** **

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-QSB**

 

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

 

# **For the quarterly period endedSeptember 29, 2001**

 

# **Commission File Number 0-11447**

 

 

**DATAKEY, INC.**

(Exact name of smallbusiness issuer as specified in its charter)

 

 

| **MINNESOTA**                                                   |   | **41-1291472**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **407 WEST TRAVELERS  TRAIL, BURNSVILLE, MN  55337**       |

** **

 

Issuer’s telephonenumber:  **(952) 890-6850**

 

 

(Former name, formeraddress and former fiscal year,

if changed since lastreport)

 

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

                                                                                                Yes  ý    No o

 

### APPLICABLEONLY TO CORPORATE ISSUERS

 

                The number of shares outstandingof the issuer’s common equity, as of November 9, 2001, is 9,960,728.

 

                Transitional SmallBusiness Disclosure Format (check One):

                                                                                                Yes  o    No ý

 

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

 
|                                                                                                                                                |   |               |       |              |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|------------|-------------------|--------|
|                                                                                                                                                |   |               |       |              |   |
|                                                                                                                                                |   |               |       |              |   |
|                                                                                                                                                |   | **September  29,** |       | **December  31,** |   |
|                                                                                                                                                |   | **2001**           |       | **2000**          |   |
|                                                                                                                                                |   | **(UNAUDITED)**    | ** ** |              |   |
| ASSETS                                                                                                                                              |   |               |       |              |   |
| CURRENT ASSETS                                                                                                                                      |   |               |       |              |   |
| Cash and cash  equivalents                                                                                                                          |   | $                  | 3,184,287  |              | $      | 1,532,558 |   |
| Trade  receivables, less allowance for doubtful accounts of  $28,000 and $26,000                                                          |   | 2,495,342          |       | 989,020           |   |
| Inventories                                                                                                                                         |   | 1,093,656          |       | 513,846           |   |
| Prepaid expenses  and other                                                                                                                         |   | 66,909             |       | 113,176           |   |
| Net assets of  discontinued operations                                                                                                              |   | 111,858            |       | 1,561,999         |   |
| Total current  assets                                                                                                                               |   | 6,952,052          |       | 4,710,599         |   |
|                                                                                                                                                |   |               |       |              |   |
| OTHER ASSETS                                                                                                                                        |   |               |       |              |   |
| Prepaid licenses  and patents at cost less amortization of $709,999 and $487,909                                                                    |   | 316,065            |       | 498,961           |   |
|                                                                                                                                                |   |               |       |              |   |
|                                                                                                                                                |   |               |       |              |   |
| EQUIPMENT AND  LEASEHOLD IMPROVEMENTS, at cost                                                                                                      |   |               |       |              |   |
| Production  tooling                                                                                                                                 |   | 23,650             |       | 63,188            |   |
| Equipment                                                                                                                                           |   | 676,656            |       | 954,397           |   |
| Furniture and  fixtures                                                                                                                             |   | 164,623            |       | 284,423           |   |
| Leasehold  improvements                                                                                                                             |   | 300,825            |       | 224,488           |   |
|                                                                                                                                                |   | 1,165,754          |       | 1,526,496         |   |
| Less accumulated  depreciation                                                                                                                      |   | (772,037           | )          | (1,300,268        | )      |
|                                                                                                                                                |   | 393,717            |       | 226,228           |   |
|                                                                                                                                                |   |               |       |              |   |
|                                                                                                                                                |   | $                  | 7,661,834  |              | $      | 5,435,788 |   |
|                                                                                                                                                |   |               |       |              |   |
|                                                                                                                                                |   |               |       |              |   |
| LIABILITIES AND SHAREHOLDERS' EQUITY                                                                                                                |   |               |       |              |   |
| CURRENT  LIABILITIES                                                                                                                                |   |               |       |              |   |
| Accounts payable                                                                                                                                    |   | $                  | 597,810    |              | $      | 386,613 |   |
| Accrued  compensation                                                                                                                               |   | 386,502            |       | 226,803           |   |
| Accrued  expenses-other                                                                                                                             |   | 218,098            |       | 74,031            |   |
| Deferred revenue                                                                                                                                    |   | 268,937            |       | 63,797            |   |
| Net liabilities  from discontinued operations                                                                                                       |   | 0                  |       | 480,875           |   |
| Total current  liabilities                                                                                                                          |   | 1,471,347          |       | 1,232,119         |   |
|                                                                                                                                                |   |               |       |              |   |
|                                                                                                                                                |   |               |       |              |   |
|                                                                                                                                                |   |               |       |              |   |
| SHAREHOLDERS'  EQUITY                                                                                                                               |   |               |       |              |   |
| Convertible  preferred stock, voting, stated value  $2.50 per share; authorized 400,000 shares;  issued and outstanding 150,000           |   | 375,000            |       | 375,000           |   |
| Common stock,  par value $.05 per share;   authorized 20,000,000 shares; issued and outstanding  9,918,273 in 2001 and 8,269,173 in  2000 |   | 495,913            |       | 413,459           |   |
| Additional  paid-in capital                                                                                                                         |   | 18,432,802         |       | 13,906,744        |   |
| Accumulated deficit                                                                                                                                 |   | (13,113,228        | )          | (10,491,534       | )      |
|                                                                                                                                                |   | 6,190,487          |       | 4,203,669         |   |
|                                                                                                                                                |   |               |       |              |   |
|                                                                                                                                                |   | $                  | 7,661,834  |              | $      | 5,435,788 |   |
|                                                                                                                                                |   |               |       |              |   |
|                                                                                                                                                |   |               |       |              |   |

 

See Notes to FinancialStatements

 

 

 

DATAKEY,INC.STATEMENTS OF INCOME(UNAUDITED)

 
|                                                         |   | **Three  Months Ended** |      | **Nine  Months Ended** |   |
|--------------------------------------------------------------|--------|-------------------------|-----------|------------------------|--------|
|                                                         |   | **September 29,**       |      | **September  30,**     |   | **September  29,** |   | **September  30,** |   |
|                                                         |   | **2001**                |      | **2000**               |   | **2001** |   | **2000** |   |
|                                                         |   |                    |      |                   |   |   |   |   |   |
| Revenue                                                      |   | $                       | 2,714,470 |                   | $      | 842,544 |   | $ | 5,066,017 |   | $ | 2,240,851 |   |
| Cost of goods  sold                                          |   | 1,191,933               |      | 555,632                |   | 2,233,963 |   | 1,330,711 |   |
|                                                         |   |                    |      |                   |   |   |   |   |   |
| Gross Profit                                                 |   | 1,522,537               |      | 286,912                |   | 2,832,054 |   | 910,140 |   |
|                                                         |   |                    |      |                   |   |   |   |   |   |
|                                                         |   |                    |      |                   |   |   |   |   |   |
| Operating  expenses:                                         |   |                    |      |                   |   |   |   |   |   |
| Research,  development and engineering                       |   | 552,119                 |      | 530,155                |   | 1,731,796 |   | 1,399,769 |   |
| Marketing and  sales                                         |   | 932,979                 |      | 634,040                |   | 2,629,813 |   | 1,545,252 |   |
| General and  administrative                                  |   | 223,554                 |      | 173,846                |   | 627,421 |   | 517,441 |   |
|                                                         |   |                    |      |                   |   |   |   |   |   |
|                                                         |   |                    |      |                   |   |   |   |   |   |
| Total operating  expenses                                    |   | 1,708,652               |      | 1,338,041              |   | 4,989,030 |   | 3,462,462 |   |
|                                                         |   |                    |      |                   |   |   |   |   |   |
| Operating loss                                               |   | (186,115                | )         | (1,051,129             | )      | (2,156,976 | ) | (2,552,322 | ) |
|                                                         |   |                    |      |                   |   |   |   |   |   |
| Interest income                                              |   | 23,437                  |      | 39,915                 |   | 63,613 |   | 137,772 |   |
|                                                         |   |                    |      |                   |   |   |   |   |   |
| Loss from  continuing operations before income taxes    |   | (162,678                | )         | (1,011,214             | )      | (2,093,363 | ) | (2,414,550 | ) |
|                                                         |   |                    |      |                   |   |   |   |   |   |
| Income tax  expense                                          |   | 0                       |      | 0                      |   | 0 |   | 0 |   |
|                                                         |   |                    |      |                   |   |   |   |   |   |
| Net loss from  continuing operations                         |   | $                       | (162,678  | )                      | $      | (1,011,214 | ) | $ | (2,093,363 | ) | $ | (2,414,550 | ) |
|                                                         |   |                    |      |                   |   |   |   |   |   |
| Basic and diluted loss  per share from continuing operations |   | $                       | (0.02     | )                      | $      | (0.12 | ) | $ | (0.22 | ) | $ | (0.31 | ) |
|                                                         |   |                    |      |                   |   |   |   |   |   |
| Loss from  operations of discontinued segment                |   | 0                       |      | (334,463               | )      | 0 |   | (364,412 | ) |
| Loss from  disposal of discontinued segment                  |   | (528,000                | )         | 0                      |   | (528,000 | ) | 0 |   |
| Net loss  attributable to common stockholders                |   | $                       | (690,678  | )                      | $      | (1,345,677 | ) | $ | (2,621,363 | ) | $ | (2,778,962 | ) |
|                                                         |   |                    |      |                   |   |   |   |   |   |
| Basic and diluted  loss per share                       |   | $                       | (0.07     | )                      | $      | (0.16 | ) | $ | (0.27 | ) | $ | (0.35 | ) |
|                                                         |   |                    |      |                   |   |   |   |   |   |
| Weighted average  number of  common  shares outstanding |   | 9,918,273               |      | 8,229,178              |   | 9,631,004 |   | 7,879,276 |   |

 

See Notes to FinancialStatements

 

 

DATAKEY, INCSTATEMENTS OF CASH FLOWS(UNAUDITED)

 
|                                                                                        |   | **Three  Months Ended** |      | **Nine  Months Ended** |   |
|---------------------------------------------------------------------------------------------|--------|-------------------------|-----------|------------------------|--------|
|                                                                                        |   | **September 29,**  |      | **September 30,** |   | **September 29,** |   | **September 30,** |   |
|                                                                                        |   | **2001**                |      | **2000**               |   | **2001** |   | **2000** |   |
| **CASH FLOWS FROM****OPERATING ACTIVITIES**                                                 |   |                    |      |                   |   |   |   |   |   |
| Net loss                                                                                    |   | $                       | (690,678  | )                      | $      | (1,345,677 | ) | $ | (2,621,363 | ) | $ | (2,778,967 | ) |
| 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 |   | (114,829                | )         | 0                      |   | (4,681 | ) | 0 |   |
| Depreciation                                                                                |   | 37,557                  |      | 75,854                 |   | 196,755 |   | 257,618 |   |
| Amortization                                                                                |   | 80,285                  |      | 75,525                 |   | 241,465 |   | 230,296 |   |
| Change in assets  and liabilities                                                           |   |                    |      |                   |   |   |   |   |   |
| (Increase)  decrease in assets net of effect of sale of business unit:                 |   |                    |      |                   |   |   |   |   |   |
| Trade  receivables                                                                          |   | (989,878                | )         | 186,689                |   | (1,119,899 | ) | 18,674 |   |
| Inventories                                                                                 |   | 850,284                 |      | (300,116               | )      | (176,982 | ) | (874,657 | ) |
| Prepaid expenses  and other                                                                 |   | 19,173                  |      | 44,780                 |   | 46,267 |   | (20,851 | ) |
| Prepaid license  fees and patent                                                            |   | (52,020                 | )         | (246,533               | )      | (62,919 | ) | (253,688 | ) |
| Increase  (decrease) in:                                                                    |   |                    |      |                   |   |   |   |   |   |
| Accounts payable                                                                            |   | (197,435                | )         | 169,104                |   | (146,343 | ) | 4,260 |   |
| Accrued expenses                                                                            |   | 320,266                 |      | 279,696                |   | 385,240 |   | 336,897 |   |
|                                                                                        |   |                    |      |                   |   |   |   |   |   |
| Net cash used in operating  activities                                                 |   | (737,275                | )         | (1,060,678             | )      | (3,262,460 | ) | (3,080,418 | ) |
|                                                                                        |   |                    |      |                   |   |   |   |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES**                                                   |   |                    |      |                   |   |   |   |   |   |
| Proceeds from  sale of discontinued business unit                                           |   | 550,000                 |      | 0                      |   | 550,000 |   | 0 |   |
| Purchase of  equipment and leasehold improvements                                           |   | (229,835                | )         | (15,411                | )      | (244,323 | ) | (91,391 | ) |
|                                                                                        |   |                    |      |                   |   |   |   |   |   |
| Net cash  provided from (used in) investing activities                                 |   | 320,165                 |      | (15,411                | )      | 305,677 |   | (91,391 | ) |
|                                                                                        |   |                    |      |                   |   |   |   |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES**                                                   |   |                    |      |                   |   |   |   |   |   |
| Net proceeds  from issuance of common stock                                            |   | 0                       |      | 223,302                |   | 4,608,512 |   | 5,490,308 |   |
| Net cash  provided by financing activities                                                  |   | 0                       |      | 223,302                |   | 4,608,512 |   | 5,490,308 |   |
|                                                                                        |   |                    |      |                   |   |   |   |   |   |
| Increase (decrease)  in cash and cash equivalents                                 |   | (417,110                | )         | (852,787               | )      | 1,651,729 |   | 2,318,499 |   |
|                                                                                        |   |                    |      |                   |   |   |   |   |   |
| **CASH  AND CASH  EQUIVALENTS**                                                        |   |                    |      |                   |   |   |   |   |   |
| Beginning                                                                                   |   | 3,601,397               |      | 3,516,208              |   | 1,532,558 |   | 344,922 |   |
| Ending                                                                                      |   | $                       | 3,184,287 |                   | $      | 2,663,421 |   | $ | 3,184,287 |   | $ | 2,663,421 |   |
|                                                                                             |        |                         |           |                        |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

See Notes to FinancialStatements

 

**DATAKEY, INC.**

**NOTES TO FINANCIAL STATEMENTS**

 

#### **GENERAL**

Inthe opinion of management, the accompanying unaudited financial statementscontain all adjustments necessary to present fairly Datakey’s financialposition as of September 29, 2001, and December 31, 2000, and results of itsoperations and cash flows for the three-month and nine-month periods endedSeptember 29, 2001, and September 30, 2000. The adjustments that have been made are of a normal recurring nature.

 

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

 

**ACCOUNTING STANDARDS NOT YET ADOPTED**

In July 2001, the Financial Accounting Standards Board (FASB) issuedtwo new statements. Statement No. 141, Business Combinations, eliminates thepooling method of accounting for business combinations. Statement No. 142,Goodwill and Other Intangible Assets, eliminates the amortization of goodwilland other intangibles that are determined to have an indefinite life andrequires, at a minimum, annual impairment tests of goodwill and otherintangible assets that are determined to have an indefinite life. The Companyhas not yet completed its full assessment of the effect of these new standardson its consolidated financial statements, but believes their impact will not besignificant. The standards generally are required to be implemented by theCompany in its 2002 financial statements.

 

In September 2001,the FASB issued Statement 143, Asset Retirement Obligations. This Statementaddresses financial accounting and reporting for obligations associated withthe retirement of tangible long-lived assets and the associated assetretirement costs. The Statement will be effective for the Company's fiscal yearending December 2003.  The Company doesnot believe that the adoption of this pronouncement will have a material effecton its financial statements. In August 2001, the FASB issued Statement 144,Accounting for Impairment or Disposal of Long-Lived Assets. This Statementaddresses financial accounting and reporting for the impairment or disposal oflong-lived assets. The Statement will be effective for the Company's fiscalyear ending December 2002.  The Companydoes not believe that the adoption of this pronouncement will have a materialeffect on its financial statements.

 

#### **OPERATING SEGMENTS**

ThroughJuly 31, 2001, the Company had two reportable segments: Electronic Products(EP) and Information Security Solutions (ISS). The Electronic Products segment produced and marketed proprietary memorykeys, cards, and custom-shaped tokens and systems that utilize these productsthat serve as a convenient way to carry electronic information.  The assets related to the ongoing businessof the EP business segment were sold in August 2001.  The Information Security Solutions segment produces and marketsproducts for the information security market, which enable user identificationand authentication, secure data exchange, and information validation.

 

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

 
|                          |   | ***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                                    | )        | (186,003                                    | )        | 23,437 |   | (766,773 | ) | *(532,681 | ) | (1,970,761 | ) | 63,613 |   | (2,439,829 | ) |
|                          |   |                                         | * * |                                        | * * |   | * * |   | * * |   | * * |   | * * |   | * * |   | * * |
|                               |        |                                              |          |                                             |          |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                          |   | ***Three Months Ended September 30, 2000*** |    | ***Nine Months Ended September 30, 2000*** | * * |
|-------------------------------|--------|---------------------------------------------|---------|--------------------------------------------|----------|
|                          |   | ***EP***                                    |    | ***ISS***                                  |     | ***UNALLOCATED*** |   | ***TOTAL*** |   | ***EP*** |   | ***ISS*** |   | ***UNALLOCATED*** |   | ***TOTAL*** | * * |
| Revenue                       |   | $                                           | 773,548 |                                       | $        | 842,544 |   | $ | – |   | $ | 1,616,092 |   | $ | 2,985,318 |   | $ | 2,240,851 |   | $ | – |   | $ | 5,226,169 |   |
| Interest income(expense)      |   | –                                      |    | –                                     |     | 39,915 |   | 39,915 |   | – |   | – |   | 137,772 |   | 137,772 |   |
| Depreciation and amortization |   | 50,129                                      |    | 101,250                                    |     | – |   | 151,379 |   | 176,602 |   | 311,312 |   | – |   | 487,914 |   |
| Segment profit (loss)         |   | (334,463                                    | )       | (1,051,129                                 | )        | 39,915 |   | (725,022 | ) | (364,412 | ) | (2,552,322 | ) | 137,772 |   | (2,778,962 | ) |
|                               |        |                                             |         |                                            |          |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

 
| *The segment profit  from the EP segment during the periods is not reflected in the Income  Statement because the estimated loss from operations and disposition of the  segment was charged to earnings in 2000. |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

 

 

**DISCONTINUED OPERATIONS**

InFebruary, 2001 the Company’s Board of Directors approved management’s plan todiscontinue the operations of the EP segment. The plan anticipated the phase down of the operations through December31, 2001, although it was possible the operations could be sold if a purchaserwas found.  (See Sale of DiscontinuedBusiness Segment).

 

Theestimated loss, taken in 2000, on the phase down of the EP segment included thewrite-off of inventory, patents, and equipment anticipated to remain at thedate of closedown and expenses associated with the phase down, net of estimatedoperating income through that date.  Thephase down of the segment is being accounted for as discontinued operationsand, accordingly, its net assets and net liabilities have been segregated fromcontinuing operations in the balance sheets and the results of operations havebeen excluded from continuing operations for all periods presented.  Net assets and liabilities of the EP segmentas of September 29, 2001 and December 31, 2000 are as follows:

 
|                                          |   | **Sept.  29, 2001** |    | **Dec.  31, 2000** |   |
|-----------------------------------------------|--------|---------------------|---------|--------------------|--------|
| Trade receivables                             |   | $                   | 111,858 |               | $      | 498,281 |   |
| Inventories                                   |   | 0                   |    | 1,927,488          |   |
| Equipment and  leasehold improvements         |   | 0                   |    | 344,418            |   |
| Patents and prepaid  expense                  |   | 0                   |    | 72,812             |   |
| Reserve for  discontinued operations          |   | 0                   |    | (1,281,000         | )      |
| Net assets from  discontinued operations      |   | $                   | 111,858 |               | $      | 1,561,999 |   |
|                                          |   |                |    |               |   |
| Accounts payable                              |   | $                   | 0       |               | $      | 357,540 |   |
| Accrued expenses:                             |   |                |    |               |   |
| Compensation                                  |   | 0                   |    | 90,165             |   |
| Other                                         |   | 0                   |    | 33,170             |   |
| Net liabilities from  discontinued operations |   | $                   | 0       |               | $      | 480,875 |   |

 

**SALE OF DISCONTINUED BUSINESS SEGMENT**

OnAugust 3, 2001 the Company completed the sale of the EP business segment fixedassets, inventory, patents and prepaid expense along with customer lists,assignment of certain customer contracts and all intellectual property requiredto operate the EP business segment.  TheCompany 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 thedate of closing, will record the cash difference between accounts receivableand accounts payable and accrued expense and profit on the customer contractsretained when realized.  Due to thenature of the transaction the final accounting is not complete but the Companyrecorded a loss of $528,000 from the disposal of discontinued operationsbecause the loss on disposal of the selected assets and the loss fromdiscontinued operations exceeded the $1,281,000 reserve that was establishedfor these losses in 2000.  This loss iscomputed as follows:

 
| Cash received upon  sale of certain assets                                     |   | $          | 550,000  |   |
|--------------------------------------------------------------------------------|--------|------------|----------|--------|
| Book value of assets  sold                                                     |   | (1,826,000 | )        |
| Loss on disposal of  assets                                                    |   | (1,276,000 | )        |
| Year-to-date loss from  discontinued operations                                |   | (533,000   | )        |
| Total loss                                                                     |   | (1,809,000 | )        |
| Loss reserve  established in 2000                                              |   | (1,281,000 | )        |
| Additional  loss for disposition of segment  provided during the third quarter |   | $          | (528,000 | )      |

 

 

 

 

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

**DATAKEY,INC.**

**RESULTSOF OPERATIONS AND FINANCIAL CONDITION**

 

***RESULTS OFOPERATIONS***

***CONTINUINGOPERATIONS***

 

**REVENUE**

ISSrevenue for the three and nine-month periods ended September 29, 2001,increased by $1,871,000, or 222 percent, and $2,825,000, or 126 percent,respectively as compared to the same periods in 2000.  The significant increase in revenue is primarily due to theshipment of a significant portion of the $2,800,000 Canadian DND order.  Management believes that revenue in thefourth quarter of 2001 will exceed fourth quarter revenue in 2000.

 

**GROSS PROFIT MARGIN**

Grossprofit as a percentage of revenue increased to 56 percent in the three-monthperiod ended September 29, 2001, from 34 percent in the three-month periodended September 30, 2000, and increased to 56 percent from 41 percent in thenine-month period.  The increase ingross profit percentage is primarily due to favorable product pricing duringthe three and nine-month periods as well as substantial reductions in materialcosts during the year.  Although theCompany does not expect to always obtain product pricing as favorable as thatobtained in the first nine months of 2001, management expects the gross marginpercentage to continue to be favorable as compared to 2000 because ofanticipated increases in revenue and reductions in material costs.

 

**OPERATING EXPENSES**

Operatingexpenses increased by $371,000, or 28 percent, in the three-month period endedSeptember 29, 2001 and $1,527,000, or 44 percent, in the nine-month periodended September 29, 2001, due to redistribution of marketing and general andadministrative expenses that were previously shared with our discontinuedoperation, expenses related to opening and staffing a European office and twoadditional US sales offices, increases in product promotion expense, increasesin staffing for software development and technical support and increases incommissions related to the increased revenue. Operating expenses in the fourth quarter are expected to remainrelatively flat compared to the third quarter.

 

**INTEREST INCOME**

Interestincome, net of interest expense, decreased to $23,000 in the three-month periodand to $64,000 in the nine-month period reflecting a lower balance in interestbearing accounts than in the 2000 and a lower rate of interest.  The Company also borrowed and repaid$500,000 from a major shareholder during the first quarter of 2001 for interimworking capital as it pursued a private placement of common stock.   Interest income is expected to decreaseover the balance of the year primarily due to declining interest rates.

 

 

***RESULTS OFOPERATIONS***

***DISCONTINUEDOPERATIONS***

***(Also SeeSale of Discontinued Business Segment in Notes to Financial Statements)***

 

**REVENUE**

Revenuefrom discontinued operations in the three months ended September 29, 2001decreased $526,000, or 68 percent, and decreased $617,000, or 21 percent, inthe nine month-period as compared to the same periods in 2000 as thediscontinued business segment was being wound down in preparation for sale.

 

**GROSS MARGIN**

Grossmargin from discontinued operations in the three-month and nine-month periodsended September 29, 2001 declined $567,000 and $805,000, respectively, from thecomparable periods in 2000 as a result of lower revenues during the wind downof the discontinued business segment.

 

**OPERATING EXPENSES**

Operatingexpenses from discontinued operations in the three-month period ended September29, 2001 declined $347,000, or 57 percent, from the comparable period in 2000and declined $724,000, or 44 percent, in the nine-month period as the Companyreduced staff and scaled back operations to conserve cash while looking for abuyer for the discontinued business segment. In addition, expenses in 2001 were covered only through August 3, 2001as the buyer of the assets of the discontinued business segment assumedoperating expenses from that point forward.

 

**OPERATING INCOME AND LOSS**

Discontinuedoperations reflected a loss of $643,000 during the quarter, compared to a lossof $334,000 in the third quarter of 2000, and a loss of $532,000 in thenine-month period, compared to a loss of $364,000 in the prior year, primarilyas a result of a substantial reduction in revenue offset, in part, by thereduction of operating expenses.  Anadditional loss of $528,000 was recorded during the current quarter as thecumulative losses from operations and disposition of assets exceeded the lossreserve.  (See Sale of Discontinued BusinessSegment in Notes to Financial Statements).

 

***LIQUIDITY ANDFINANCIAL CONDITION***

 

TheCompany experienced a decrease in cash and cash equivalents of $417,000 in thethree-month period ended September 29, 2001 as a result of the operating loss,and experienced an increase of $1,651,000 in the nine-month period as a resultof a successful private placement in the first quarter that raised $4,600,000which offset the operating loss and increases in inventory and receivables.  The statements of cash flows includediscontinued operations as well as continuing operations in the periodspresented.

 

Datakey’sbalance sheet reflects $5,481,000 in working capital as of September 29, 2001and a current assets to current liabilities ratio of 4.72 to 1.  The Company believes that its current cashand cash equivalents in addition to its $1 million bank line of credit willprovide sufficient funding for at least the next twelve months.

 

 

**FORWARD LOOKING STATEMENTS AND RISK FACTORS**

 

The Management’s Discussion and Analysis contains certainforward-looking statements relating to the implication that the informationsecurity product revenue will continue to improve, that fourth quarter revenuein 2001 will exceed fourth quarter revenue in 2000, that gross margins will continueto be favorable, and that the Company will be able to fund its operations forat least twelve months.  Thesestatements are subject to certain risks and uncertainties which may causeactual results to differ materially from those projected.

 

These risks and uncertainties include: (i) that market acceptance anddemand for the Company’s information security products may not increase at therate expected or may decrease due to economic, competitive or other marketconditions; (ii) that the Company may not be able to obtain continued favorablepricing for its ISS products; (iii) the introduction of competitive informationsecurity products, (iv) the ability of the Company to attain profitability andpositive cash flows by significantly increasing ISS product revenues whilecontrolling expenses; and (v) the uncertain market conditions created by thecurrent economic downturn.

 

**PART II.  OTHERINFORMATION**

 

 

 

**ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K**

(a)   Reports on Form 8-K

 

TheCompany filed a Form 8-K dated August 3, 2001 to report the sale of itsElectronic Products Business.

 

 

 

**SIGNATURES**

 

 

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

 
| Dated: November 12, 2001 | Datakey, Inc. |                                                                                                                                  |
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|                     | By:           |     /s/Alan  G. Shuler                                                                                                 |   |
|                     |          | Alan G. Shuler                                                                                                                        |   |
|                     |          |     Vice  President & Chief Financial Officer    (Principal Financial and  Accounting Officer) |