assure you that
others have not developed or will not develop similar products or manufacturing
processes, duplicate any of our 13




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products or manufacturing processes or
design around our patents or other intellectual property. We also rely on unpatented
trade secrets to protect our proprietary technology, and we cannot assure you
that others will not develop independently or otherwise acquire substantially
equivalent techniques, gain access to our proprietary technology or disclose
our technology, or that we can ultimately protect meaningful rights to our
unpatented proprietary technology. 
 ITEM 2. CHANGES IN SECURITIES AND SMALL BUSINESS ISSUER
PURCHASES OF EQUITY SECURITIES On February 10, 2004, we issued ten-year options to purchase an aggregate of
181,750 shares of common stock at $0.82 per share to seventeen employees, which
options vest annually over a two-year period. On February 23, 2004, we granted
ten-year options to purchase an aggregate of 425,000 shares of common stock at
$0.79 per share to three officers, which options vest annually over a two or
three year period. The option grants were exempt from registration under
Section 4(2) of the Securities Act of 1933, as amended, which provides an
exemption for transactions not involving a public offering. 
 ITEM 3. CONTROLS AND PROCEDURES As of the end of the period covered by this report, the Company conducted an
evaluation, under the supervision and with the participation of the principal
executive officer and principal financial officer, of the Companys disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934 (the Exchange Act)). Based on this
evaluation, the principal executive officer and principal financial officer
concluded that the Companys disclosure controls and procedures are effective
to ensure that information required to be disclosed by the Company in reports
that it files or submits under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in Securities and
Exchange Commission rules and forms. There was no change in the Companys
internal control over financial reporting during the Companys most recently
completed fiscal quarter that has materially affected, or is reasonably likely
to materially affect, the Companys internal control over financial reporting. 
 PART II. OTHER INFORMATION 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits The following exhibits are included in this report: See Exhibit Index
immediately following the following the signature page of this Form 10-QSB. (b) Reports on Form 8-K A Form 8-K dated February 23, 2004, was filed announcing its 2003 fourth
quarter financial results. 14




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SIGNATURES In accordance with the requirements of the Exchange Act of 1934, the Registrant
has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized. Dated: May 5, 2004
    Datakey, Inc. By:
    /s/David A. FesteDavid A. FesteVice President & Chief Financial Officer
(Principal Financial and Accounting Officer,duly authorized to sign
on behalf of the registrant) 15




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EXHIBIT INDEX TO FORM 10-QSB Exhibit No.
    
    Description3.1
    
    Restated Articles of Incorporation, as amended (Incorporated by reference to
Exhibit 3.1 to Form 10-KSB for fiscal year ended December 31, 2002)3.2
    
    Restated Bylaws (Incorporated by reference to Exhibit 3.2 to Form 10-KSB for fiscal
year ended December 31, 2002)4.1
    
    Rights Agreement dated October 26, 2001 between the Company and Wells Fargo Bank,
as Rights Agent, including Statement of Designation of Series B Preferred Stock,
Summary of Rights to Purchase Shares of Series B Preferred Stock and Form of Rights
Certificate included as exhibits (incorporated by reference to Exhibit to the
Companys Registration Statement on Form 8-A, Reg. No. 0-11447)10.1*
    
    Employment Agreement dated May 1, 2003, between Timothy L. Russell and the Company**10.2*
    
    Nonqualified stock option agreement between Timothy L. Russell and the Company
dated February 23, 2004**10.3*
    
    Nonqualified stock option agreement between Christopher A. Schwartzbauer and the
Company dated February 23, 2004**10.4*
    
    Nonqualified stock option agreement between David A. Feste and the Company dated
February 23, 2004**10.5*
    
    Lease Extension and Space Reduction Agreement between the Company and
Kraus-Anderson, Incorporated dated April 5, 200431.1*
    
    Certification of Chief Executive Officer Pursuant to Section 302 of the
Sarbanes-Oxley Act of 200231.2*
    
    Certification of Chief Financial Officer Pursuant to Section 302 of the
Sarbanes-Oxley Act of 200232.1*
    
    Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes
Oxley Act of 200232.2*
    
    Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes
Oxley Act of 2002
  *
    
    Filed herewith.**
    
    Designates a management contract or compensatory plan or arrangement. 16