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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 June 30, 2004 Commission File Number 0-11447 DATAKEY, INC.   MINNESOTA
    
    41-1291472(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    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.  APPLICABLE ONLY TO CORPORATE ISSUERS The number of shares outstanding of the issuers common equity as of
August 2, 2004 is 11,767,254. Transitional Small Business Disclosure Format (check One):




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INDEX
Datakey, Inc.  
 Page No.PART I. FINANCIAL INFORMATIONItem 1. Financial StatementsBalance Sheets  June 30, 2004 and December 31, 2003.
    
    
    3Statements of Operations  Three and six months ended June 30, 2004 and June 30, 2003.
    
    
    4Statements of Cash Flows  Six month months ended June 30, 2004 and June 30, 2003.
    
    
    5Notes to Financial Statements.
    
    
    6Item 2. Managements Discussion and Analysis or Plan of Operation.
    
    
    6Item 3. Controls and Procedures.
    
    
    14PART II. OTHER INFORMATIONItems 1, 3, and 5 have been omitted since all items are inapplicable or answers negative.Item 2. Changes in Securities and Small Business Issuer Purchases of Equity SecuritiesItem 4. Submission of Matters to a Vote of Security Shareholders
    
    
    14Item 6. Exhibits and Reports on Form 8-K
    
    
    14Signature
    
    
    15Exhibit Index
    
    
    16Employment Agreement with David A. FesteCertification 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
 June 30,
    
    December 31,2004
    
    2003(Unaudited)
    
    (see Note)AssetsCurrent AssetsCash and cash equivalents
    
    $
    1,405,031
    
    
    $
    2,702,222Trade receivables, net
    
    
    1,482,421
    
    
    
    930,183Inventories
    
    
    926,745
    
    
    
    442,775Prepaid expenses and other
    
    
    74,458
    
    
    
    68,296Total current assets
    
    
    3,888,655
    
    
    
    4,143,476Other AssetsLicenses
    
    
    443,414
    
    
    
    445,739All other, less accumulated amortization
    
    
    37,802
    
    
    
    80,852481,216
    
    
    
    526,591Equipment and Leasehold Improvements, at costTooling, equipment, fixtures and leasehold improvements
    
    
    1,243,248
    
    
    
    1,233,030Less accumulated depreciation
    
    
    (1,153,616
    )
    
    
    (1,085,555
    )89,632
    
    
    
    147,475Total assets
    
    $
    4,459,503
    
    
    $
    4,817,542Liabilities and Stockholders EquityCurrent LiabilitiesNotes payable
    
    $
    1,821,311
    
    
    $
    1,522,951Accounts payable
    
    
    1,043,024
    
    
    
    413,864Accrued expenses
    
    
    607,590
    
    
    
    371,973Deferred revenue
    
    
    634,797
    
    
    
    306,324Total current liabilities
    
    
    4,106,722
    
    
    
    2,615,112Commitments and ContingenciesStockholders 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
    
    
    20,648,347
    
    
    
    20,621,092Accumulated deficit
    
    
    (21,258,929
    )
    
    
    (19,380,297
    )Total stockholders equity
    
    
    352,781
    
    
    
    2,202,430Total liabilities and stockholders equity
    
    $
    4,459,503
    
    
    $
    4,817,542
 Note: See Notes to Financial Statements. 3




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Datakey, Inc. 
 Statements of Operations  Unaudited
 For the Three Months Ended
    
    For the Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net sales
    
    $
    2,124,386
    
    
    $
    1,032,692
    
    
    $
    3,625,410
    
    
    $
    1,827,060Costs and expenses:Cost of goods sold
    
    
    973,315
    
    
    
    567,878
    
    
    
    1,517,000
    
    
    
    1,173,751Research and development, engineering
    
    
    506,280
    
    
    
    517,246
    
    
    
    1,003,082
    
    
    
    1,065,804Marketing and sales
    
    
    963,839
    
    
    
    706,823
    
    
    
    1,956,887
    
    
    
    1,482,540General and administrative
    
    
    214,612
    
    
    
    117,079
    
    
    
    637,177
    
    
    
    535,372Total costs and expenses
    
    
    2,658,046
    
    
    
    1,909,026
    
    
    
    5,114,146
    
    
    
    4,257,467Operating loss
    
    
    (533,660
    )
    
    
    (876,334
    )
    
    
    (1,488,736
    )
    
    
    (2,430,407
    )Interest income (expense), net
    
    
    (195,884
    )
    
    
    3,859
    
    
    
    (389,894
    )
    
    
    8,856Loss from operations before income taxes
    
    
    (729,544
    )
    
    
    (872,475
    )
    
    
    (1,878,630
    )
    
    
    (2,421,551
    )Income tax expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    $
    (729,544
    )
    
    $
    (872,475
    )
    
    $
    (1,878,630
    )
    

    $
    (2,421,551
    )Loss per share:Basic and diluted loss per share
    
    $
    (0.06
    )
    
    $
    (0.09
    )
    
    $
    (.16
    )
    
    $
    (0.24
    )Weighted-average common shares:Basic and diluted
    
    
    11,767,254
    
    
    
    10,125,261
    
    
    
    11,763,838
    
    
    
    10,119,945
 See Notes to Financial Statements. 4




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Datakey, Inc. 
 Statements of Cash Flows  Unaudited
 For the Six Months EndedMarch 31,2004
    
    2003Cash Flows From Operating ActivitiesNet loss
    
    $
    (1,878,630
    )
    
    $
    (2,421,551
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation
    
    
    78,417
    
    
    
    90,450Amortization
    
    
    344,840
    
    
    
    15,356Warrant expense
    
    
    8,600
    
    
    
    Changes in operating assets and liabilities:Trade receivable
    
    
    (552,238
    )
    
    
    771,772Inventories
    
    
    (483,970
    )
    
    
    421,474Prepaid expenses and licenses
    
    
    (3,837
    )
    
    
    (163,862
    )Accounts payable
    
    
    629,160
    
    
    
    (250,126
    )Accrued expenses
    
    
    235,617
    
    
    
    (59,986
    )Deferred revenue
    
    
    328,473
    
    
    
    63,574Net cash used in operating activities
    
    
    (1,293,568
    )
    
    
    (1,532,899
    )Cash Flows from Investing ActivitiesPurchases of equipment
    
    
    (20,574
    )
    
    
    (16,724
    )Increase in patents
    
    
    (3,430
    )
    
    
    Net cash used in investing activities
    
    
    (24,004
    )
    
    
    (16,724
    )Cash Flows from Financing ActivitiesNet proceeds from issuance of common stock
    
    
    20,381
    
    
    
    50,969Net cash provided by financing activities
    
    
    20,381
    
    
    
    50,969Decrease in cash and cash equivalents
    
    
    (1,297,191
    )
    
    
    (1,498,654
    )Cash and Cash EquivalentsBeginning
    
    
    2,702,222
    
    
    
    2,562,611Ending
    
    $
    1,405,031
    
    
    $
    1,063,957
 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 June 30, 2004, and December 31, 2003, and results of its
operations and cash flows for the three-month and six-month periods ended June
30, 2004, and June 30, 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 three-month and six-month periods ended June 30, 2004 and June
30, 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. For the three month period ended June 30, 2004,
the Company recognized expense of $8,600 from the issuance of warrants. 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. Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net loss, as reported
    
    $
    (729,544
    )
    
    $
    (872,475
    )
    
    $
    (1,878,630
    )
    
    $
    (2,421,551
    )Deduct total stock-based employee
compensation
expense determined under the fair
value-based method for all awards
    
    
    (125,285
    )
    
    
    (177,176
    )
    
    
    (270,958
    )
    
    
    (350,482
    )Net loss, pro forma
    
    $
    (854,829
    )
    
    $
    (1,049,651
    )
    
    $
    (2,149,588
    )
    
    $
    (2,772,033
    )Basic and diluted loss per share, as reported
    
    $
    (0.06
    )
    
    $
    (0.09
    )
    
    $
    (0.16
    )
    
    $
    (0.24
    )Basic and diluted loss per share, pro forma
    
    $
    (0.07
    )
    
    $
    (0.10
    )
    
    $
    (0.18
    )
    
    $
    (0.27
    )
 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 $1.4
million, will provide sufficient liquidity to fund 2004 operations, provided
the maturity date of a $2,000,000 convertible promissory note is extended from
October 17, 2004 into 2005. The Company believes the secured convertible
promissory note holders are likely to 6




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approve a short-term extension of the maturity date of the convertible
promissory note, but it expects such an extension could result in significant
additional dilution to current shareholders. To date, the Company has not
agreed to terms that would result in a conversion or an extension of the
maturity date of the notes. If the Company does not agree to terms for an
extension of the maturity date of the secured convertible promissory notes and
is unsuccessful in obtaining additional new financing by October 17, 2004, the
Company will be unable to repay the secured convertible promissory note holders
and would be in default. In the event of a default, the secured convertible
promissory note holders have a first security interest in substantially all of
the Companys assets and may take legal action to collect amounts due under the
notes, which could include the sale of the Companys intellectual property and
inventories, assignment and collection of accounts receivable and/or the
commencement of an involuntary liquidation of the Company. The Company is
exploring other sources of funding from accredited investors who have expressed
an interest in the Company, but it does not have any binding commitments for
such funding at this time. The Company cannot be certain that additional
financing will be available on favorable terms, or at all. Even if the Company
is successful in obtaining new financing or term extensions of the existing
notes payable, it is believed substantial additional dilution to current
shareholders will be the likely result. 
 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 in 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 2-factor authentication solutions supporting PKI, password and
other authentication methods, our product and service offering is Datakey Axis.
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 for us 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. Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Revenue
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Cost of goods sold
    
    
    46
    
    
    
    55
    
    
    
    42
    
    
    
    64Gross margin
    
    
    54
    
    
    
    45
    
    
    
    58
    
    
    
    36
 7




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##### Table of Contents



Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Cost and Expenses:Research and development, engineering
    
    
    24
    
    
    
    50
    
    
    
    28
    
    
    
    58Marketing and sales
    
    
    45
    
    
    
    68
    
    
    
    54
    
    
    
    81General and administrative
    
    
    10
    
    
    
    11
    
    
    
    17
    
    
    
    29Total cost and expenses
    
    
    79
    
    
    
    129
    
    
    
    99
    
    
    
    168Operating loss
    
    
    (25
    )
    
    
    (84
    )
    
    
    (41
    )
    
    
    (132
    )Interest income (expense), net
    
    
    (9
    )
    
    
    
    
    
    
    (11
    )
    
    
    Loss before income taxes
    
    
    (34
    )
    
    
    (84
    )
    
    
    (52
    )
    
    
    (132
    )Income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    
    (34
    )%
    
    
    (84
    )%
    
    
    (52
    )%
    
    
    (132
    )%
 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 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 8




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expense of $84,000 in the six-month period ended 2003 and included this expense
in cost of goods sold. We did not incur impairment expense in the three or
six-month periods ended June 30, 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 $10,060,000 and
$9,375,000, at June 30, 2004 and December 31, 2003, respectively, to reduce the
carrying value of our deferred tax assets to zero. 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 $31,000 and $31,000 at June 30, 2004 and December 31, 2003,
respectively, and reserves for slow moving and obsolete inventories of $129,000
and $119,000 at June 30, 2004 and December 31, 2003, respectively. Results of Operations Comparison of Three and Six-Month Periods Ended June 30, 2004 and 2003 Total revenue:Net sales of our products and services for the three and
six-month periods of 2004 were $2,124,000 and $3,625,000, respectively,
compared to $1,033,000 and $1,827,000, respectively, for the comparable periods
of 2003. The increase in net sales of $1,091,000 and $1,798,000, respectively,
resulted from (1) a substantial increase in spending by certain financial and
governmental customers of Datakey CIP and CMS products, (2) service and
hardware revenues related to a biometric authentication solution for a project
commissioned by the U.S. State Department and (3) licensing revenue from an
original equipment manufacturer. During 2004, we announced (1) the signing of a
multi-year sales agreement with a U.S. financial services organization for
delivery of Datakey CIP and Datakey CMS authentication solutions, which
contributed more than $400,000 to revenue in the six-month period ended June
30, 2004, and is expected to contribute approximately $2.4 million of
additional revenue over several quarters beginning in the second quarter of
2005, (2) a project to add biometric authentication to a smart ID badge
deployment for the U.S. State Department, which has contributed approximately
$1.0 million to revenue in the six-month period ended June 30, 2004, and is
expected to contribute additional revenue in subsequent quarters, and (3) our
first four important Datakey Axis deployments. 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 178 new customers
added during the first half of this year, coupled with the continued growth in
our pipeline of sales opportunities. 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 $16.0 million over the next four quarters, which is an increase
of more than 88% from the fourth quarter of last year. Datakey Axis is an
important reason for the growth in our pipeline. Gross margins: For the three and six-month periods of 2004, product gross
margins were 54% and 58%, respectively, compared to 45% and 36% of revenue for
the comparable periods of 2003. Gross margin percentages increased by 9 and 22
percentage points, respectively, principally because of a greater percentage of
higher gross margin software products in the sales mix, as well as high margin
service and licensing revenues that were earned during these periods. In
addition, gross margins in the first six months of 2003 were negatively
affected by an $84,000 impairment expense related to a revaluation of certain
prepaid licenses. Our gross margin percentage in the second quarter of 2004 was
ten percentage points lower than our gross margin percentage in the first
quarter of 2004 because of a higher level of lower margin hardware products in
the sales mix. 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 9




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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: For the three and
six-month periods of 2004, we incurred research and development, engineering
and technical support expense of $506,000 (24% of revenue) and $1,003,000 (28%
of revenue), respectively, compared to $517,000 (50% of revenue) and $1,066,000
(58% of revenue), respectively, for the comparable periods of 2003. Research
and development, engineering and technical support expense decreased by $11,000
and $63,000, respectively, primarily because of a reduction in payroll costs
associated with a head count reduction that occurred late in the first half of
2003. We expect research and development, engineering and technical support
expense for full-year 2004 to be higher than 2003 due to personnel additions we
are planning in the second half of 2004. Marketing and sales: For the three and six-month periods of 2004, we incurred
marketing and sales expense of $964,000 (45% of revenue) and $1,957,000 (54% of
revenue), respectively, compared to $707,000 (68% of revenue) and $1,483,000
(81% of revenue), respectively, for the comparable periods of 2003. Marketing
and sales expense increased by $257,000 and $474,000, respectively, primarily
because of 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. General and administrative:For the three and six-month periods of 2004, we
incurred general and administrative expense of $215,000 (10% of revenue) and
$637,000 (17% of revenue), respectively, compared to $117,000 (11% of revenue)
and $535,000 (29% of revenue), respectively, for the comparable periods of
2003. General and administrative expense increased by $98,000 and $102,000,
respectively, primarily because of higher professional and consulting fees
which were partly offset by lower severance costs. We expect general and
administrative expense for full-year 2004 to be higher than 2003 due to costs
related to the replacement of an officer during the first quarter of 2004 and
for higher professional and consulting fees. Interest income (expense), net:For the three and six-month periods of 2004, we
incurred net interest expense of $196,000 (9% of revenue) and $390,000 (11% of
revenue), respectively, compared to net interest income of $4,000 and $9,000,
respectively, for the comparable periods of 2003. Net interest expense
increased by $200,000 and $399,000, respectively, because of 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 $1,746,000 from $1,528,000 at December 31, 2003 to $(218,000) at
June 30, 2004. Cash decreased by $1,297,000 from $2,702,000 at December 31,
2003 to $1,405,000 at June 30, 2004. We used $1,302,000 of cash to fund
operating activities. The adjustments to reconcile our cash flow from
operations consist primarily of an increase in trade receivables due to higher
levels of sales and an increase in inventories to support higher levels of
sales, which are more than offset by non cash charges for depreciation and
amortization, higher levels of accounts payable due to our decision to stretch
payment terms on selected vendors, and higher levels of accrued expenses and
deferred revenue. The largest single component of our working capital is the
convertible promissory notes payable of $1,821,000 and related accrued interest
expense of $141,000, which are classified as current liabilities due to the
contractual maturity date of October 17, 2004. 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, provided the maturity date of the
outstanding secured convertible debt is extended to at least March 31, 2005. We
have met with representatives of the Companys secured convertible promissory
note holders to negotiate terms that would result in either the conversion 10




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of the notes to preferred stock or an extension of the October 17, 2004
maturity date. To date, we have not agreed to terms that would result in a
conversion or an extension of the maturity date of the notes. However, we
believe the Companys secured convertible promissory note holders are likely to
approve a short-term extension of the maturity date of the convertible
promissory note, but we expect such an extension would likely result in
significant additional dilution to current shareholders. If we do not agree to
terms for an extension of the maturity date of the secured convertible
promissory notes and we are unsuccessful in obtaining additional new financing
by October 17, 2004, the Company will be unable to repay the secured
convertible promissory note holders and would be in default. In the event of a
default, the secured convertible promissory note holders have a first security
interest in substantially all of the Companys assets and may take legal action
to collect amounts due under the notes, which could include the sale of the
Companys intellectual property and inventories, assignment and collection of
accounts receivable and/or the commencement of an involuntary liquidation of
the Company. We are exploring other sources of funding from accredited
investors who have expressed an interest in the Company, but we do not have any
binding commitments for such funding at this time. We cannot be certain that
additional financing will be available on terms favorable to us, or at all.
Even if we are successful in obtaining new financing or term extensions of the
existing notes payable, we believe substantial additional dilution to current
shareholders will be the likely result. 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 two
quarters of 2004 total $72,000 and debt and related accrued interest associated
with the convertible promissory notes could total $2,200,000 on October 17,
2004. Approximately $45,000 of our total lease obligations of $72,000 relate to
our office and warehouse lease, which expires on December 31, 2004. 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. We received and shipped the hardware products in the second
quarter of 2004 and fulfilled this customers order in full. 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 a
contract with a U.S. financial services organization that anticipates adding
approximately $2.4 million in revenues over several quarters, beginning in the
second quarter of 2005; and additional revenues from a biometric authentication
project for the U.S. State Department smart ID badge deployment that has
already contributed approximately $1.0 million to revenue in the six-month
period ended June 30, 2004, and is expected to contribute additional revenue in
subsequent quarters. Our expected pipeline of $16.0 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 11




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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 provided the
maturity date of the outstanding secured convertible debt is extended to at
least March 31, 2005. However, if we do not agree to terms for an extension of
the maturity date of the secured convertible debt and we are unsuccessful in
obtaining additional new financing by October 17, 2004, our cash and cash
equivalents together with expected revenues from operations will not be
sufficient to repay the outstanding convertible debt, and we will be in
default. 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; our
past losses and expected future losses cast doubt on our ability to operate
profitably; we rely on third parties to market, distribute and sell our
products and those third parties may not perform; 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; raising the required
capital to conduct our operations and develop our products is time critical;
our common stock is traded on the OTC Bulletin Board, which may affect its
market price and liquidity; success of our new product, Datakey Axis, depends
on commercial acceptance and demand; the price of our Common Stock has
significantly decreased since January 2003; we face the risks related to rapid
technological change; we face significant price competition; our success is
highly dependent on our ability to retain our management team and technical
expertise; and we may not be able to adequately enforce or protect our
intellectual property rights or to protect ourselves against infringement
claims by others. All forward-looking statements are qualified by, and should
be considered in conjunction with, such cautionary statements. Our past losses and expected future losses cast doubt on our ability to operate
profitably. The last twelve month period that we reported net income was for our fiscal
year ended December 31, 1995. Since December 31, 1995 and through June 30,
2004, we have accumulated losses in the aggregate of $27,068,000. 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. 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 than we would like. 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 will likely fail to grow as expected or may decline. Raising the required capital to pay off existing notes, or extending the due
date is time critical. See Liquidity and Capital Resources Our Common Stock is traded on the OTC Bulletin Board, which may affect its
market price and liquidity. 12




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Our common stock 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. 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
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 last nineteen
months, from a high of $1.92 on January 7, 2003 to a low of $0.40 on July 16,
2004. The overall decrease over this period is due in part to a decrease in the
market for certain technology related stocks during this time period, the
delisting of our common stock by the Nasdaq Stock Market on November 12, 2003
and our working capital position during 2004. Other factors that could
adversely affect our stock price include:  
    
    unavailability of alternative future sources of financing and the
anticipated dilution to current shareholders if financing or an
extension is obtained;  
    
    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. 13




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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 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 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 2. CHANGES IN SECURITIES AND SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES On June 17, 2004, we issued a five-year warrant with an effective issuance date
of September 3, 2003 to purchase 50,000 shares of common stock at $0.70 per
share to a financial advisor. The Company relied upon the exemption in Section
4(2) of the Securities Act, which provides an exemption for transactions not
involving a public offering. 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY SHAREHOLDERS The Company held its Annual Meeting on Wednesday, May 26, 2004. Proxies for the Annual Meeting were solicited pursuant to Regulation 14 under
the Securities Exchange Act of 1934. There was no solicitation in opposition to
managements nominee as listed in the Companys proxy statement, and that
nominee was elected. By 10,520,508 votes in favor, with 366,460 votes opposed, and 8,475 votes
abstaining, the shareholders set the number of directors at four (4). The shareholders elected the nominee named below as a Class III Director, to
serve a three-year term, pursuant to the following votes: Votes Cast forNominee
    
    the Director
    
    Votes WithheldTerrence W. Glarner
    
    
    10,785,058
    
    
    
    110,385
 14




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The terms of Eugene Courtney, Thomas King, and Timothy Russell, as directors of
the Company, continued after the meeting. The shareholders also ratified the appointment of McGladrey and Pullen, LLP, as
independent auditors for the Company, for the fiscal year ending December 31,
2004, by 10,839,228 votes in favor, with 46,165 votes opposed, and 10,050 votes
abstaining. 
 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 April 29, 2004, was filed announcing its 2004 first quarter
financial results. 15




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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: August 9, 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)
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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 August 1, 2004, between David A. Feste and the Company**31.1*
    
    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. 17