**Table
      of Contents**









**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


Washington,
      D.C. 20549










**FORM
      10-K**








x  ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934




For
      the
      Fiscal Year Ended September 30, 2006




o  TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For
      the
      Transition Period From _____ to _____





COMMISSION
      FILE NUMBER 0-24765





**hi/fn,
      inc.**


(Exact
      Name of Registrant as specified in its Charter)





**Delaware**
            **33-0732700**(State
                or other jurisdiction of
            (IRS
                Employerincorporation
                or organization)
            Identification
                Number)





**750
      University Avenue, Los Gatos, California 95032**


(Address
      of principal executive offices and Zip Code)





Registrant’s
      telephone number, including area code: **(408)
      399-3500**





Securities
      registered pursuant to Section 12(b) of the Act:





**Common
                Stock, $0.001 Par Value**
            **Nasdaq
                Global Market**(Title
                of Each Class)
            (Name
                of Exchange on Which Registered)





Securities
      registered pursuant to Section 12(g) of the Act:


**None**


(Title
      of
      Class)




Indicate
      by check mark if the Registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act.




YES
o
      NO þ





Indicate
      by check mark if the Registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Act.




YES
o
      NO þ





Indicate
      by check mark whether the Registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the Registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.




YES
þ
      NO o




**Table
            of Contents**


Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the best
      of registrant’s knowledge, in definitive proxy or information statements
      incorporated by reference in Part III of this Form 10-K or any amendment to
      this
      Form 10-K.




o





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of
      the
      Exchange Act).





Large
      accelerated filer o Accelerated
      filer þ Non-accelerated filer o





Indicate
      by check mark whether the Registrant is a shell company (as defined in Rule
      12b-2 of the Act).




YES
oNO
þ





The
      aggregate market value of the voting and non-voting common equity held by
      non-affiliates of the Registrant as of March 31, 2006 was $28,793,398 (based
      upon the closing price reported on the NASDAQ Global Market as of the last
      business day of the Registrant’s most recently completed second fiscal quarter).
      For purposes of this disclosure, shares of Common Stock held by persons who
      hold
      more than 5% of the outstanding shares of Common Stock and shares held by
      officers and directors of the Registrant have been excluded in that such persons
      may be deemed to be affiliates. This determination of affiliate status is not
      necessarily conclusive.





The
      number of shares outstanding of the Registrant’s Common Stock as of December 11,
      2006, was 13,969,763.








**DOCUMENTS
      INCORPORATED BY REFERENCE**





Parts
      of
      the Proxy Statement for Registrant’s 2007 Annual Meeting of Shareholders to be
      held February 20, 2007 (the “Proxy Statement”) are incorporated by reference
      into Part III of this Form 10-K Report.









**Table
          of Contents**





Part
                IItem
                1. BusinessItem
                1A. Risk FactorsItem
                1B. Unresolved Staff CommentsItem
                2. PropertiesItem
                3. Legal ProceedingsItem
                4. Submission of Matters to a Vote of Security
                HoldersPart
                IIItem
                5. Market for the Registrant’s Common Equity, Related
                Stockholder Matters and Issuer Purchases of Equity
                SecuritiesItem
                6. Selected Financial DataItem
                7. Management’s Discussion and Analysis of Financial
                Condition and Results of OperationsItem
                7A. Quantitative and Qualitative Disclosure About
                Market RiskItem
                8. Financial Statements and Supplementary
                DataREPORT
                OF INDEPENDENT AUDITORSItem
                9. Changes in and Disagreements with Accountants on
                Accounting and Financial DisclosureItem
                9A. Controls and ProceduresPart
                IIIItem
                10. Directors and Executive Officers of the
                RegistrantItem
                11. Executive CompensationItem
                12. Security Ownership of Certain Beneficial Owners
                and Management and Related Stockholder MattersItem
                13. Certain Relationships and Related
                TransactionsItem
                14. Principal Accountant Fees and
                ServicesPart
                IVItem
                15. Exhibits and Financial Statement
                SchedulesSIGNATURESINDEX
                TO EXHIBITSEXHIBIT
                10.31EXHIBIT
                10.32EXHIBIT
                10.33EXHIBIT
                10.34EXHIBIT
                10.35EXHIBIT
                21.1EXHIBIT
                23.1EXHIBIT
                31.1EXHIBIT
                31.2EXHIBIT
                32.1EXHIBIT
                32.2




**Table
          of Contents**




TABLE
      OF CONTENTS





Page


**PART
      I**





Item
                1.
            Business
            1Item
                1A.
            Risk
                Factors
            12Item
                1B.
            Unresolved
                Staff Comments
            20Item
                2.
            Properties
            21Item
                3.
            Legal
                Proceedings
            21Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            21





**PART
      II**


Item
                  5.
              Market
                  for Registrant’s Common Equity, Related StockholderMatters and Issuer Purchases of Equity Securities
              23Item
                  6.
              Selected
                  Financial Data
              24Item
                  7.
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              25Item
                  7A.
              Quantitative
                  and Qualitative Disclosure About Market Risk
              37Item
                  8.
              Financial
                  Statements and Supplementary Data
              38Item
                  9.
              Changes
                  in and Disagreements with Accountants on Accounting and Financial
                  Disclosure
              60Item
                  9A.
              Controls
                  and Procedures
              60




**PART
      III**





Item
                10.
            Directors
                and Executive Officers of the Registrant
            61Item
                11.
            Executive
                Compensation
            61Item
                12.
            Security
                Ownership of Certain Beneficial Owners and Managementand Related Stockholder Matters
            61Item
                13.
            Certain
                Relationships and Related Transactions
            61Item
                14.
            Principal
                Accountant Fees and Services
            61





**PART
      IV**


Item
                  15.
              Exhibits
                  and Financial Statement Schedules
              62SIGNATURES
              
              64


**Table
            of Contents**




**CAUTIONARY
      STATEMENT REGARDING FORWARD-LOOKING STATEMENTS**





*With
      the exception of historical facts, the statements contained in this Annual
      Report on Form 10-K are forward-looking statements within the meaning of Section
      27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
      Exchange Act of 1934, as amended (the “Exchange Act”), and are subject to the
      safe harbor provisions created by such statutes. Certain statements contained
      herein, including, without limitation, statements containing the words
“believes,” “anticipates,” “estimates,” “expects,” and words of similar import,
      relating to matters including, but not limited to: (i) the relationship between
      the Company’s technology and competitive advantage; (ii) the effect of our
      ongoing product and technology development on product integration and
      performance; (iii) our belief that our patented compression technology comprises
      the fundamental know-how for the design and implementation of low-cost
      high-performance implementation of lossless data compression and is the
      recognized de facto standard; (iv) the increase of competition from existing
      and
      new competitors, including major domestic and international semiconductor
      suppliers; (v) our expectation that we will have an adequate opportunity to
      order sufficient quantities of products; (vi) the impact of U.S. export
      regulations on our European competitors; (vii) the competitive factors in our
      markets; (viii) the impact of our distribution agreement on global demand for
      network security products; (ix) the importance of our comprehensive product
      service and support on our market position and design efficiency; (x) the
      reliance on subcontract manufacturers for substantially all manufacturing;
      (xi)
      the communications from third parties asserting patents, mask works rights,
      intellectual property or copyrights on certain products and technologies; (xii)
      the sufficiency of our alternate suppliers; (xiii) the impact of the transition
      of our products to smaller semiconductor dimensions; (xiv) the retention of
      future earnings and dividend policies; (xv) our investment in Research and
      Development; (xvi) our level of capital expenditures; (xvii) the sufficiency
      of
      our existing cash resources for the next twelve months; (xviii) future operating
      results; (xix) our belief that international sales will continue to grow; (xx)
      the composition of our customer base; (xxi) the anticipated average selling
      prices of our products; (xxii) estimates of future contractual commitments;
      (xxiii) the application of net proceeds of our February 6, 2005 private
      placement; (xxiv) our belief that employee relations are good; (xxv) the
      fluctuating market price of our common stock; and (xxvi) future performance
      of
      our investment portfolio constitute forward-looking statements that involve
      risks and uncertainties. Such statements are based on current expectations
      and
      are subject to risk, uncertainties and changes in condition, significance,
      value
      and effect, including those discussed within the section of this report entitled
      “Item 1A. Risk Factors” and reports filed by hi/fn, inc. with the Securities and
      Exchange Commission, specifically Forms 8-K and 10-Q. Such risks, uncertainties
      and changes in condition, significance, value and effect could cause our actual
      results to differ materially from those anticipated events. Although we believe
      that the assumptions underlying the forward-looking statements are reasonable,
      any of the assumptions could prove inaccurate, including, but not limited to,
      statements as to our future operating results and business plans. We disclaim
      any intention or obligation to update or revise any forward-looking statements,
      whether as a result of new information, future events or
      otherwise.*








**PART
      I**





**Item
      1.*****Business***




**Overview**





hi/fn,
      inc., together with its subsidiaries, Hifn Limited, Hifn Netherlands B.V. and
      Hifn International and its subsidiary, Saian (Hangzhou) Microsystems, Co.,
      Ltd.,
      together with Hangzhou Ansai Information Technology Co., Ltd., a contractually
      controlled company of Hifn International, (collectively
      referred to as “Hifn,” “we,” “us” or “our”) is a network- and storage-security
      market leader, as recognized by independent industry analyst firms, including
      The Linley Group, that supplies most major network equipment manufacturers
      (“OEM”) with patented technology to protect information at risk, whether it is
      in transit data or data at rest. Hifn designs, develops and markets both
      hardware and software solutions to a targeted customer base of networking-,
      security- and storage-OEMs. Our solutions are attractive to customers because
      they feature high-performance, including some of the fastest compression
      processing speeds available in the market, multi-protocol capabilities,
      development tools and board level products that help reduce their
      time-to-market. Our processor solutions perform the computation-intensive tasks
      of compression, encryption and authentication, providing our customers with
      high-performance, interoperable implementations of a wide variety of
      industry-standard networking and storage protocols. Our network- and
      security-processors, compression, flow classification and content search
      solutions are used in networking, security and storage equipment such as
      routers, remote access concentrators, Virtual Private Networks (“VPN”), Virtual
      Tape Libraries (“VTL”), switches, broadband access equipment, network interface
      cards, firewalls and back-up storage devices.





The
      Hifn
      encryption/compression and public key processors allow network equipment vendors
      to add security functions to their products. Our encryption/compression and
      public key processors provide industry-recognized algorithms that are used
      in
      products, such as VPNs, which enable businesses to reduce wide area networking
      costs by replacing dedicated leased-lines with lower-cost IP-based networks
      such
      as the Internet. Using VPNs, businesses can also provide customers, partners
      and
      suppliers with secure, authenticated access to the corporate network, increasing
      productivity through improved communications. Storage equipment vendors use
      our
      compression processor products and recently announced VTL *Express* boards
      to improve the performance and capacity of a


-1-
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          of Contents**




wide
      range of disk and tape back-up systems. For example, Storage OEMs who design
      in
      a Hifn VTL *Express* board
      can offer their customers a storage solution that reduces the time to back-up
      their systems by 50%, saving time and money for the company.





Hifn’s
      flow classification technology enables network equipment vendors to add unique
      traffic differentiation and recognition capabilities to their products. Our
      flow
      classification solutions provide precise details about packets and data
      traversing a network and are used in implementing and monitoring quality of
      service (“QoS”) and class of service (“CoS”), which enables businesses to
      enhance the effectiveness of their systems. Using QoS- or CoS-enabled network
      equipment, businesses can provide differentiated services to their customers
      or
      build new revenue streams based on available services. This capability is
      becoming more important to customers and end users as corporate networks are
      being flooded with VoIP and Video traffic. These types of traffic require the
      highest level of QoS to maintain its integrity and usefulness.





Additionally,
      Hifn announced in 2006 Hifn Pattern Matching (“HPM”) technology which
      accelerates regular expression pattern matching, a key search function in
      security systems such as, Anti-Virus, Anti-Spam and Intrusion
      Detection/Prevention. HPM contains
      “rule compression” technology that creates a highly compact rules database
      format. The database, along with HPM’s small code footprint, can reside in a
      microprocessor cache enabling the search function to run at the speed of the
      processor. Network edge security devices and Unified Threat Management (“UTM”)
      appliances all have the same fundamental limitation: they can only process
      packets at the speed they can detect signatures.





Hifn’s
      network processor technology, acquired from International Business Machines
      Corporation (“IBM”), complements our security processor business and expands our
      product offerings to include a programmable, yet deterministic, device that
      performs computation-intensive, deep packet inspection for high-touch services.
      The architecture of our network processor is unique and is an architecture
      used
      with applications that require high-touch services.





**General**




Stac,
      Inc. (“Stac”) incorporated Hifn as a wholly owned subsidiary on August 14, 1996.
      On November 21, 1996, Stac transferred its semiconductor business, along with
      the associated technology, assets and liabilities, to Hifn in exchange for
      6,000,000 shares of Hifn Series A Preferred Stock and 100 shares of Hifn Common
      Stock pursuant to a Stock Purchase Agreement.





On
      March
      25, 1999, the Company completed its initial public offering when it was spun
      off
      from Stac, Inc. The initial public offering raised approximately $49.2 million,
      net of offering expenses, followed by an additional $9.3 million when the
      Company’s underwriters exercised their option to purchase additional shares of
      Hifn’s Common Stock on April 19, 1999.




**Industry
      Background**





The
      need
      for a more effective use of the public network infrastructure in a business
      environment is one of the main drivers of the extensive deployment of
      network-based communications systems. The resulting increase in connectivity
      has
      further driven the need for technology that safeguards and manages the access
      to
      information available over these expanding global networks.





The
      network computing market has undergone several major transitions over the past
      decade and it is the convergence of these transitions that contributed to the
      recent increase in global connectivity. One of these transitions was the
      migration of corporate computing environments from centralized mainframe systems
      to distributed client/server environments. The ability to access and share
      information through client/server technology expanded the need for connectivity
      beyond workgroup local area networks (“LAN”) to enterprise-wide networks
      spanning multiple LANs and wide area networks (“WAN”). Another transition was
      the widespread adoption of the Internet for business-to-business communications.
      Internet-based business applications have expanded beyond e-mail to a broad
      range of business applications and services including electronic publishing,
      direct to customer transactions, product marketing, advertising and customer
      support. Yet another transition was the emergence of consumer-to-business or
      e-commerce communications. The convergence of these major transitions led to
      the
      need for secure, managed communications and the emergence of VPNs that use
      the
      Internet infrastructure and associated protocols and applications to share
      information and services both within the enterprise and with business partners
      and customers. As a result of adding security to the network infrastructure,
      businesses are able to share internal information and run enterprise
      applications across geographically dispersed facilities as well as enable
      customers, suppliers and other business partners to inexpensively link into
      their enterprise information systems. As businesses and consumers demand more
      functionality from their networks, and as they adopt wireless networks into
      their infrastructure, the need for layered security, while maintaining
      performance, will be a driving factor for products such as our network-,
      security- and compression-processors.







-2-
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          of Contents**




**The
      Complexity of and Need for Network Security**




Driven
      to
      provide the significant benefits of connectivity and information exchange,
      organizations potentially expose sensitive information and mission critical
      applications to unauthorized access, both through connections to the Internet
      and from within the enterprise. In addition, transmission of data over the
      Internet may also expose such data to unauthorized interception. These risks
      create a critical need for enterprises to protect their information and
      information systems from unauthorized access and use. Historical methods for
      securing information resources are no longer adequate to meet the security
      requirements of today’s global networks. Today’s distributed network
      environments provide multiple points of access and multiple network resources,
      making it impractical to individually secure every application and resource
      on
      the network. Therefore, additional layers of security at the network level
      are
      required to control access to the network and to regulate and protect the flow
      of data between network segments.





The
      increasing demands placed on data communication security systems by the
      expansion of Internet services and global enterprise networking quickly outpaces
      the capabilities of many traditional Internet security appliance architectures.
      These demands include the need to define and transparently enforce an
      integrated, enterprise-wide security policy that can be managed centrally and
      implemented on a distributed basis. An effective network security solution
      also
      needs to be open and extensible to enable it to address the rapidly changing
      requirements of the Internet and intranets, including the addition of new
      security applications, such as authentication, encryption, URL filtering,
      anti-virus protection, spyware, intrusion detection and Java and ActiveX
      security services and functions. This increased complexity, along with the
      higher demand placed by ever-increasing bandwidths and storage requirements,
      some of which are driven by regulations, and the increasing number of users
      has
      given rise to the creation of data communications semiconductors specifically
      designed for the security task. These high-performance security integrated
      circuits create the next generation security platform for our customers based
      on
      a combination of protocol features, customer complex core logic and
      standards-based buses and interfaces. This is at the core of Hifn’s network
      security processor products.




**The
      Hifn Solution**





Hifn
      is a
      network and security market leader that supplies most major network and security
      equipment vendors with patented technology to accelerate and secure end-customer
      data. We design, develop and market high-performance, multi-protocol devices,
      boards and software to protect information at risk, whether it is “in-transit”
traveling across the network or “at-rest” stored on a tape- or disk-drive. We
      provide our customers with high-performance, interoperable implementations
      of a
      wide variety of industry-standard networking and storage protocols by offering
      efficient compression, encryption/compression and public key cryptography
      products and solutions. We believe that our patented compression technology
      comprises the fundamental know-how for the design and implementation of
      low-cost, high-performance implementations of lossless data compression and
      is
      the recognized de-facto standard, which gives our products a strong competitive
      advantage. By offering a wide range of high-performance implementations of
      our
      patented, standards-compliant technology, we are able to sell products to
      network and storage equipment vendors that allow them to reduce development
      costs and get their products to market faster.





Our
      patented Lempel-Ziv-Stac compression technology (“LZS”) is incorporated into
      several networking protocol standards, including Point-to-Point Protocol (“PPP”)
      and the frame relay protocol, allowing network equipment vendors to rapidly
      integrate proven solutions for mitigating the costs associated with traditional
      private leased-line network architectures. The Microsoft Point-to-Point
      Compression (“MPPC”) implementation of our patents, developed by Microsoft, is
      incorporated into the PPP and Point-to-Point Tunneling Protocol (“PPTP”)
      implementations of the Windows 95, 98, ME, NT, 2000 and XP operating systems.
      We
      offer high-performance compression processors that implement LZS and MPPC.
      We
      also license software implementations of LZS and MPPC to industry-leading
      network equipment vendors for use in their networking products.





In
      support of VPN architectures, we introduced the first network security
      processors, integrating the critical functions of compression, encryption and
      data authentication in compliance with the Internet Protocol Security (“IPsec”),
      Secure Session Layer (“SSL”), Transport Layer Security (“TLS”) and proposed
      Advanced Encryption Standard (“AES”) ciphersuite extensions to TLS protocols.
      This integration allows network equipment vendors to add highly-integrated,
      high-performance VPN capabilities to their routers, remote access concentrators,
      session border controllers, switches, broadband access equipment and firewalls.





Businesses
      rely on the Internet to conduct their normal business operations. Unlike the
      traditional telecommunications network used by businesses to communicate, such
      as the fixed-line telephone, the Internet is vastly more complex, unreliable
      and
      generally not secure. In addition, there is an overall lack of differentiation
      or prioritization of business-critical applications from general use of the
      Internet. These applications tend to be bundled together and use the same
      resources throughout the Internet. Our flow classification solutions enable
      the
      integration of precise differentiation and measurement of business-critical
      transactions within network equipment vendors’ devices. This feature allows the
      creation of differentiated services within the Internet, enabling our OEM
      customers to provide valuable services to their customers.




-3-
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          of Contents**


Hifn’s
      line
      of compression processors and boards are targeted at back-up storage
      applications providing storage equipment vendors with high-performance
      implementations of our patented compression technology, doubling the capacity
      and performance of mid- to high-end VTLs and tape drive systems. The LZS
      implementation of our patents is used in the Digital Linear Tape (“DLT”) drive
      products from Quantum. The Adaptive Lossless Data Compression (“ALDC”)
      implementation of our patents, developed by IBM, is used in a variety of tape
      storage products, including the Linear Tape Open (“LTO”) drives and Travan style
      of quarter-inch cartridge tape drives. Additionally, our compression products
      provide companies in the storage market that develop disk-to disk- and the
      disk-to-disk-to-tape-back-up products with solutions that meet their performance
      and capacity requirements.




**Customers
      and Products**





A
      number
      of leading manufacturers of network and storage equipment have designed products
      that incorporate the Hifn solutions. To date, we have secured design wins with
      a
      number of networking, security and storage equipment vendors. To qualify as
      a
      design win, an equipment vendor must have ordered samples of our products or
      an
      evaluation or reference board and initiated a product design that incorporates
      our solutions. During the design-in process, we work with each customer,
      providing training on our products, assisting in resolving technical questions
      and providing price and delivery information to assist the customer in getting
      our products into volume production. We cannot assure that any of the design
      wins we have secured will result in demand for our products. See “Item 1A. Risk
      Factors — Our Business Depends Upon The Development Of The Packet Processor
      Market” and “— We Face Risks Associated With Evolving Industry Standards And
      Rapid Technological Change.”





At
      September 30, 2006, we had a backlog of semiconductor orders representing $10.6
      million of products deliverable to customers over the 6 months following the
      placement of these orders. At September 30, 2005, we had a backlog of $8.5
      million. Because we quote product lead times to customers of approximately
      three
      to five months, most products shipped during a quarter are ordered during the
      previous quarter. Since customers may reschedule or cancel orders, subject
      to
      negotiated windows, orders scheduled for shipment in a quarter may be moved
      to a
      subsequent quarter or cancelled altogether. Therefore, backlog is not
      necessarily indicative of future sales.





Hifn’s
      products — compression processors/boards, encryption/compression
      processors/boards, public key processors, network processors and flow
      classification and pattern matching software — provide a broad range of
      price/performance alternatives for the implementation of intelligent, secure,
      high-performance networks and efficient, high-performance storage devices.
      We
      also offer evaluation boards to assist customers in the evaluation of our
      products. All of Hifn’s products work to protect information at risk, whether
      that information is in transit or at rest.





*Network
      Bandwidth Enhancement Products.* Hifn’s
      9710, 9711 and 9751 compression processors provide essential
      bandwidth-enhancement for network equipment such as routers, remote access
      concentrators, broadband access equipment and switches. These products provide
      flexible bus interfaces and a variety of memory configuration options to allow
      customers to tailor their uses to meet a variety of network system requirements.
      We license a line of software compression libraries that provide similar
      functionality to our line of compression processor products for ‘real-estate’
constrained applications in lower-bandwidth products such as modems and ISDN
      links. Our software products are offered in source and object code
      toolkits.





*Network
      Security Products* .
      Current
      networking products demand strong security features that can operate at
      multi-gigabit per second speeds without slowing down a system’s central
      processing unit (“CPU”) with computationally intensive cryptographic processing.
      Hifn offers a wide selection of security processors that meet the needs of
      current and future networking equipment for fast cryptography without excessive
      system overhead.




Look-aside
      processors operate as a co-processor to the system CPU or network processing
      unit (“NPU”) to accelerate security functions. All of our security
      processors offer a full suite of security algorithms, data compression,
      symmetric key cryptography, public key cryptography, data
      authentication and true random number generation. We offer two
      families of look-aside security processors. Our Hifn Intelligent
      Packet Processor (“HIPP”) I and HIPP II products offload all aspects of
      IPsec or SSL packet processing at rates up to over two gigabits per
      second. For network elements with lower throughput demands and tighter cost
      constraints, we offer algorithm accelerator products which are low cost devices
      that offer the same security functions as the high end HIPP processors
      but depend on the host CPU to perform packet manipulation. Hifn’s line of
      HIPP I and II processors (7855 and 8155) and algorithm accelerators (7954,
      7955
      and 7956) are actively being sold into new designs.




Hifn
      also
      maintains production of the 6500 public key processor, 7901, 7902
      and 7951 algorithm accelerators, 7711, 7751 and 7811 encryption processors,
      and
      7814, 7851 and 7854 packet processors, which are in full production design
      with
      customers.





We
      have
      also introduced a new family of board level products which provide customers
      with a higher integration, faster time-to-market solution. These products
      are targeted at OEMs that may not have the expertise or resources to design
      their own boards or the


-4-
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          of Contents**


time
      to
      complete the necessary integration of the boards into their systems. The
      Hifn acceleration boards (“HXL”) are low cost and production optimized. The
      HXL boards can be used with open source software systems to add security to
      network equipment and servers.





*Network
      FlowThroughTM Security Products* .
      Hifn’s
      HIPP III line of intelligent FlowThrough security processors is unique in the
      marketplace. The FlowThrough capability, sometimes referred to as a “bump in the
      wire,” is targeted both for the traditional VPN networking market as well as the
      storage area network (“SAN”) security market using the iSCSI (Internet Small
      Computer Systems Interface) and FCIP (Fibre Channel over Internet Protocol)
      protocols. The Hifn 4300, 4350, 8300 and 8350 are capable of performing the
      entire IPsec protocol on-chip at multi-gigabit speeds, as well as the Internet
      Key Exchange (“IKE”) handshake, all in one device. Interfacing these devices to
      a system is straightforward as they sit at the Ethernet I/O between the Physical
      layer transceiver and the Ethernet MAC function. New to the HIPP III family
      this
      year is the 4450 and 8450. These are the next-generation FlowThrough security
      processors that add IPv6 and MACsec support at Gigabit speeds.





*Network
      Processors.* Hifn’s
      network processor (“NP”) is a programmable network processing device optimized
      for performing high-touch packet and flow-based services at multi-gigabit line
      speeds. The deterministic processing capabilities of our NP is enabled through
      an embedded processor complex which consists of sixteen picoprocessors and
      more
      than eighty hardware coprocessors and accelerators. The dual-threaded
      picoprocessors are able to simultaneously process thirty-two packets in a
      Simultaneous Multi-Threading (“SMT”) execution model. The hardware coprocessors
      and accelerators perform a number of functions including classification, tree
      searches and frame forwarding, filtering and ordering, as well as frame
      manipulation, including checksum computation. The SMT “run-to-completion”
execution model of the picoprocessors, combined with zero-overhead
      hardware-based thread switching, provides a single threaded programmer’s view on
      top of a multi-threaded, multi-processor platform. Hifn also offers a full
      suite
      of software tools for the network processor product line. Our Advanced Software
      Offering (“ASO”), a comprehensive development package, provides customers with
      an established development platform, while reducing their time-to-market. ASO
      is
      a production-ready software package containing both control and data plane
      code
      as well as mature software development tools.





*Network
      Flow Classification Products.* Hifn’s
      MeterFlow products provide comprehensive ****** application
      identification to support the differentiation of business-critical application
      network traffic from other general-purpose network traffic. MeterFlow provides
      additional information on the performance of these application transactions
      and
      data flows in network equipment devices to support the deployment of integrated
      and differentiated services. These functions are the key to enabling stateful
      inspection firewalls, security, network address translation (“NAT”) and port
      address translation (“PAT”) transforms, QoS and CoS, and server load balancing
      in routers, switches and network security appliances. MeterFlow-based flow
      classification also enables monitoring, metering, billing, service level
      agreement (“SLA”) validation, and other statistics-gathering
      applications.





*Storage
      Enhancement Products.* Hifn’s
      9600, 9610, 9620 and 9630 high-performance compression processors provide the
      fastest known compression rates in the market today and typically increase
      storage capacity for customers by fifty percent. Additionally, the 96XX family
      offers customers high-assurance features for data integrity.





A
      recent
      addition to Hifn’s compression solutions is the Virtual Tape Library (“VTL”) *Express* and VTL *Express* Mini
      compression boards. The VTL Express family optimizes our customer’s VTL products
      for backup and restore operations utilizing the industry standard LZS
      compression algorithm, while providing a high-assurance solution in an easy
      to
      integrate board. The newest addition to the family, the VTL *Express* Mini
      provides 600MB of compression performance in a half-height board. This new
      form
      factor opens up VTL compression capabilities for our customer to use in their
      1U
      and 2U high solutions.





*Evaluation
      (Reference) Boards.* Delivering on our corporate goal of enabling our customers to get to market
      faster, we routinely design system-level boards that simulate actual end
      products or subsystems. The evaluation boards include basic hardware and
      software that enable customers to expedite their designs. Our customers can
      use
      the boards as a reference or they may incorporate portions of the evaluation
      board into their own products.




**Technology**





Hifn’s
      multi-protocol packet processors, which are high-performance compression,
      encryption/compression and public key processors, our network processors and
      our
      network flow classification software have been designed to meet the needs of
      networking and storage equipment vendors. We believe that our patented
      compression technology, employed in our compression and encryption/compression
      processors, gives us a strong competitive advantage. In addition to core
      technologies that we have developed, we enhance the features and functionality
      of our products through the licensing of certain technologies from third
      parties.





*Compression
      Algorithms and Architectures.* Hifn
      holds key patents that cover a wide variety of lossless compression algorithms
      and their implementations. Specific implementations of our compression patents
      include the following compression algorithms: LZS,


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developed
      by Stac; MPPC, developed by Microsoft; and ALDC, developed by IBM. We have
      continued to improve the performance, functionality and architectures of these
      compression techniques. For example, semiconductor implementations of the LZS
      algorithm have improved in performance by a factor of forty in under four years.
      Through the use of various architectural implementations of our compression
      algorithms, we are able to provide compression solutions over a broad
      price-performance spectrum.





*Encryption,
      Data Authentication and Public Key Algorithms.* Hifn
      develops high-performance implementations of industry standard encryption
      algorithms (e.g., Advanced Encryption Standard (“AES”), Data Encryption Standard
      (“DES”), Triple-DES and Alleged RC4 (“ARC4”)) and data authentication algorithms
      (e.g., Message Digest 5 (“MD5”) and Secure Hash Algorithm (“SHA1”)). Coupled
      with our patent ownership in compression, we are positioned to combine
      compression with encryption and data authentication as specified in the most
      widely used network security protocols, such as IPsec and PPTP. In addition,
      we
      also implement public key cryptography algorithms which are used in a wide
      variety of network security protocols. Public key cryptography algorithms
      implemented by us include the RSA-compatible and Diffie-Hellman algorithms
      as
      well as the RSA-compatible and DSA digital signature algorithms. Our
      semiconductor products, including the RSA-compatible public key cryptosystem
      and
      the ARC4 symmetric key encryption algorithms, are compatible with the
      corresponding algorithms from RSA Data Security, Inc.





*Flow
      Classification and Measurement Architectures.* Our
      flow
      classification technology, MeterFlow, has enabled us to extend our reach into
      the packet processing area. This technology is a software solution for network
      equipment vendors and has seven patents issued and an additional fourteen (14)
      patents pending that cover the ability to discover applications within the
      content of network packets and flows. MeterFlow enables network equipment
      vendors to add unique traffic differentiation capabilities to their products.
      Our flow classification solutions provide precise details about packets and
      data
      traversing a network, how network applications are performing and the effect
      they are having on network productivity. The flow classification solutions
      are
      used in deploying QoS and CoS, which enables businesses to enhance the
      effectiveness of using the Internet network. Using QoS- or CoS-enabled network
      equipment, businesses can maintain more consistent and reliable interactions
      with their customers and business partners. Further, use of MeterFlow technology
      can enable firewalls, NAT/PAT transforms, billing, metering, monitoring and
      SLA
      validation applications to be application-aware.





*Integrated,
      High-Performance Packet Processing.* Hifn is
      continuing to develop additional packet processing functionality, including
      integration of computation-intensive security protocol processing functions,
      and
      integration of the MeterFlow classification capabilities. Ongoing product and
      technology development is expected to increase product integration and increase
      product performance in the future.





*Pattern
      Matching Architecture.* Hifn
      introduced a technology which accelerates regular expression pattern matching
      (“HPM”), a key search function in security systems such as, Anti-Virus,
      Anti-Spam and Intrusion Detection/Prevention. HPM contains “rule compression”
technology that creates a highly compact rules database format. The database,
      along with HPM’s small code footprint, can reside in a microprocessor cache
      enabling the search function to run at the speed of the processor. Network
      edge
      security devices and Unified Threat Management (“UTM”) appliances all have the
      same fundamental limitation: they can only process packets at the speed they
      can
      detect signatures. This technology is a software solution and has two (2)
      patents pending that cover the ability to discover patterns within a stream
      of
      data.




**Intellectual
      Property**





Our
      future success and ability to compete are dependent, in part, upon our
      proprietary technology. We rely in part on patent, trade secret, trademark,
      maskwork and copyright laws to protect our intellectual property. We own
      twenty-four (24) United States patents and eight foreign patents. The issued
      patents and patent applications primarily cover various aspects of our
      compression, flow classification, bandwidth management, cryptographic packet
      processing, pattern matching and rate shaping technologies and have expiration
      dates ranging from 2006 to 2022. We also have three pending patent applications
      in the United States and a total of fourteen (14) in Europe, Asia and Australia
      covering flow classification, cryptographic packet processing and pattern
      matching. We cannot assure that any patents will be issued under our current
      or
      future patent applications or that the patents issued under such patent
      applications will not be invalidated, circumvented or challenged. We cannot
      assure that any patents issued to us will be adequate to safeguard and maintain
      our proprietary rights, to deter misappropriation or to prevent an unauthorized
      third party from copying our technology, designing around the patents we own
      or
      otherwise obtaining and using our products, designs or other information. In
      addition, we cannot assure that others will not develop technologies that are
      similar or superior to our technology. See “Item 1A. Risk Factors — Our Success
      Depends Upon Protecting Our Intellectual Property.”





As
      is
      typical in the semiconductor industry, we may in the future receive
      communications from third parties asserting patents, mask work rights,
      intellectual property or copyrights on certain of our products and technologies.
      Although we are not currently a party to any material litigation regarding
      intellectual property, in the event a third party were to make a valid
      intellectual property


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claim
      and
      a license relating to such intellectual property was not available on
      commercially reasonable terms, our operating results could be materially and
      adversely affected. Litigation, which could result in substantial cost to us
      and
      diversion of our resources, may also be necessary to enforce our patents or
      other intellectual property rights or to defend against claimed infringement
      of
      the rights of others. The failure to obtain necessary licenses or the occurrence
      of litigation relating to patent infringement or other intellectual property
      matters could have a material adverse effect on our business and operating
      results. We cannot assure that the steps we take to protect our intellectual
      property will be adequate to prevent misappropriation or that others will not
      develop competitive technologies or products. See “Item 1A. Risk Factors — We
      Face Risks Associated With Evolving Industry Standards And Rapid Technological
      Change” and “— Our Success Depends Upon Protecting Our Intellectual
      Property.”





In
      addition, we claim copyright protection for certain proprietary software and
      documentation. We attempt to protect our trade secrets and other proprietary
      information through agreements with our customers, suppliers, employees and
      consultants, and through other security measures. Although we intend to protect
      our rights vigorously, we cannot assure that these measures will be successful.
      Furthermore, the laws of certain countries in which our products are or may
      be
      manufactured or sold may not protect our products and intellectual property.
      See
“Item 1A. Risk Factors — We Face Risks Associated With Our International
      Business Activities.”





**Export
      Restrictions on Encryption Algorithms**





A
      key
      element of Hifn’s packet processor architecture is the encryption algorithms
      embedded in our semiconductor and software products. These products are subject
      to export control regulations administered by the U.S. Department of Commerce.
      The regulations permit our domestic network equipment customers to export
      non-military specific products incorporating our encryption technology only
      after the finished product has received a one-time technical review from the
      Department of Commerce. In addition, those U.S. export control laws prohibit
      the
      export of many products, including any products with encryption, to a number
      of
      countries deemed hostile by the U.S. government. Furthermore, U.S. government
      regulations require export licenses from the Department of State for all
      military-specific products. The sale of our packet processors could be hindered
      or harmed by the failure of our network equipment customers to obtain the
      required technical reviews or by the costs of compliance. See “Sales, Marketing
& Technical Support” and “Item 1A. Risk Factors — Our Products Are Subject
      To Export Restrictions.”




**Competition**





The
      networking and storage equipment markets into which we sell our products are
      intensely competitive and are subject to frequent product introductions with
      improved price-performance characteristics, rapid technological change, unit
      price erosion and the continued emergence of new industry standards. The
      semiconductor industry is also intensely competitive and is characterized by
      rapid technological change, product obsolescence and unit price erosion. We
      expect competition to increase in the future from existing competitors and
      from
      companies that may enter our existing or future markets, including certain
      customers, with similar or substitute solutions that may be less costly or
      provide better performance or features than our products. To be successful
      in
      the future, we must continue to respond promptly and effectively to changing
      customer performance, feature and pricing requirements, technological change
      and
      competitors’ innovations. We cannot assure that we will be able to compete
      successfully against current and future competitors or that competitive
      pressures faced by us will not materially adversely affect our business,
      financial condition and results of operations. See “Item 1A. Risk Factors —
Trends, Risks and Uncertainties — Our Markets Are Highly
      Competitive.”





Our
      products compete with products from companies such as Safenet, Inc., Broadcom
      Corporation, Cavium Networks, Freescale Semiconductor, Inc., Intel Corporation,
      Agere Systems and Applied Micro Circuits Corporation (AMCC). Hifn was a
      wholly-owned subsidiary of Stac, Inc. until Hifn’s spin-off from Stac in 1996
      upon which Stac assigned two license agreements with IBM, entered into in 1994,
      in which Stac granted IBM the right to use, but not sublicense, our patented
      compression technology in IBM hardware and software products. Stac also assigned
      its license agreement with Microsoft Corporation (“Microsoft”), entered into in
      1994, whereby Stac granted Microsoft the right to use, but not sublicense,
      our
      compression technology in their software products. The license agreement with
      Microsoft, however, prohibits Microsoft from creating hardware implementations
      of our patents. We also compete against software solutions that use
      general-purpose microprocessors to run encryption algorithms and our software
      compression libraries. In addition, as noted above, our encryption/compression
      and public key processors are subject to export control restrictions
      administered by the U.S. Department of Commerce, which permit our network
      equipment customers to export products incorporating encryption technology
      only
      after receiving a one-time technical review. As a result of these regulations,
      sales by foreign competitors facing less stringent controls on their encryption
      products could hinder or harm the sale of our encryption/compression and public
      key processors to network equipment customers in the global market. However,
      we
      expect significant future competition from major domestic and international
      semiconductor suppliers. Several established electronics and semiconductor
      suppliers have recently entered or indicated an intent to enter the network
      equipment market. We may also face competition from suppliers of products based
      on new or emerging technologies. Furthermore, many of our existing and potential
      customers internally develop application specific integrated circuits,
      general-purpose microprocessors and other devices that attempt to perform all
      or
      a portion of the functions performed by our products.


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Many
      of
      our current and potential competitors have longer operating histories, greater
      name recognition, access to larger customer bases and significantly greater
      financial, technical, marketing and other resources than us. As a result, they
      may be able to adapt more quickly to new or emerging technologies and changes
      in
      customer requirements or to devote greater resources to the promotion and sale
      of their products than us. Such competitors may have proprietary semiconductor
      manufacturing ability, preferred vendor status with many of our customers,
      extensive marketing power and name recognition, greater financial resources
      than
      us and other significant advantages over us. In addition, current and potential
      competitors may determine, for strategic reasons, to consolidate, to lower
      the
      price of their products substantially or to bundle their products with other
      products. Current and potential competitors have established or may establish
      financial or strategic relationships among themselves or with existing or
      potential customers, resellers or other third parties. Accordingly, it is
      possible that new competitors or alliances among competitors could emerge and
      rapidly acquire significant market share. We cannot assure that we will be
      able
      to compete successfully against current and future competitors. Increased
      competition may result in price reductions, reduced gross margins and loss
      of
      market share, any of which could materially adversely affect our business,
      financial condition and results of operations.





We
      believe that important competitive factors in our markets are price-performance
      characteristics, rapid technological change, the continued emergence of new
      industry standards, length of development cycles, design wins with major network
      and storage equipment vendors, support for new network and storage standards,
      features and functionality, adaptability of products to specific applications,
      reliability, technical service and support and protection of products by
      effective utilization of intellectual property laws. Our failure to successfully
      develop products that compete successfully with those of other suppliers in
      the
      market would harm our business, financial condition and results of operations.
      In addition, we must compete for the services of qualified distributors and
      sales representatives. To the extent that our competitors offer such
      distributors or sales representatives more favorable terms on a higher volume
      of
      business, such distributors or sales representatives may decline to carry,
      or
      discontinue carrying, our products. Our business, financial condition and
      results of operations could be harmed by any failure to maintain and expand
      our
      distribution network. See “Item 1A. Risk Factors — Our Markets Are Highly
      Competitive.”




**Research
      and Development**





Our
      success will depend to a substantial degree upon our ability to develop and
      introduce in a timely fashion new products and enhancements to our existing
      products that meet changing customer requirements and emerging industry
      standards. We have made, and plan to continue to make, substantial investments
      in research and development. Extensive product development input is obtained
      from customers and through our participation in industry organizations and
      standards setting bodies including the Internet Engineering Task Force (“IETF”),
      the Storage Networking Industry Association (“SNIA”), as well as the Optical
      Internetworking Forum and the Network Processing Forum.





As
      of
      September 30, 2006, our research and development staff consisted of 117
      employees, of which 52 are in the US. Our research and development expenditures
      were $21.0 million (including stock-based compensation expenses of $455,000)
      in
      the fiscal year ended September 30, 2006, $21.7 million in the fiscal year
      ended
      September 30, 2005 and $22.4 million in the fiscal year ended September 30,
      2004, representing 48%, 47% and 53% of net revenues for such periods,
      respectively. Research and development expenses primarily consist of salaries
      and related costs of employees engaged in ongoing research, design and
      development activities, costs of fabricating chip mask sets and subcontracting
      costs. We perform our research and product development activities at our
      facilities in Los Gatos and Carlsbad, California, Framingham, Massachusetts,
      Morrisville, North Carolina and Hangzhou, People’s Republic of
      China.





The
      acquisition of pattern matching technology in September 2004 and of certain
      assets of IBM in December 2003 further strengthened our strategy of expanding
      our current markets with technologies that are complementary to our core
      competencies. The addition of the new hardware, software and intellectual
      property to our product portfolio enables us to continue to broaden our reach
      into potentially high-margin markets. For example, these acquisitions enable
      us
      to expand our product base to include converged security appliances, emerging
      storage security markets, high-performance IPsec, acceleration for firewall
      applications, bandwidth management, and QoS and CoS functionality.





Our
      future performance depends on a number of factors, including our ability to
      identify emerging technological trends in our target markets, develop and
      maintain competitive products, enhance our products by adding innovative
      features that differentiate our products from those of our competitors, bring
      products to market on a timely basis at competitive prices, properly identify
      target markets and respond effectively to new technological changes or new
      product announcements by others. In evaluating new product decisions, we must
      anticipate well in advance the future demand for product features and
      performance characteristics, as well as available supporting technologies,
      manufacturing capacity, industry standards and competitive product offerings.
      We
      cannot ensure that our design and introduction schedules for any additions
      and
      enhancements to our existing and future products will be able to be sold at
      prices that are favorable to us.





We
      must
      also continue to make significant investments in research and development in
      order to continue enhancing the


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performance
      and functionality of our products to keep pace with competitive products and
      customer demands for improved performance, features and functionality. The
      technical innovations required for us to remain competitive are inherently
      complex and require long development cycles. Such innovations must be completed
      before developments in networking technologies or standards render them obsolete
      and must be sufficiently compelling to induce network and storage equipment
      vendors to favor them over alternative technologies. Moreover, we must generally
      incur substantial research and development costs before the technical
      feasibility and commercial viability of a product line can be
      ascertained.





We
      cannot
      assure that revenues from future products or product enhancements will be
      sufficient to recover the development costs associated with such products or
      enhancements or that we will be able to secure the financial resources necessary
      to fund future development. The failure to successfully develop new products
      on
      a timely basis could have a material adverse effect on our business, financial
      condition and results of operations. See “Item 1A. Risk Factors — We Face Risks
      Associated With Evolving Industry Standards And Rapid Technological
      Change.”




**Sales,
      Marketing & Technical Support**





We
      market
      our products through a direct sales and marketing organization, headquartered
      in
      Los Gatos, California, with sales offices in Massachusetts, Texas and North
      Carolina as well as in China, the United Kingdom and the Netherlands. We also
      market our products through independent contract sales representatives in the
      United States, Europe, Japan and other areas. Furthermore, we retain account
      managers to focus on individual customer relationships. Our customers in foreign
      countries are serviced through international distributors. Sales representatives
      are selected for their understanding of the marketplace and their ability to
      provide effective field sales support for our products. Our relationships with
      some of our sales representatives have been established within the last two
      years, and we are unable to predict the extent to which some of these
      representatives will be successful in marketing and selling our
      products.





Semiconductor
      and software sales to Cisco Systems, Inc., an OEM producer of networking
      equipment, through its manufacturing subcontractors, comprised 50%, 49% and
      41%
      of our net revenues for fiscal years ended September 30, 2006, 2005 and 2004,
      respectively. Semiconductor sales to Quantum Corporation, through its
      manufacturing subcontractor, represented 7%, 11% and 14% of our net revenues
      for
      fiscal years ended September 30, 2006, 2005 and 2004, respectively.
      Semiconductor sales to Huawei Technologies, Inc., an OEM producer of networking
      equipment, represented 13%, 10% and 14% of our net revenues for fiscal years
      ended September 30, 2006, 2005 and 2004, respectively. Our customers are not
      subject to any binding obligation to order from us. If our sales to Cisco,
      Quantum or Huawei decline, our business, financial condition and results of
      operations could suffer. For example, during the three months ended September
      30, 2006, a combined decrease of 49% in sales to Cisco and Quantum Corporation
      compared to the immediately preceding quarter resulted in significant reduction
      in our overall revenues and results of operations. Our most significant
      customers in the future could be different from our largest customers today
      for
      a number of reasons, including customers’ deployment schedules and budget
      considerations. As a result, we may experience significant fluctuations in
      our
      results of operations on a quarterly and an annual basis. See “Item 1A. Risk
      Factors — We Depend Upon A Small Number Of Customers.”





Sales
      to
      customers within the United States totaled $16.7 million for 2006. Sales to
      customers outside the United States totaled $27.1 million, comprised of $18.1
      million and $5.9 million in sales to Hong Kong and the rest of the Asia Pacific
      region, respectively, and $1.1 million in sales to North America (outside the
      U.S.) and $2.0 million in sales to Europe and the Middle East
      combined.





Hifn
      has
      a number of outbound marketing programs designed to inform network, security
      and
      storage equipment vendors about the capabilities and benefits of our products.
      Our marketing efforts include participation in industry trade shows, technical
      conferences, preparation of competitive analyses, sales training, publication
      of
      technical and educational articles in industry journals, the Hifn website,
      our
      customer extranet site, electronic newsletters and direct mail distribution
      of
      our literature.





Hifn
      has
      established a number of strategic partnerships for both the network- and
      storage-security processors. Hifn’s efforts with these partners range from
      market- and product-development to participating in joint marketing programs.
      Hifn will continue to partner with companies that offer complementary
      technologies and market strengths.





Technical
      support to customers is provided through field applications engineers and,
      if
      necessary, applications engineers and product designers. Local field support
      is
      provided in person or by telephone. We believe that providing customers with
      comprehensive product service and support is critical to maintaining a
      competitive position in the market and is critical to shortening the time
      required to design in our products. We work with our customers to monitor the
      performance of our product designs and to provide support at each stage of
      customer product development.





The
      semiconductor industry has experienced significant downturns and wide
      fluctuations in supply and demand. The industry has also experienced significant
      fluctuations in anticipation of changes in general economic conditions. This
      has
      caused significant


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variances
      in product demand, production capacity and rapid erosion of average selling
      prices. Industry-wide fluctuations in the future could harm our business,
      financial condition and results of operations.




**Manufacturing**





Currently,
      we subcontract all manufacturing on a turnkey basis, with our suppliers
      delivering fully assembled and tested products based on our proprietary designs.
      The use of the fabless model allows us to focus substantially all of our
      resources on determining customer requirements and on the design, development
      and support of our products. This model also allows us to have significantly
      reduced capital requirements.





We
      subcontract our semiconductor manufacturing to Atmel Corporation, Toshiba
      Corporation, IBM, Open Silicon and Philips Semiconductor. Our board
      manufacturing are subcontracted to Haugjia, Symprotec and Vai Precision. These
      manufacturers were selected based on the breadth of available technology,
      quality, manufacturing capacity and support for design tools that we use. None
      of our products are currently manufactured by more than one supplier. However,
      in the event one of our suppliers notifies us that it intends to cease
      manufacturing a product, we expect that we will have an adequate opportunity
      to
      order sufficient quantities of the affected products so that shipments to
      customers will not be adversely affected while we qualify a new
      manufacturer.





We
      use
      mature and proven technology processes for the manufacture of our products,
      avoiding dependence on the latest process technology available. This approach
      reduces our technical risks and avoids the risks related to production capacity
      constraints typically associated with leading-edge semiconductor processes.
      This
      approach also allows us to focus on providing differentiated functionality
      in
      our products. Our current main products are manufactured using .6, .4, .3,
      .25,
      .18 and .13 micron Complementary Metal Oxide Semiconductor (“CMOS”) processes.
      Products under development are being designed with the .13-micron CMOS process.
      We believe that transitioning our products to increasingly smaller semiconductor
      dimensions will be important for us to remain competitive. We cannot assure
      that
      future process migration will be achieved without difficulty.





For
      the
      foreseeable future, we intend to continue to rely on our subcontract
      manufacturers for substantially all of our manufacturing, assembly and test
      requirements. All of our subcontract manufacturers produce products for other
      companies. We do not have long-term manufacturing agreements with any of our
      subcontract manufacturers. Our subcontract manufacturers are not obligated
      to
      supply products to us for any specific period, in any specific quantity or
      at
      any specific price, except as may be provided in a particular purchase order
      that has been accepted by one of our subcontract manufacturers.





We
      must
      place orders approximately 20 to 23 weeks in advance of expected delivery.
      As a
      result, we have only a limited ability to react to fluctuations in demand for
      our products, which could cause us to have an excess or a shortage of inventory
      of a particular product. Failure of worldwide semiconductor manufacturing
      capacity to rise along with a rise in demand could result in our subcontract
      manufacturers allocating available capacity to customers that are larger or
      have
      long-term supply contracts in place. Our inability to obtain adequate foundry
      capacity at acceptable prices, or any delay or interruption in supply, could
      reduce our product revenue or increase our cost of revenue and could harm our
      business, financial condition and results of operations. See “Item 1A. Risk
      Factors — We Depend Upon Independent Manufacturers And Limited Sources Of
      Supply.”




**Employees**





As
      of
      September 30, 2006, Hifn employed a total of 176 full-time employees. Of the
      total number of employees, 117 were employed in research and development (65
      were in China), 25 in sales and marketing (six were in China), seven in
      operations (one was in China) and 27 in finance and administration (11 were
      in
      China). Our employees are not represented by any collective bargaining
      agreement, we have never experienced a work stoppage and we believe our employee
      relations are good.





The
      competition for technical personnel in the industry in which we operate is
      intense, particularly for engineering personnel with related security,
      networking and integrated circuit design expertise, and applications support
      personnel with networking product design expertise. We believe our future
      success is heavily dependent upon our ability to hire and retain qualified
      personnel. To date, we believe we have been successful in recruiting qualified
      personnel however, there is no assurance that we will continue to be successful
      in the future. See “Item 1A. Risk Factors — We Depend Upon Key
      Personnel.”




**Available
      Information**





Financial
      and other information relating to the Company is available on our Company’s
      website at http://www.hifn.com. The Company makes available, free of charge,
      copies of its annual reports on Form 10-K, quarterly reports on Form 10-Q,
      current reports on Form 8-K and amendments to those reports filed or furnished
      pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably
      practicable after filing such material electronically or otherwise furnishing
      it
      to the Securities and Exchange Commission


-10-
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          of Contents**


(“SEC”).
      Additionally, copies of materials filed by the Company with the SEC may be
      accessed at the SEC’s Public Reference Room at 450 Fifth Street, N.W.,
      Washington, D.C. 20549 or at http://www.sec.gov. For information about the
      SEC’s
      Public Reference Room, the public may contact 1-800-SEC-0330.




-11-
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          of Contents**


**Item
      1A.** ***Risk
      Factors***





In
      future
      periods, Hifn’s business, financial condition and results of operations may be
      affected by many factors including, but not limited to, the
      following:





**Restructuring
      Activities May Result In Unforeseen Negative Results To Operations And Customer
      Relations.**




On
      June
      28, 2006 the Company announced a restructuring that reduced engineering
      personnel and associated operating expenses in an effort to return to
      profitability. Certain development projects were cancelled. The Company does
      not
      expect the cancellation of these projects to have an adverse effect on customer
      relations but this cannot be assured.  With redirected engineering effort,
      particularly in the area of network processing, customers may accelerate their
      migration from existing designs to alternative solutions from our competitors.
      The restructure may not achieve the expected benefits, and future restructuring
      may be necessary.





With
      the
      closing of the Carlsbad, California facility, the order fulfillment function
      was
      transferred to our Los Gatos, California facility during the last quarter of
      fiscal 2006. This move may affect the timely shipments of product to the
      Company's customers.





The
      restructuring significantly reduced the research and development resources
      in
      the United States.  While the Company believes that the relations with the
      employees still remain good, it is possible that the Company may experience
      unanticipated turnover from the remaining staff.




**The
        Company May Have Difficulty Establishing Adequate Management, Legal, and
        Financial Controls in the People’s Republic of China.**
 
 The
        People's
        Republic of China historically has been deficient in Western style management
        and financial reporting concepts and practices, as well as in modern banking,
        computer and other control systems. The Company may have difficulty in hiring
        and retaining a sufficient number of qualified employees to work in The Peoples
        Republic of China. As a result of these factors, it may experience difficulty
        in
        establishing management, legal and financial controls, collecting financial
        data, books of account and records and instituting business practices that
        meet
        Western standards.
 
 If
        we are
        unable to protect our proprietary technology in China, our ability to succeed
        will be harmed.
 
 Our
        ability to compete successfully and achieve future growth will depend, in
        part,
        on our ability to protect our proprietary technology. We rely on a combination
        of patent, copyright, trademark, and trade secret laws and restrictions on
        disclosure to protect our intellectual property rights. However, the steps
        we
        have taken may not prevent the misappropriation of our intellectual property,
        particularly in foreign countries, such as China, where the laws may not
        protect
        our proprietary rights as fully as in the United States. If we are unable
        to
        protect our proprietary technology, our ability to succeed will be harmed.
        We
        may in the future initiate claims or litigation against third parties for
        infringement of our proprietary rights. These claims could result in costly
        litigation and the diversion of the attention of our technical and management
        personnel.
 
 **Our
        Contractual Arrangement with Hangzhou Ansai Information Technology May Not
        Be As
        Effective as Direct Ownership.**
 
 Since
        the
        People's Republic of China (“PRC”) regulations do not allow a wholly
        foreign-owned enterprise to contract with the Chinese government, Hifn opted
        to
        create a contractually controlled company called Hangzhou Ansai Information
        Technology Co., Ltd. (“Ansai”), to expand our business in the PRC. Hifn
        International, one of the subsidiaries of Hifn, controls Ansai by contractual
        arrangement only and does not have any equity ownership in the company. These
        contractual arrangements may not provide control over Ansai similar to that
        of
        direct ownership.




**Our
      Business Depends Upon The Development Of The Packet Processor Market.**





Our
      prospects are dependent upon the acceptance of packet processors as an
      alternative to other technology traditionally utilized by network and storage
      equipment vendors. Many of our current and potential customers have substantial
      technological capabilities and financial resources and currently develop
      internally the application specific integrated circuit components and program
      the general purpose microprocessors utilized in their products as an alternative
      to our packet processors. These customers may in the future continue to rely
      on
      these solutions or may determine to develop or acquire components, technologies
      or packet processors that are similar to, or that may be substituted for, our
      products. In order to be successful, we must anticipate market trends and the
      price, performance and functionality requirements of such network and storage
      equipment vendors and must successfully develop and manufacture products that
      meet their requirements. In addition, we must make products available to these
      large customers on a timely basis and at competitive prices. If orders from
      customers are cancelled, decreased or delayed, or if we fail to obtain
      significant orders from new customers, or any significant customer delays or
      fails to pay, our business, financial condition and results of operations could
      suffer.




-12-
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            of Contents**




**Our
      Business Depends Upon The Continued Growth of the Network Equipment and Storage
      Equipment Markets And Our Penetration Of The Virtual Private Network, iSCSI
      and
      Network Processor Markets.**





Our
      success is largely dependent upon continued growth in the market for network
      security equipment, such as routers, remote access concentrators, switches,
      broadband access equipment, security gateways, firewalls and network interface
      cards. Our success also depends upon storage equipment vendors incorporating
      our
      packet processors into their systems. We want to be a leading supplier of packet
      processors that implement the network security protocols necessary to support
      the deployment of virtual private networks. Additionally, we have entered into
      the network processor market and developed products that we anticipate fulfills
      the need for security in the iSCSI market.





These
      markets, which are either emerging or evolving, may not grow or be material.
      Alternatively, if they do emerge or continue to grow, our products may not
      successfully serve these markets. Our ability to generate significant revenue
      in
      the network and storage equipment, virtual private network, network processor
      and iSCSI markets will depend upon, among other things, the
      following:





·
            Capital
                spending levels;





·
            Additions
                to, changes in or lack of industry
                standards;





·  Our
      ability to demonstrate the benefits of our technology to distributors, original
      equipment manufacturers and end users;





·
            The
                increased use of the Internet by businesses as replacements for,
                or
                enhancements to, their private networks;
                and





·
            The
                adoption of security as a necessary feature in
                iSCSI.





We
      are
      unable to determine the rate or extent to which the network equipment and
      storage markets will grow, if at all. Additionally, if we are unable to
      penetrate the virtual private network, network processor or iSCSI markets,
      or if
      these markets fail to develop, our business, financial condition and results
      of
      operations could suffer. Any decrease in the growth of the network or storage
      equipment market, a decline in demand for our products or our inability to
      penetrate new markets could harm our business, financial condition and results
      of operations.




**Because
      We Depend Upon A Small Number Of Customers, If Our Sales To Any Of These
      Customers Decline, Our Business, Financial Condition and Results of Operations
      May Suffer.**





The
      Company’s major customers are generally original equipment manufacturers with
      manufacturing subcontractors who purchase products directly from us. Our
      principal end customers and their respective contribution to net revenues for
      the last three years are as follows:





**Year
                Ended September 30,****2006**
            
            **2005**
            
            **2004**Cisco
                Systems, Inc.
            
            
            50
            %
            
            49
            %
            
            41
            %Huawei
                Technologies, Inc.
            
            
            13
            %
            
            10
            %
            
            14
            %Quantum
                Corporation
            
            
            7
            %
            
            11
            %
            
            14
            %70
            %
            
            70
            %
            
            69
            %





Cisco,
      Quantum and Huawei are not under any binding obligation to order from us. A
      decline in our sales to Cisco, Quantum or Huawei decline, our business,
      financial condition and results of operations could suffer. During the three
      months ended September 30, 2006, sales to Quantum Corporation and Cisco
      decreased 81% and 44%, respectively, over revenues generated from each
      respective customer in the preceding quarter, significantly affecting the
      Company’s revenue levels and results of operations for the quarter. It is
      possible that our most significant customers in the future could be different
      from our largest customers today for a number of reasons, including customers’
deployment schedules and budget considerations. As a result, we believe we
      may
      experience significant fluctuations in our results of operations on a quarterly
      and annual basis.





Limited
      numbers of network and storage equipment vendors account for a majority of
      packet processor purchases in their respective markets. In particular, the
      market for network equipment that would include packet processors, such as
      routers, remote access concentrators and firewalls, is dominated by a few large
      vendors, including Cisco, Nortel Networks, Inc. and 3Com




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Corporation.
      As a result, our future success will depend upon our ability to establish and
      maintain relationships with these companies. If these network equipment vendors
      do not incorporate our packet processors into their products, our business,
      financial condition and results of operations could suffer.




**Our
      Operating Results May Fluctuate Significantly.**





Our
      operating results have fluctuated significantly in the past and we expect that
      they will continue to fluctuate in the future. This fluctuation is a result
      of a
      variety of factors including the following:




·
            General
                business conditions in our markets as well as global economic
                uncertainty;





·
            Increases
                or reductions in demand for our customers’ products;





·
            The
                timing and volume of orders we receive from our customers;





·
            Cancellations
                or delays of customer product orders;





·  Acquisitions
      or mergers involving us, our competitors or customers;





·
            Any
                new product introductions by us or our competitors;





·
            Our
                suppliers increasing costs or changing the delivery of products to
                us;


· Increased
      competition or reductions in the prices that we are able to charge;





·
            The
                variety of the products that we sell as well as seasonal demand for
                our
                products; and





·
            The
                availability of manufacturing capacity necessary to make our
                products.




**The
      Length Of Time It Takes To Develop Our Products And Make A Sale To Our Customers
      May Impair Our Operating Results.**





Our
      customers typically take a long time to evaluate our products. It usually takes
      our customers 3 to 6 months or more to test our products with an additional
      9 to
      18 months or more before they commence significant production of equipment
      incorporating our products. As a result of this lengthy sales cycle, we may
      experience a delay between increasing expenses for research and development
      and
      sales and marketing efforts on the one hand, and the generation of related
      revenues, if any, on the other hand. In addition, the delays inherent in such
      a
      lengthy sales cycle raise additional risks of customer decisions to cancel
      or
      change product plans, which could result in the loss of anticipated sales.
      Our
      business, financial condition and results of operations could suffer if
      customers reduce or delay orders or choose not to release products using our
      technology.





**We
      Depend Upon Independent Manufacturers And Limited Sources Of Supply.**





We
      rely
      on subcontractors to manufacture, assemble and test our packet processors.
      We
      currently subcontract our semiconductor manufacturing to Atmel Corporation,
      Toshiba Corporation, Philips Semiconductor and IBM. Since we depend upon
      independent manufacturers, we do not directly control product delivery schedules
      or product quality. None of our products are manufactured by more than one
      supplier. Since the semiconductor industry is highly cyclical, foundry capacity
      has been very limited at times in the past and may become limited in the
      future.





We
      depend
      on our suppliers to deliver sufficient quantities of finished product to us
      in a
      timely manner. Since we place orders on a purchase order basis and do not have
      long-term volume purchase agreements with any of our suppliers, our suppliers
      may allocate production capacity to their other customers’ products while
      reducing deliveries to us on short notice. In the past, one of our suppliers
      delayed the delivery of one of our products. As a result, we switched production
      of the product to a new manufacturer, which caused a 3-month delay in shipments
      to our customers. We have also experienced yield and test anomalies on a
      different product manufactured by another subcontractor that could have
      interrupted our customer shipments. In this case, the manufacturer was able
      to
      correct the problem in a timely manner and customer shipments were not affected.
      The delay and expense associated with qualifying a




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new
      supplier or foundry and commencing volume production can result in lost revenue,
      reduced operating margins and possible harm to customer relationships. The
      steps
      required for a new manufacturer to begin production of a semiconductor product
      include:





·
            Adapting
                our product design, if necessary, to the new manufacturer’s
                process;





·
            Creating
                a new mask set to manufacture the
                product;





·
            Having
                the new manufacturer prepare sample products so we can verify the
                product
                specification; and





·
            Providing
                sample products to customers for qualification.





In
      general, it takes from 3 to 6 months for a new manufacturer to begin full-scale
      production of one of our products. We could have similar or more protracted
      problems in the future with existing or new suppliers.





Toshiba
      Corporation manufactures products for us in plants located in Asia. To date,
      the
      financial and stock market dislocations that have occurred in the Asian
      financial markets in the past have not harmed our business. However, present
      or
      future dislocations or other international business risks, such as currency
      exchange fluctuations or recessions, could force us to seek new suppliers.
      We
      must place orders approximately 20 to 23 weeks in advance of expected delivery.
      This limits our ability to react to fluctuations in demand for our products,
      and
      could cause us to have an excess or a shortage of inventory of a particular
      product. In addition, if global semiconductor manufacturing capacity fails
      to
      increase in line with demand, foundries could allocate available capacity to
      larger customers or customers with long-term supply contracts. If we cannot
      obtain adequate foundry capacity at acceptable prices, or our supply is
      interrupted or delayed, our product revenues could decrease and our cost of
      revenues could increase. This could harm our business, financial condition
      and
      results of operations.




We
      regularly consider using smaller semiconductor dimensions for each of our
      products in order to reduce costs. We have begun to decrease the dimensions
      in
      our new product designs, and believe that we must do so to remain competitive.
      We may have difficulty decreasing the dimensions of our products. In the future,
      we may change our supply arrangements to assume more product manufacturing
      responsibilities. We may subcontract for wafer manufacturing, assembly and
      test
      rather than purchase finished products. However, there are additional risks
      associated with manufacturing, including variances in production yields, the
      ability to obtain adequate test and assembly capacity at reasonable cost and
      other general risks associated with the manufacture of semiconductors. We may
      also enter into volume purchase agreements that would require us to commit
      to
      minimum levels of purchases and which may require up-front investments. If
      we
      fail to effectively assume greater manufacturing responsibilities or manage
      volume purchase arrangements, our business, financial condition and results
      of
      operations will suffer.





**We
      Face Risks Associated With Acquisitions.**





We
      continually evaluate strategic acquisitions of businesses and technologies
      that
      would complement our product offerings or enhance our market coverage or
      technological capabilities and may make additional acquisitions in the future.
      Future acquisitions could be effected without stockholder approval, and could
      cause us to dilute shareholder equity, incur debt and contingent liabilities
      and
      amortize acquisition expenses related to intangible assets, any of which could
      harm our operating results and/or the price of our Common Stock. Acquisitions
      entail numerous risks, including:





·
            Difficulties
                in assimilating acquired operations, technologies and
                products;





·
            Diversion
                of management’s attention from other business concerns;





·
            Risks
                of entering markets in which we have little or no prior experience;
                and





·
            Loss
                of key employees of acquired organizations.





We
      may
      not be able to successfully integrate businesses, products, technologies or
      personnel that we acquire. If we fail to do so, our business, financial
      condition and results of operations could suffer.





**We
      Face Risks Associated With The Integration Of The IBM Network Processor Product
      Line Into Our Business.**





On
      December 31, 2003, we acquired certain assets and intellectual property related
      to the IBM network processor product line. Prior to our acquisition of these
      assets, we understand IBM informed its customers that it was discontinuing
      selected research and




-15-
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development
      activities in connection with the assets and would not be developing any related
      follow-on products with respect to the products associated with the acquired
      assets. While the Company has, to date, been able to retain the customer in
      existence for the network processors as of the time of the acquisition, there
      can be no assurance that the established customer base will continue to purchase
      the products based on the acquired assets from us or maintain their relationship
      with us in the future for follow-on products. If we fail to maintain the
      established customer base, we may not be able to maintain the revenue and profit
      performance levels that IBM established with respect to these products. Loss
      of
      the established customer base could negatively impact our results of operations,
      business and financial condition.





**We
      Face Order And Shipment Uncertainties, Which Makes it Difficult to Forecast
      Future Revenues Accurately and May Cause Us to Hold Too Much Inventory.**





We
      generally make our sales under individual purchase orders that may be canceled
      or deferred by customers on short notice without significant penalty, if any.
      Cancellation or deferral of product orders could cause us to hold excess
      inventory, which, by increasing our costs without a commensurate increase in
      revenue, could harm our profit margins and restrict our ability to fund our
      operations. Such variability in customer demand coupled with customers’ ability
      to cancel orders on short notice also makes it more difficult to forecast future
      revenue. We recognize revenue upon shipment of products to our customers.
      Revenue from products sold to distributors is deferred until the distributor
      sells the products to a third party. An unanticipated level of returns could
      harm our business, financial condition and results of operations.





**We
      Face Risks Associated With Evolving Industry Standards And Rapid Technological
      Change.**





The
      markets in which we compete are characterized by rapidly changing technology,
      frequent product introductions and evolving industry standards. Our performance
      depends on a number of factors, including our ability to do the
      following:


· Properly
      identify emerging target markets and related technological trends;





·
            Develop
                and maintain competitive products;





·
            Develop
                end-to-end, ubiquitous systems
                solutions;





·
            Develop,
                or partner with providers of, security services
                processors;





·
            Develop
                both hardware and software security services
                solutions;





·
            Enhance
                our products by adding innovative features that differentiate our
                products
                from those of competitors;





·
            Bring
                products to market on a timely basis at competitive prices; and





·
            Respond
                effectively to new technological changes or new product announcements
                by
                others.





Our
      past
      success has been dependent in part upon our ability to develop products that
      have been selected for design into new products of leading equipment
      manufacturers. However, the development of our packet processors is complex
      and,
      from time to time, we have experienced delays in completing the development
      and
      introduction of new products. We may not be able to adhere to our new product
      design and introduction schedules and our products may not be accepted in the
      market at favorable prices, if at all.





In
      evaluating new product decisions, we must anticipate future demand for product
      features and performance characteristics, as well as available supporting
      technologies, manufacturing capacity, competitive product offerings and industry
      standards. We must also continue to make significant investments in research
      and
      development in order to continue to enhance the performance and functionality
      of
      our products to keep pace with competitive products and customer demands for
      improved performance, features and functionality. The technical innovations
      required for us to remain competitive are complicated and require a significant
      amount of time and money. During fiscal 2004, we acquired certain technology
      for
      embedded processors, pattern matching and network processors. We may experience
      substantial difficulty in introducing new products, such as new products
      containing the acquired technologies and we may be unable to offer enhancements
      to existing products on a timely or cost-effective basis, if at all. For
      instance, the performance of our encryption/compression and public key
      processors depends upon the integrity of our security technology. If any
      significant advances in overcoming cryptographic systems are made, then the
      security of our encryption/compression and public key processors will be reduced
      or eliminated unless we are able to develop further technical innovations that
      adequately enhance the security of these products. Our inability to develop
      and
      introduce new products or




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enhancements
      directed at new industry standards could harm our business, financial condition
      and results of operations.





**Our
      Markets Are Highly Competitive.**





We
      compete in markets that are intensely competitive and are expected to become
      increasingly competitive as current competitors expand their product offerings
      and new competitors enter the market. The markets that we compete in are subject
      to frequent product introductions with improved price-performance
      characteristics, rapid technological change, and the continued emergence of
      new
      industry standards. Our products compete with offerings from companies such
      as
      SafeNet, Inc., Broadcom Corporation, Cavium Networks, Freescale Technologies,
      Inc., Intel Corporation, Agere Systems and Applied Micro Circuits Corporation.
      Hifn was a wholly-owned subsidiary of Stac, Inc. until Hifn’s spin-off from Stac
      in 1996 upon which Stac assigned two license agreements entered into with IBM
      in
      1994 in which Stac granted IBM the right to use, but not sublicense, our
      patented compression technology in IBM hardware and software products. Stac
      also
      assigned to us its license agreement with Microsoft Corporation (“Microsoft”) in
      1994 whereby Stac granted Microsoft the right to use, but not sublicense, our
      compression technology in their software products. We expect significant future
      competition from major domestic and international semiconductor suppliers.
      Several established electronics and semiconductor suppliers have recently
      entered, or expressed an interest to enter, the network equipment market. We
      also may face competition from suppliers of products based on new or emerging
      technologies. Furthermore, many of our existing and potential customers
      internally develop solutions which attempt to perform all or a portion of the
      functions performed by our products.





A
      key
      element of our packet processor architecture is our encryption technology.
      Until
      recently, in order to export our encryption-related products, the U.S.
      Department of Commerce required us to obtain a license. Foreign competitors
      that
      were not subject to similar requirements have an advantage over us in their
      ability to establish existing markets for their products and rapidly respond
      to
      the requests of customers in the global market. Although the export restriction
      has been liberalized, we may not be successful
      in entering or competing in the foreign encryption markets. See “Our Products
      Are Subject To Export Restrictions.”





Many
      of
      our current and prospective competitors offer broader product lines and have
      significantly greater financial, technical, manufacturing and marketing
      resources than us. As a result, they may be able to adapt more quickly to new
      or
      emerging technologies and changes in customer requirements or to devote greater
      resources to promote the sale of their products. In particular, companies such
      as Intel Corporation, Lucent Technologies Inc., Motorola, Inc., National
      Semiconductor Corporation and Texas Instruments Incorporated have a significant
      advantage over us given their relationships with many of our customers, their
      extensive marketing power and name recognition and their much greater financial
      resources. In addition, current and potential competitors may decide to
      consolidate, lower the prices of their products or bundle their products with
      other products. Any of the above would significantly and negatively impact
      our
      ability to compete and obtain or maintain market share. If we are unable to
      successfully compete against our competitors, our business, results of
      operations and financial condition will suffer.





We
      believe that the important competitive factors in our markets are the
      following:





·
            Performance;





·
            Price;





·
            The
                time that is required to develop a new product or enhancements to
                existing
                products;





· The
      ability to achieve product acceptance with major network and storage equipment
      vendors;





·
            The
                support that exists for new network and storage standards;





·
            Features
                and functionality;





·
            Adaptability
                of products to specific applications;





·
            Reliability;
                and





·
            Technical
                service and support as well as effective intellectual property
                protection.





If
      we are
      unable to successfully develop and market products that compete with those
      of
      other suppliers, our business, financial




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            of Contents**




condition
      and results of operations could be harmed. In addition, we must compete for
      the
      services of qualified distributors and sales representatives. To the extent
      that
      our competitors offer distributors or sales representatives more favorable
      terms, these distributors and sales representatives may decline to carry, or
      discontinue carrying, our products. Our business, financial condition and
      results of operations could be harmed by any failure to maintain and expand
      our
      distribution network.





**Our
      Success Depends Upon Protecting Our Intellectual Property.**





Our
      proprietary technology is critical to our future success. We rely in part on
      patent, trade, trademark, mask work and copyright law to protect our
      intellectual property. We own twenty-four (24) United States patents and eight
      foreign patents. Our issued patents and patent applications primarily cover
      various aspects of our compression, flow classification, bandwidth management,
      cryptographic packet processing, rate shaping and pattern matching technologies
      and have expiration dates ranging from 2006 to 2022. We also have three pending
      patent applications in the United States and a total of fourteen (14) in Europe,
      Asia and Australia covering flow classification, cryptographic packet
      processing, and pattern matching. Patents may not be issued under our current
      or
      future patent applications, and the patents issued under such patent
      applications could be invalidated, circumvented or challenged. In addition,
      third parties could make infringement claims against us in the future. Such
      infringement claims could result in costly litigation. We may not prevail in
      any
      such litigation or be able to license any valid and infringed patents from
      third
      parties on commercially reasonable terms, if at all. Regardless of the outcome,
      an infringement claim would likely result in substantial cost and diversion
      of
      our resources. Any infringement claim or other litigation against us or by
      us
      could harm our business, financial condition and results of operations. The
      patents issued to us may not be adequate to protect our proprietary rights,
      to
      deter misappropriation or to prevent an unauthorized third party from copying
      our technology, designing around the patents we own or otherwise obtaining
      and
      using our products, designs or other information. In addition, others could
      develop technologies that are similar or superior to our
      technology.


We
      also
      claim copyright protection for certain proprietary software and documentation.
      We attempt to protect our trade secrets and other proprietary information
      through agreements with our customers, employees and consultants, and through
      other security measures. However, our efforts may not be successful.
      Furthermore, the laws of certain countries in which our products are or may
      be
      manufactured or sold may not protect our products and intellectual
      property.





**Network
      And Storage Equipment Prices Typically Decrease.**





Average
      selling prices in the networking, storage and semiconductor industries have
      rapidly declined due to many factors, including:





·
            Rapidly
                changing technologies;





·
            Price-performance
                enhancements; and





·
            Product
                obsolescence.




The
      decline in the average selling prices of our products may cause substantial
      fluctuations in our operating results. We anticipate that the average selling
      prices of our products will decrease in the future due to product introductions
      by our competitors, price pressures from significant customers and other
      factors. Therefore, we must continue to develop and introduce new products
      that
      incorporate features which we can sell at higher prices. If we fail to do so,
      our revenues and gross margins could decline, which would harm our business,
      financial condition and results of operations.





**We
      Face Product Return, Product Liability And Product Defect Risks.**





Complex
      products such as ours frequently contain errors, defects and bugs when first
      introduced or as new versions are released. We have discovered such errors,
      defects and bugs in the past. Delivery of products with production defects
      or
      reliability, quality or compatibility problems could hinder market acceptance
      of
      our products. This could damage our reputation and harm our ability to attract
      and retain customers. Errors, defects or bugs could also cause interruptions,
      delays or a cessation of sales to our customers. We would have to expend
      significant capital and resources to remedy these problems. Errors, defects
      or
      bugs could be discovered in our new products after we begin commercial
      production of them, despite testing by us and our suppliers and customers.
      This
      could result in additional development costs, loss of, or delays in, market
      acceptance, diversion of technical and other resources from our other
      development efforts, claims by our customers or others against us or the loss
      of
      credibility with our current and prospective customers. Any such event would
      harm our business, financial condition and results of operations.




-18-
 **Table
            of Contents**




**We
      Depend Upon Key Personnel.**





Our
      success greatly depends on the continued contributions of our key management
      and
      other personnel, many of whom would be difficult to replace. We do not have
      employment contracts with any of our key personnel, nor do we maintain any
      key
      man life insurance on any of our personnel. We have recently entered into
      severance and change of control agreements with our executive and other
      officers, however, there can be no assurance that such personnel will
      necessarily remain with the Company. It may be difficult for us to integrate
      new
      members of our management team. We must also attract and retain experienced
      and
      highly skilled engineering, sales and marketing and managerial personnel.
      Competition for such personnel has, in the past, been intense in the geographic
      areas and market segments in which we compete, and we may not be successful
      in
      hiring and retaining such people. If we lose the services of any key personnel,
      or cannot attract or retain qualified personnel, particularly engineers, our
      business, financial condition and results of operations could suffer. In
      addition, companies in technology industries whose employees accept positions
      with competitors have in the past claimed that their competitors have engaged
      in
      unfair competition or hiring practices. We could receive such claims in the
      future as we seek to hire qualified personnel. These claims could result in
      material litigation. We could incur substantial costs in defending against
      any
      such claims, regardless of their merits.





We
      currently have an interim Chief Executive Officer. Since the departure of our
      prior Chairman, President and CEO, Christopher G. Kenber on November 9, 2006,
      we
      have been engaged in a search for a new CEO. Though we hope to hire a qualified
      candidate in the near term, no assurance can be given that we will be able
      to
      attract and retain a suitable CEO. An extended period of time without a
      permanent CEO could materially adversely affect our business, financial
      conditions or results of operations.





**The
      Cyclical Nature Of The Semiconductor Industry May Harm Our Business.**




The
      semiconductor industry has experienced significant downturns and wide
      fluctuations in supply and demand. The industry has also experienced significant
      fluctuations in anticipation of changes in general economic conditions. This
      has
      caused significant variances in product demand, production capacity and rapid
      erosion of average selling prices. Industry-wide fluctuations in the future
      could harm our business, financial condition and results of
      operations.





**We
      Face Risks Associated With Our International Business Activities.**





A
      significant portion of our products are sold to customers outside the United
      States. If our international sales increase, particularly in light of decreased
      export restrictions, we may encounter increased risks inherent in international
      operations. All of our international sales to date are denominated in U.S.
      dollars. As a result, if the value of the U.S. dollar increases relative to
      foreign currencies, our products could become less competitive in international
      markets. We also obtain some of our manufacturing, assembly and test services
      from suppliers located outside the United States. International business
      activities could be limited or disrupted by any of the following:




·  The
      imposition of governmental controls;





·  Export
      license/technical review requirements;





·  Restrictions
      on the export of technology;





·  Currency
      exchange fluctuations;





·  Political
      instability;





·  Financial
      and stock market dislocations;





·  Military
      and related activities;





·  Trade
      restrictions; and





·  Changes
      in tariffs.





Demand
      for our products also could be harmed by seasonality of international sales
      and
      economic conditions in our primary overseas markets. These international factors
      could harm future sales of our products to international customers and our
      business, financial condition and results of operations in general.




-19-
 **Table
            of Contents**




The
      Company has established a development facility in China. The facility faces
      some
      of the same risks with respect to international business activities as
      referenced above, including, without limitation, the imposition of governmental
      controls, currency exchange fluctuations and political instability.




As
      of
      September 30, 2006, the aggregate amount of loans to the shareholders of Ansai
      was RMB 2.0 million (USD $250,000). Depending on future operational needs and
      profitability, Ansai may require additional loans in the future.





**Our
      Products Are Subject To Export Restrictions.**





The
      encryption algorithms embedded in our products are a key element of our packet
      processor architecture. These products are subject to U.S. Department of
      Commerce export control restrictions. Our network equipment customers may only
      export products incorporating encryption technology if they obtain a one-time
      technical review. These U.S. export laws also prohibit the export of encryption
      products to a number of countries deemed by the U.S. to be hostile. Many foreign
      countries also restrict exports to many of these countries deemed to be
“terrorist-supporting” states by the U.S. government. Because the restrictions
      on exports of encryption products have been liberalized, we, along with our
      network equipment customers have an opportunity to effectively compete with
      our foreign
      competitors. The existence of these restrictions until recently may have enabled
      foreign competitors facing less stringent controls on their products to become
      more established and, therefore, more competitive in the global market than
      our
      network equipment customers. In addition, the list of products and countries
      for
      which export approval is required, and the regulatory policies with respect
      thereto, could be revised, and laws limiting the domestic use of encryption
      could be enacted. While the U.S. government now allows U.S. companies to assume
      that exports to non-government end-users will be approved within 30 days of
      official registration with the Department of Commerce, the sale of our packet
      processors could be harmed by the failure of our network equipment customers
      to
      obtain the required approvals or by the costs of compliance.




**Our
      Stock Price May Be Volatile.**





The
      market price of our Common Stock has fluctuated in the past and is likely to
      fluctuate in the future. In addition, the securities markets have experienced
      significant price and volume fluctuations and the market prices of the
      securities of technology-related companies including networking, storage and
      semiconductor companies have been especially volatile. Such fluctuations can
      result from:





·
            Quarterly
                variations in operating results;





·
            Announcements
                of new products by us or our competitors;





·  The
      gain
      or loss of significant customers;





·
            Changes
                in analysts’ estimates;





·
            Short-selling
                of our Common Stock; and





·
            Events
                affecting other companies that investors deem to be comparable to
                us.








**If
      We Determine That Our Long-Lived Assets Have Been Impaired Or That Our Goodwill
      Has Been Further Impaired Our Financial Condition and Results of Operations
      May
      Suffer.**





We
      perform impairment analyses of goodwill and long-lived and intangible assets
      on
      an annual basis. During fiscal 2003 and 2002, we determined that impairment
      had
      been realized on certain developed technology and goodwill, resulting in
      recognition of impairment charges of $3.9 million and $27.4 million,
      respectively. Pursuant to SFAS 142, “Goodwill and Other Intangible Assets,” we
      will continue to perform an annual impairment test and if, as a result of this
      analysis, we determine that there has been an impairment of our goodwill and
      other long-lived and intangible assets, asset impairment charges will be
      recognized. Approximately $1.0 million of goodwill remains as of September
      30,
      2006. If we determine that our long-lived assets have been impaired or that
      our
      goodwill has been further impaired, our financial condition and results of
      operations may suffer.





**Item
      1B.** ***Unresolved
      Staff Comments***




-20-
 **Table
            of Contents**


**Item
      2.** ***Properties***





Hifn’s
      corporate and technical headquarters are located in Los Gatos, California.
      We
      lease approximately 19,900 square feet of space in Los Gatos, California, under
      a lease that expires in September 2009. We also lease other facilities,
      including 2,700 square feet of design space in Carlsbad, California, under
      a
      lease that expires in August 2009; 4,200 square feet of design space in
      Framingham, Massachusetts, under a lease that expires in November 2011; 11,300
      square feet of design space in Morrisville, North Carolina, under lease that
      expire in April 2009; 5,500 square feet of design space in Hangzhou, People’s
      Republic of China under leases that expires November 2006, April 2007 and March
      2008, respectively; 11,500 square feet of design space in Beijing, People’s
      Republic of China under leases that expires March 2007 and April 2008,
      respectively; and small field sales offices in Charlotte and North Carolina.
      Additionally, we have international field offices in Hong Kong, the United
      Kingdom and the Netherlands.





**Item
      3.** ***Legal
      Proceedings***





None.


**Item
      4.** ***Submission
      of Matters to a Vote of Security Holders*** ****





No
      matters were submitted to a vote of security holders during the fourth quarter
      of the fiscal year covered by this report.




-21-
 **Table
            of Contents**


***EXECUTIVE
      AND OTHER OFFICERS OF HIFN***




The
      following table sets forth certain information concerning the executive and
      other officers of the Company as of November 15, 2006:




**Name**
            
            **Age**
            
            **Position**Albert
                E. Sisto
            
            57
            
            Chairman,
                Interim Chief Executive OfficerWilliam
                R. Walker
            
            65
            
            Vice
                President of Finance, Chief Financial Officer and
                SecretaryRussell
                S. Dietz
            
            43
            
            Vice
                President and Chief Technical OfficerKamran
                Malik, Ph.D.
            
            54
            
            Vice
                President of EngineeringThomas
                A. Moore
            
            49
            
            Vice
                President of Sales, Marketing and OperationsDouglas
                L. Whiting, Ph.D
            
            50
            
            Chief
                Scientist and Director




*Albert
      E. Sisto* has
      served as out Chairman of the Board and interim Chief Executive Officer since
      November 2006 and has served as a director of Hifn since December 1998. From
      June 1999 to May 2006 he was President and Chief Executive Officer of
      Phoenix Technologies Ltd., a provider of Internet platform-enabling software,
      where he also served as Chairman of the Board of Directors. From November 1997
      to June 1999, he was Chief Operating Officer of RSA Security, Inc., a
      subsidiary of Security Dynamics Technologies, Inc., and a provider of encryption
      technology. From September 1994 to October 1997, Mr. Sisto was Chairman,
      President and CEO of Documagix, Inc., a software developer of document imaging
      software. Mr. Sisto holds a B.E. degree from the Stevens Institute of
      Technology.





*William
      R. Walker* has
      served as Vice President, Chief Financial Officer and Secretary of Hifn since
      November 1997. He was Hifn’s Acting Chief Executive Officer and Acting President
      from July 1998 through October 1998. From 1996 to 1997, Mr. Walker was Vice
      President, Chief Financial Officer and Secretary at MMC Networks, Inc., a
      networking company. From 1984 to 1996, Mr. Walker held the position of Senior
      Vice President and Chief Financial Officer at Zilog, Inc., a semiconductor
      supplier. Mr. Walker has a B.S. in Economics from the University of Wisconsin
      and an M.B.A. from the University of Maryland, and is a certified public
      accountant.




*Russell
      S. Dietz* has
      served as Vice President and Chief Technology Officer of Hifn since August
      2000.
      Mr. Dietz is the primary architect of the MeterFlow and MeterWorks
      technologies. Prior to joining Hifn, Mr. Dietz was Chief Technical Officer
      of Apptitude, Inc. Mr. Dietz was a founding partner of Technically Elite
      Concepts, which merged into Technically Elite, Inc. in 1995. From 1984 through
      1988, Mr. Dietz held various technical positions at Magnavox Electronic
      Systems and Digital Equipment Corporation. Mr. Dietz is an active member of
      the Internet and Engineering Task Force (IETF), the IEEE802 subcommittees and
      the Optical Internetworking Forum (OIF). Mr. Dietz serves as Chairperson and
      as
      a member of the Board of Directors of the Network Processing Forum where he
      was
      also the founding Hardware Working Group Chair. Mr. Dietz has been awarded
      five
      patents to date, all in the field of data communications traffic analysis and
      behavior.





*Kamran
      Malik, Ph.D.* has
      served as Vice President of Engineering of Hifn since November 2002. Dr. Malik
      has over 25 years of experience in VLSI and ASIC development for
      high-performance processors and networking chips, successfully managing complex
      projects and delivering products to market. From 1999 through 2002, Dr. Malik
      led the hardware development of a new class of storage networking products
      around the IP and Gigabit Ethernet standards at Nishan Systems, Inc. From 1992
      through 1998, Dr. Malik architected, directed and managed the design and
      development of a high-end super scalar 128-bit RISC MIPS processor used in
      Sony’s PlayStation 2 Emotion Engine at Toshiba Corporation. Dr. Malik holds a
      B.S. in Electrical Engineering from the University of Engineering and
      Technology, Lahore, Pakistan and an MS and Ph.D. in Electrical and Computer
      Engineering from Oregon State University.





*Thomas
      A. Moore,* has
      served as Vice President of Sales of Hifn since January 2002 and of Sales and
      Marketing since September 2003. Mr. Moore has also served as Vice President
      of
      Operation since June 2004. Mr. Moore has over 20 years of executive sales
      management, business development and general management experience. Prior to
      joining Hifn, Mr. Moore was President and CEO of Pixami, an Internet
      infrastructure technology provider. For the five years prior to Pixami, he
      served as President of Image Software, a private software licensing and
      technology company. During the preceding 15 years, Mr. Moore successfully
      managed direct and indirect sales organizations for Xerox, DEST and Exxon.
      He
      brings with him extensive experience in direct and indirect sales channel
      management. Mr. Moore received his B.A. in Economics from the University of
      California, Los Angeles.




*Douglas
      L. Whiting, Ph.D.,* Chief
      Scientist, previously served as Chief Technology Officer of Hifn through August
      2000. Dr. Whiting has been a director of Hifn since November 1996 and served
      as
      Chairman of the Board of Directors from August 2000 through October 2001. He
      also has served as Vice President of Technology of Stac from 1985 to 1998 and
      has served as a director of Stac since 1983. He was President of Stac from
      1984
      to 1986. Dr. Whiting received his Ph.D. in Computer Science from the California
      Institute of Technology.




-22-
 **Table
            of Contents**


**PART
      II**





**Item
                5.**
            ***Market
                for the Registrant’s Common Equity, Related Stockholder Matters and Issuer
                Purchases of Equity
                Securities***




**Price
      Range of Common Stock**





Hifn’s
      Common Stock is traded on the Nasdaq Global Market under the symbol “HIFN.” The
      only class of Hifn securities that is traded is Hifn Common Stock. The following
      table lists quarterly information on the price range of the Common Stock based
      on the high and low reported close prices for the Common Stock as reported
      on the Nasdaq Global Market for the periods indicated below:




**High**
            
            **Low****Fiscal
                Year Ended September 30, 2006:**Fourth
                Quarter
            
            $
            6.24
            
            $
            4.64Third
                Quarter
            
            
            8.02
            
            
            5.28Second
                Quarter
            
            
            7.88
            
            
            5.70First
                Quarter
            
            
            5.94
            
            
            5.26**Fiscal
                Year Ended September 30, 2005:**Fourth
                Quarter
            
            $
            7.26
            
            $
            5.13Third
                Quarter
            
            
            7.47
            
            
            5.40Second
                Quarter
            
            
            9.33
            
            
            7.06First
                Quarter
            
            
            9.42
            
            
            6.70





On
      December 11, 2006, the reported last sale price of Common Stock on the Nasdaq
      Global Market was $5.18 per share and there were approximately 607 holders
      of record of our Common Stock.




**Dividend
      Policy**





We
      have
      never declared or paid any dividends on our capital stock. We intend to retain
      any future earnings to finance the growth and development of our business and
      do
      not expect to pay any cash dividends in the foreseeable future.




**Equity
      Compensation Plans**





The
      information required by this Item 5 regarding equity compensation plans is
      incorporated by reference to the information set forth in Item 12 of this Annual
      Report on Form 10-K.




**Purchase
      of Equity Securities by the Issuer**





On
      April
      25, 2005, the Company’s Board of Directors authorized a stock repurchase program
      whereby the Company may repurchase shares of the Company’s common stock with an
      aggregate fair market value of up to $10 million from time to time through
      open
      market and privately negotiated transactions at prices determined by management.
      The stock repurchase program expired on April 25, 2006. The Company did not
      repurchase any shares during the fiscal year ended September 30,
      2006.




-23-
 **Table
            of Contents**




**Item
      6.**  ***Selected
      Financial Data***





The
      following selected financial data should be read in conjunction with
“Management’s Discussion and Analysis of Financial Condition and Results of
      Operations” and the Consolidated Financial Statements and Notes included
      elsewhere in this Annual Report on Form 10-K:




**Year
                  Ended September 30,****2006**
              
              **2005**
              
              **2004**
              
              **2003**
              
              **2002**(in
                  thousands, except per share amounts)**Statement
                  of Operations Data:**Net
                  revenues
              
              $
              43,764
              
              $
              46,394
              
              $
              42,142
              
              $
              20,480
              
              $
              21,791Costs
                  and operating expenses:Cost
                  of revenues
              
              
              15,507
              
              
              14,798
              
              
              11,957
              
              
              6,567
              
              
              6,413Research
                  and development
              
              
              20,983
              
              
              21,721
              
              
              22,418
              
              
              20,329
              
              
              18,221Sales
                  and marketing
              
              
              7,382
              
              
              7,515
              
              
              7,324
              
              
              7,211
              
              
              8,445General
                  and administrative
              
              
              6,984
              
              
              5,332
              
              
              4,492
              
              
              3,862
              
              
              12,309Amortization
                  of intangibles
              
              
              3,161
              
              
              3,296
              
              
              3,062
              
              
              1,319
              
              
              10,480Impairment
                  of assets
              
              
              292
              
              
              —
              
              
              —
              
              
              3,919
              
              
              27,366Purchased
                  in-process research & development
              
              
              —
              
              
              —
              
              
              4,230
              
              
              —
              
              
              1,137Loss
                  from operations
              
              
              (10,545
              )
              
              (6,268
              )
              
              (11,341
              )
              
              (22,727
              )
              
              (62,580
              )Interest
                  income, net
              
              
              1,916
              
              
              1,193
              
              
              525
              
              
              566
              
              
              1,067Other
                  expense, net
              
              
              (54
              )
              
              (51
              )
              
              (52
              )
              
              (22
              )
              
              (72
              )Provision
                  for (benefit from) income taxes
              
              
              41
              
              
              90
              
              
              —
              
              
              (1,842
              )
              
              6,014Net
                  loss
              
              $
              (8,724
              )
              $
              (5,216
              )
              $
              (10,868
              )
              $
              (20,341
              )
              $
              (67,599
              )Net
                  loss per share, basic and diluted
              
              $
              (0.63
              )
              $
              (0.38
              )
              $
              (0.84
              )
              $
              (1.89
              )
              $
              (6.49
              )Weighted
                  average shares outstanding, basic and diluted
              
              
              13,769
              
              
              13,887
              
              
              12,993
              
              
              10,741
              
              
              10,417







**September 30,****2006**
              
              
              **2005**
              
              
              **2004**
              
              
              **2003**
              
              
              **2002**(in
                  thousands)**Balance
                  Sheet Data:**Cash
                  and short-term investments
              
              $
              38,777
              
              $
              44,440
              
              $
              50,032
              
              $
              43,074
              
              $
              54,666Total
                  assets
              
              
              57,476
              
              
              66,451
              
              
              76,242
              
              
              52,821
              
              
              72,279Working
                  capital
              
              
              40,199
              
              
              42,755
              
              
              46,711
              
              
              35,465
              
              
              44,071Total
                  debt
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —Total
                  stockholders’ equity
              
              
              50,685
              
              
              56,756
              
              
              64,229
              
              
              41,117
              
              
              56,656
  -24-
 **Table
            of Contents**
 **Item
      7.**  ***Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations***





*The
      following discussion should be read in conjunction with the Consolidated
      Financial Statements and Notes included elsewhere in this Annual Report on
      Form
      10-K. The results shown in this report are not necessarily indicative of the
      results to be expected in any future periods. This discussion contains
      forward-looking statements based on current expectations which involve risks
      and
      uncertainties. Actual results and the timing of certain events may differ
      significantly from those projected in such forward-looking statements due to
      the
      factors set forth in the section entitled "Item 1A. Risk Factors” and appearing
      elsewhere in this report. See “Cautionary Statement Regarding Forward-Looking
      Statements” in Part I of this Annual Report on Form 10-K.*




**Overview**





hi/fn,
      inc., together with its subsidiaries, Hifn Limited, Hifn Netherlands B.V. and
      Hifn International and its subsidiary, Saian (Hangzhou) Microsystems, Co.,
      Ltd.,
      together with Hangzhou Ansai Information Technology Co., Ltd., a contractually
      controlled company of Hifn International, (collectively
      referred to as “Hifn,” “we,” “us” or “our”) is a network- and storage-security
      market leader, as recognized by independent industry analyst firms, including
      The Linley Group, that supplies most major network equipment manufacturers
      (“OEMs”) with patented technology to protect information at risk, whether it is
      in transit data or data at rest. Hifn designs, develops and markets both
      hardware and software solutions to a targeted customer base of networking-,
      security- and storage-OEMs. Our solutions are attractive to customers because
      they feature high-performance, including some of the fastest compression
      processing speeds available in the market, multi-protocol capabilities,
      development tools and board level products that help reduce their
      time-to-market. Our processor solutions perform the computation-intensive tasks
      of compression, encryption and authentication, providing our customers with
      high-performance, interoperable implementations of a wide variety of
      industry-standard networking and storage protocols. Our network- and
      security-processors, compression, flow classification and content search
      solutions are used in networking, security and storage equipment such as
      routers, remote access concentrators, virtual private networks (“VPNs”), Virtual
      Tape Libraries (“VTLs”), switches, broadband access equipment, network interface
      cards, firewalls and back-up storage devices.





The
      Hifn
      encryption/compression and public key processors allow network equipment vendors
      to add security functions to their products. Our encryption/compression and
      public key processors provide industry-recognized algorithms that are used
      in
      products, such as VPNs, which enable businesses to reduce wide area networking
      costs by replacing dedicated leased-lines with lower-cost IP-based networks
      such
      as the Internet. Using VPNs, businesses can also provide customers, partners
      and
      suppliers with secure, authenticated access to the corporate network, increasing
      productivity through improved communications. Storage equipment vendors use
      our
      compression processor products and recently announced VTL *Express* boards
      to improve the performance and capacity of a wide range of disk and tape back-up
      systems. For example, Storage OEMs who design in a Hifn VTL *Express* board
      can offer their customers a storage solution that reduces the time to back-up
      their systems by 50%, saving time and money for the company.





Hifn’s
      flow classification technology enables network equipment vendors to add unique
      traffic differentiation and recognition capabilities to their products. Our
      flow
      classification solutions provide precise details about packets and data
      traversing a network and are used in implementing and monitoring quality of
      service (“QoS”) and class of service (“CoS”), which enables businesses to
      enhance the effectiveness of their systems. Using QoS- or CoS-enabled network
      equipment, businesses can provide differentiated services to their customers
      or
      build new revenue streams based on available services. This capability is
      becoming more important to customers and end users as corporate networks are
      being flooded with VoIP and Video traffic. These types of traffic require the
      highest level of QoS to maintain its integrity and usefulness.





Additionally,
      Hifn announced in 2006 Hifn Pattern Matching (“HPM”) technology which
      accelerates regular expression pattern matching, a key search function in
      security systems such as, Anti-Virus, Anti-Spam and Intrusion
      Detection/Prevention. HPM contains
      “rule compression” technology that creates a highly compact rules database
      format. The database, along with HPM’s small code footprint, can reside in a
      microprocessor cache enabling the search function to run at the speed of the
      processor. Network edge security devices and Unified Threat Management (“UTM”)
      appliances all have the same fundamental limitation: they can only process
      packets at the speed they can detect signatures.





Hifn’s
      network processor technology, acquired from International Business Machines
      Corporation (“IBM”), complements our security processor business and expands our
      product offerings to include a programmable, yet deterministic, device that
      performs computation-intensive, deep packet inspection for high-touch services.
      The architecture of our network processor is unique and is an architecture
      used
      with applications that require high-touch services.


-25-
 **Table
          of Contents**


Our
      principal end customers and their respective contribution to net revenues for
      the respective periods are as follows:


**Year
                  Ended September 30,****2006**
              
              
              **2005**
              
              
              **2004**Cisco
                  Systems, Inc.
              
              
              50
              %
              
              49
              %
              
              41
              %Huawei
                  Technologies, Inc.
              
              
              13
              %
              
              10
              %
              
              14
              %Quantum
                  Corporation
              
              
              7
              %
              
              11
              %
              
              14
              %70
              %
              
              70
              %
              
              69
              %


International
      sales comprised 62%, 65% and 68% of net revenues for fiscal 2006, 2005 and
      2004,
      respectively, and we anticipate that international sales will continue to grow
      in the future.





In
      September 2004, Hifn acquired certain technology related to pattern matching
      core for $1.8 million in cash, including acquisition related costs. Assets
      acquired include developed and core technology and acquired workforce. In
      connection with this asset acquisition, in fiscal year 2005, we recognized
      $900,000 of engineering services expense for the completion of certain
      development milestones.




In
        April
        2004, the Company acquired certain assets and intellectual property related
        to
        processor technology for $1.0 million in cash.




On
      February 6, 2004, the Company entered into a securities purchase agreement
      with
      certain investors for the private placement of 2.2 million shares of the
      Company’s Common Stock at a price of $15.00 per share for aggregate proceeds of
      $30.9 million, net of expenses of approximately $2.1 million. The shares were
      issued and paid for on February 6, 2004.





In
      December 2003, Hifn acquired certain assets and intellectual property valued
      at
      $15.9 million, including acquisition related costs. Assets acquired include
      inventory, fixed assets, developed and core technology and contract backlog.
      The
      acquired assets included in-process research and development of approximately
      $3.3 million, which was expensed at the time of the acquisition.





During
      the third quarter of fiscal 2006, our product plans changed as a result of
      a
      shift in customer feature requirements and demand. Consequently, certain
      long-lived and intangible assets associated with terminated projects were
      impaired and we recorded a charge of $292,000. The
      impairment was calculated using the full unamortized balance of the asset at
      the
      date of impairment.





Hifn’s
      quarterly and annual operating results are affected by a wide variety of factors
      that could materially and adversely affect net sales, gross margins and
      operating income. These factors include the volume and timing of orders
      received, changes in the mix of proprietary and second source products sold,
      market acceptance of our and our customers’ products, competitive pricing
      pressures, our ability to introduce new products on a timely basis, the timing
      and extent of research and development expenses, fluctuations in manufacturing
      yields, cyclical semiconductor industry conditions, our access to advanced
      process technologies and the timing and extent of process development costs.
      Historically in the semiconductor industry, average selling prices of products
      have decreased over time. If we are unable to introduce new products with higher
      margins, maintain our product mix between proprietary and second source
      products, or reduce manufacturing cost to offset decreases in the prices of
      our
      existing products, then our operating results will be adversely affected. Our
      business is characterized by short-term orders and shipment schedules, and
      customer orders typically can be canceled or rescheduled without penalty to
      the
      customer. Since most of our backlog is cancelable without penalty, we typically
      plan our production and inventory levels based on internal forecasts of customer
      demand. Customer demand remains highly unpredictable and variances to the
      forecast can fluctuate substantially. In addition, because of high fixed costs
      in the semiconductor industry, we are limited in our ability to reduce costs
      quickly in response to any revenue shortfalls. As a result of the foregoing
      or
      other factors, we have experienced, and may in the future experience, material
      adverse fluctuations in our operating results on a quarterly or annual basis,
      which have in the past, and would in the future, materially affect our business,
      financial condition and results of operations.




**Restructuring
      Charges**




On
      June
      28, 2006, the company implemented a restructuring plan to be more focused on
      the
      strategy in the networking and storage markets and to take advantage of their
      expanding development capacity in China. The actions were aimed to reduce the
      company’s cost structure, including a reduction in its North America workforce
      by 43 employees, which represented about 21% of its overall workforce at the
      time, the impact of the termination of certain engineering projects and the
      closure of the facility in Carlsbad, California.


-26-
 **Table
          of Contents**





Involuntary
      Termination Cost





**Expense**
              **Accrued**
              **June
                30, 2006**
            
            **Adjustments**
            
            **Paid
                as of September 30, 2006**
            
            **Balance
                September 30, 2006**(in
                thousands)Cost
                of revenues
            
            $
            64
            
            $
            (6
            )
            $
            53
            
            $
            5Research
                and development
            
            
            471
            
            
            (17
            )
            
            454
            
            
            -Sales
                and marketing
            
            
            59
            
            
            
            
            
            59
            
            
            -General
                and administrative
            
            
            24
            
            
            
            
            
            24
            
            
            -Total
            
            $
            618
            
            $
            (23
            )
            $
            590
            
            $
            5





Impairment
      Of Long-lived Assets





The
      restructure resulted in a $292,000 impairment of certain software assets related
      to projects that were terminated.




Non-recurring
      Engineering Expense Recovery




The
      cancellation of projects resulted in the reversal of previously accrued
      non-recurring engineering costs of $516,000. This reversal is reflected in
      the
      research and development line item on the Statement of Operations.




Termination
      Of Operating Lease




As
      part
      of the restructure, the company closed its facility in Carlsbad, California
      and
      ceased use of the facility as of September 30, 2006. A liability related to
      the
      Carlsbad facility of $550,000 was accrued during the last quarter of fiscal
      year
      2006, reflecting the fair value of the future lease obligations, net of sublease
      income. The non-cancelable lease agreement for this facility terminates in
      June
      2010. At September 30, 2006, the remaining lease obligation is estimated to
      be
      $1.5 million, which will be paid monthly for the remainder of the lease contract
      period. Additional costs of approximately $74,000 were incurred in the September
      quarter for the relocation of operations and equipment from the closing
      facility. At September 30, 2006, $555,000 was included in accrued expenses
      and other current liabilities in the accompanying balance sheet.





Net
      Restructuring Cost





Including
      the fair value of the lease obligation and relocation costs, the net expense
      for
      the restructure as of September 30, 2006 amounts to $995,000. The majority
      of
      the expenses, with the exception of the lease, were paid during the last quarter
      of fiscal year 2006. These payments were funded by available cash on
      hand.




**Critical
      Accounting Policies**





The
      financial statements included in this report are prepared in conformity with
      accounting principles generally accepted in the United States of America and
      require management to make estimates and assumptions in certain circumstances
      that affect amounts reported in the accompanying consolidated financial
      statements and related footnotes. As such, we are required to make certain
      estimates, judgments and assumptions that we believe are reasonable based upon
      the information available. These estimates and assumptions affect the reported
      amounts of assets and liabilities at the date of the financial statements and
      the reported amounts of revenues and expenses during the periods presented.
      The
      significant accounting policies which we believe are the most critical to aid
      in
      fully understanding and evaluating our reported financial results include the
      following:





**Revenue
      recognition.** We
      derive
      our revenue from the sale of processors and software license fees. Customers
      comprise primarily OEMs and, to a lesser extent, distributors. Revenue from
      the
      sale of processors is recognized upon shipment when persuasive evidence of
      an
      arrangement exists, legal title and risk of ownership has transferred to the
      customer, the price is fixed or determined and collection of the resulting
      receivables is reasonably assured. Revenue from processors sold to distributors
      under agreements allowing certain rights of return is deferred until the
      distributor sells the product to a third party. At the time of shipment to
      distributors, we record a trade receivable for the purchase price based on
      the
      Company’s legally enforceable right to payment. Additionally, since legal right
      for the inventory transfers to the distributors, inventory is relieved at the
      carrying value of the products shipped. The related gross margin is recognized
      as a liability and recorded as deferred income.


Software
      license revenue is generally recognized when a signed agreement or other
      persuasive evidence of an arrangement exists, vendor-specific objective evidence
      exists to allocate a portion of the total fee to any undelivered elements of
      the
      arrangement, the software has been shipped or electronically delivered, the
      license fee is fixed or determinable and collection of the resulting receivables
      is reasonably assured. Returns, including exchange rights for unsold licenses,
      are recorded based on agreed-upon return rates or historical experience and
      are
      deferred until the return rights expire. To the extent we experience increased
      levels of returns, revenue will decrease resulting in decreased gross profit.





We
      receive software license revenue from OEMs that sublicense our software shipped
      with their products. The OEM sublicense agreements are generally valid for
      a
      term of one year and include rights to unspecified future upgrades and
      maintenance during the term of the agreement. License fees under these
      agreements are recognized ratably over the term of the




-27-
 **Table
            of Contents**




agreement.
      Revenues from sublicenses sold in excess of the specified volume in the original
      license agreement are recognized when they are reported as sold to end customers
      by the OEM. Our deferred software license revenue balance as of September 30,
      2006 was $307,000 and included approximately $69,000 in exchange rights for
      unsold licenses.





Management
      judgments and estimates must be made regarding the collectibility of fees
      charged. Should changes in conditions cause management to determine the
      collectibility criteria are not met for certain future transactions, revenue
      recognized for any reporting period could be adversely affected.





**Inventories.** We value
      our inventory at the lower of cost (determined on a first-in, first-out cost
      method) or market. Inventories are comprised solely of finished goods, which
      are
      manufactured by third party foundries for resale by us. We provide for obsolete,
      slow moving or excess inventories, based on forecasts prepared by management,
      in
      the period when obsolescence or inventory in excess of expected demand is first
      identified. Reserves are established to reduce the cost basis of inventory
      for
      excess and obsolete inventory. As a result of unfavorable economic conditions
      and decreased demand for semiconductor devices, in fiscal 2001, we recorded,
      as
      a charge to cost of sales, a provision for excess inventory of $3.4 million.
      In
      fiscal year 2006 we recorded, as a charge to cost of sales, an additional
      $603,000 for excess inventory. In fiscal year 2005, we recognized gross margin
      benefits of $137,000, as a result of the sale of inventories that had been
      previously written down. During the fourth quarter of fiscal 2006 we scrapped
      inventory with a reserved value of $1.7 million. As of September 30, 2006,
      inventories of $1.0 million at original purchase price that were subsequently
      written down were still on hand. Subsequent increases in projected demand will
      not result in a reversal of these reserves until the sale of the related
      inventory.





We
      are
      subject to technological change, new product development, and product
      obsolescence. Actual demand may differ from forecasted demand and such
      differences may have a material effect on our financial position and results
      of
      operations.





**Valuation
      of long-lived and intangible assets and goodwill.** We
      evaluate the recovery of finite lived intangible assets and other finite
      long-lived assets, including property and equipment, acquired intangible assets
      and licensed intellectual property, whenever events or changes in circumstances
      indicate that their carrying value may not be recoverable through the estimated
      undiscounted future cash flows resulting from the use of the assets. If we
      determine that the carrying value of goodwill, other intangible assets and
      other
      long-lived assets may not be recoverable, we measure impairment by using the
      projected discounted cash flow method. Our judgments regarding the existence
      of
      impairment indicators are based on market conditions and operational performance
      of our business. During the third quarter of fiscal 2006, the Company’s product
      plans changed as a result of a shift in customer feature requirements and
      demand. Consequently, assets associated with terminated projects were
      impaired and resulted in a charge of $292,000. The impairment charge was based
      on the present value of management estimates of future cash flows.





In
      accordance with SFAS 142, the value of goodwill and intangible assets deemed
      to
      have indefinite lives are not amortized but are instead subject to annual
      impairment tests or interim impairment tests whenever events or circumstances
      indicate that their carrying value may not be recoverable. Other intangible
      assets will continue to be amortized over their useful lives. The carrying
      value
      of goodwill was approximately $1.0 million at September 30, 2006. Asset
      impairment charges could have a material effect on our consolidated financial
      position and results of operations.





**Allowance
      for doubtful accounts receivable.** We
      estimate uncollectible accounts receivable at each reporting period.
      Specifically, we analyze the aging of accounts receivable, bad debt history,
      payment history, customer concentration, customer credit-worthiness, and current
      economic trends when evaluating the adequacy of the allowance for doubtful
      accounts. Additionally, we review our accounts payable and accrued liabilities
      balances at each reporting period, and accrue liabilities as appropriate. Our
      analysis includes consideration of items such as product design and
      manufacturing activities, commitments made to or the level of activity with
      vendors, payroll and employee-related costs, historic spending and anticipated
      changes in the cost of services.


**Accounting
      for income taxes.** As
      part
      of the process of preparing our consolidated financial statements we are
      required to estimate our income taxes, which involve estimating our actual
      current tax exposure together with assessing temporary differences resulting
      from differing treatment of items for tax and accounting purposes. These
      differences result in deferred tax assets and liabilities. Significant
      management judgment is required to assess the likelihood that our deferred
      tax
      assets will be recovered from future taxable income. Continuing losses in recent
      reporting periods increase the uncertainties regarding realizability of deferred
      tax assets. While we have considered future taxable income and ongoing prudent
      and feasible tax planning strategies in assessing the need for the valuation
      allowance, in the event we were to determine that we would be able to realize
      our deferred tax assets in the future in excess of its net recorded amount,
      an
      adjustment to the deferred tax asset would increase income in the period such
      determination is made.





**Litigation.** From
      time
      to time, we may become involved in litigation relating to claims arising from
      the ordinary course of business. Management considers such claims on a
      case-by-case basis. We accrue for loss contingencies if both of the following
      conditions are met: (a) information available prior to the issuance of the
      financial statements indicates that it is probable that an asset has been
      impaired or a liability has been incurred at the date of the financial
      statements; and (b) the amount of loss can be reasonably estimated.




-28-
 **Table
            of Contents**
  **Stock-Based
        Compensation**
 
 On
        October 1, 2005, the Company adopted Statement of Financial Accounting Standards
        No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which
        requires the measurement and recognition of compensation expense for all
        share-based payment awards, including employee stock options and employee
        stock
        purchases, based on estimated fair values. SFAS 123(R) supersedes the Company’s
        previous accounting under Accounting Principles Board Opinion No. 25,
“Accounting for Stock Issued to Employees” (“APB 25”) for periods beginning in
        fiscal 2006. In March 2005, the Securities and Exchange Commission issued
        Staff
        Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). The
        Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).
        The Company adopted SFAS 123(R) using the modified prospective transition
        method, which requires the application of the accounting standard as of October
        1, 2005, the first day of the Company’s fiscal year 2006. The Company’s
        Consolidated Financial Statements as of and for the three and nine months
        ended
        June 30, 2006, reflect the effect of SFAS 123(R).
 
 We
        estimate the fair value of stock options using the Black-Scholes model,
        consistent with the provisions of SFAS 123(R), SEC SAB No. 107 and our
        prior period pro forma disclosures of net earnings, including stock-based
        compensation (determined under a fair value method as prescribed by SFAS
        123).  SFAS 123(R) requires the use of option pricing models that were not
        developed for use in valuing employee stock options. The Black-Scholes model
        was
        developed for use in estimating the fair value of short-lived exchange traded
        options that have no vesting restrictions and are fully transferable. In
        addition, option-pricing models require the input of highly subjective
        assumptions, including the option’s expected life and the price volatility of
        the underlying stock. The expected stock price volatility assumption was
        determined using the historical volatility of the Company’s common stock.
        Changes in the subjective assumptions required in the valuation models may
        significantly affect the estimated value of the awards, the related stock-based
        compensation expense and, consequently, our results of
        operations.


**Results
      of Operations**





The
      following table sets forth certain statement of operations data as a percentage
      of total revenue for the periods indicated:


**Year
                  Ended September 30,****2006**
              
              **2005**
              
              **2004**Net
                  revenues:Processors
              
              92
              %
              91
              %
              85
              %Software
                  licenses and other
              
              
              8
              
              
              9
              
              
              15Total net revenues
              
              
              100
              
              
              100
              
              
              100Costs
                  and operating expenses:Cost
                  of revenues - processors
              
              
              34
              
              
              31
              
              
              27Cost
                  of revenues - software licenses and other
              
              
              1
              
              
              1
              
              
              1Research
                  and development
              
              
              48
              
              
              47
              
              
              53Sales
                  and marketing
              
              
              17
              
              
              16
              
              
              17General
                  and administrative
              
              
              16
              
              
              11
              
              
              11Amortization
                  of intangibles
              
              
              7
              
              
              7
              
              
              8Impairment
                  of assets
              
              
              1
              
              
              —
              
              
              —Purchased
                  in-process research & development
              
              
              —
              
              
              —
              
              
              10Total
                  costs and operating expenses
              
              
              124
              
              
              113
              
              
              127Loss
                  from operations
              
              
              (24
              )
              
              (13
              )
              
              (27
              )Interest
                  and other income, net
              
              
              4
              
              
              2
              
              
              1Loss
                  before income taxes
              
              
              (20
              )
              
              (11
              )
              
              (26
              )Provision
                  for income taxes
              
              
              —
              
              
              —
              
              
              —Net
                  loss
              
              
              (20
              )%
              
              (11
              )%
              
              (26
              )%


-29-
 **Table
          of Contents**


**Years
      Ended September 30, 2006, 2005 and 2004**





*Net
      Revenues.*





Net
      revenues by category, as a percentage of total net revenues and the
      year-over-year change were as follows:




**Year
                  Ended September 30,****2006**
              
              **2005**
              
              **2004**
              
              **2006
                  vs. 2005 Change**
              
              **2005
                  vs. 2004 Change**(dollars
                  in thousands)
              
              
              
              
              **%
                  of net revenues**
              
              
              
              **%
                  of net revenues**
              
              
              
              **%
                  of net revenues**Processors
              
              
              $
              40,262
              
              
              92%
              
              $
              42,055
              
              
              91%
              
              $
              35,773
              
              
              85%
              
              
              (4)%
              
              
              18%Software
                  licenses and other
              
              
              
              3,502
              
              
              8%
              
              
              4,339
              
              
              9%
              
              
              6,369
              
              
              15%
              
              
              (19)%
              
              
              (32)%$
              43,764
              
              
              100%
              
              $
              46,394
              
              
              100%
              
              $
              42,142
              
              
              100%
              
              
              (6)%
              
              
              10%
 
 Net
        revenues decreased by $2.6 million in fiscal 2006 as compared to fiscal 2005.
        The decrease reflects the net effect of a decrease in processor revenues
        and
        software license and royalties of $1.8 million and $837,000, respectively.
        The
        decrease in processor revenues was mainly attributable to a
        change
        in the timing of purchases from one of our major customers, leading to a
        significant reduction in there inventory that reduced Hifn
        deliveries. The
        average selling price of these processors remained at relatively the same
        levels. The decrease in revenues from software license and royalties resulted
        from the variability in demand for and timing of customers’ purchase of certain
        of the Company’s licensed software products.





Net
      revenues increased by $4.3 million in fiscal 2005 as compared to fiscal 2004.
      The increase reflects the net effect of an increase in processor revenues of
      $6.3 million, offset by a decrease in software license and royalties of $2.0
      million. The increase in processor revenues was attributable to increases in
      sales of network processors of $3.6 million and in sales of our data compression
      and encryption processor products of $2.7 million, resulting from higher volume
      of customer purchases. The average selling price of these processors remained
      at
      relatively the same levels. Therefore, the increase in processor revenues
      between the comparable periods is attributable to a combination of an increase
      in sales of network processors coupled with an overall increase in volume.
      The
      decrease in revenues from software license and royalties resulted from the
      variability in demand for and timing of customers’ purchase of certain of the
      Company’s licensed software products.





Semiconductor
      and software sales to our principal end customers and their respective
      contribution to net revenues for the respective periods are as follows:





**Year
                Ended September 30,****2006**
            
            **2005**
            
            **2004**Cisco
                Systems, Inc.
            
            
            50
            %
            
            49
            %
            
            41
            %Huawei
                Technologies, Inc.
            
            
            13
            %
            
            10
            %
            
            14
            %Quantum
                Corporation
            
            
            7
            %
            
            11
            %
            
            14
            %70
            %
            
            70
            %
            
            69
            %





No
      other
      customers accounted for more than 10% of revenues in the periods
      presented.





*Cost
      of Revenues.*





Cost
      of
      revenues by category, as a percentage of the respective revenue category and
      the
      year-over-year change were as follows:




**Year
                    Ended September 30,****2006**
                
                **2005**
                
                **2004**(dollars
                    in thousands)
                
                
                
                **%
                    of r****evenue
                    category**
                
                
                
                **%
                    of revenue category**
                
                
                
                **%
                    of revenue category**
                
                **2006
                    vs. 2005 Change**
                
                **2005
                    vs. 2004 Change**Processors
                
                $
                15,001
                
                
                37%
                
                $
                14,246
                
                
                34%
                
                $
                11,477
                
                
                32%
                
                
                5%
                
                
                24%Software
                    licenses and other
                
                
                506
                
                
                14%
                
                
                552
                
                
                13%
                
                
                480
                
                
                8%
                
                
                (8)%
                
                
                15%$
                15,507
                
                
                35%
                
                $
                14,798
                
                
                32%
                
                $
                11,957
                
                
                28%
                
                
                5%
                
                
                24%
  -30-
 **Table
                of Contents**
 Cost
          of
          revenues consists primarily of semiconductors which were manufactured to
          our
          specifications by third parties for resale by us. Cost of processor revenues
          as
          a percentage of net processor revenues increased three percentage points
          for
          fiscal 2006 as compared to the same period in fiscal 2005. During fiscal
          2006 we
          recorded, as a charge to cost of sales, $603,000 for excess inventory,
          as
          compared to a benefit of $139,000 in fiscal 2005. As a result, processor
          cost of
          revenues as a percentage of net revenues increased two percent. Operational
          costs increased $128,000, mainly as a result of a combination of higher
          average
          salary rates, severance cost of $64,000 and increased activities in China.
          Cost
          of processor revenues as a percentage of net processor revenues increased
          two
          percentage points for fiscal 2005 as compared to the same period in fiscal
          2004.
          The Company’s product offerings in fiscal 2005 included a higher proportion of
          network processors, which carry a higher cost, both in absolute dollars
          and as a
          percentage of revenues, as compared to all other processors. As a result,
          processor cost of revenues as a percentage of net revenues increased. During
          fiscal 2005 and 2004, we sold $139,000 and $560,000, respectively, in
          inventories that had previously been written down.





Cost
      of
      software licenses and other revenues is primarily comprised of engineering
      labor
      related to support and maintenance of sold licenses. The decreasing trend in
      such costs, in absolute dollars, is attributable to the decrease in the number
      of full-time-equivalent staff allocated to provide support and maintenance.
      The
      fluctuation in software licenses and other costs as a percentage of software
      licenses and other revenues is dependent upon the mix of licensed software
      and
      royalties earned during the period.





*Research
      and Development.*




**Year
                  Ended September 30,**(dollars
                  in thousands)
              **2006**
              
              **2005**
              
              **2004**
              
              **2006
                  vs. 2005**
                **Change**
              
              **2005
                  vs. 2004**
                **Change**Research
                  & development expenses
              $20,983
              
              $21,721
              
              $22,418
              
              (3)%
              
              (3)%As
                  a percentage of net revenues
              48%
              
              47%
              
              53%
  Research
        and development expenses consist primarily of salaries, employee benefits,
        overhead, outside contractors and non-recurring engineering fees. Such research
        and development expenses decreased $738,000 in fiscal 2006 as compared to
        fiscal
        2005. The decrease is attributable to decreases of $2.2 million in non-recurring
        engineering costs associated with project cancellations during the June 2006
        restructure, tape-out, mask activities and qualification testing of products
        under development, $140,000 in engineering and consulting services as outsourced
        projects were completed, $350,000 in building expenses due to the expiration
        of
        a lease, together with a reduction of $201,000 in travel and entertainment
        and
        other expenses. These decreases were partially offset by increases in
        depreciation, supplies and miscellaneous expense of $776,000, mainly due
        to
        increased activities in China and $1.4 million in salaries and benefits expense
        mainly as a result of a combination of higher average salary rates, and the
        addition of seventeen engineers at our China location, together with
        involuntarily termination costs of $454,000 and $456,000 as a result of the
        adoption of FAS 123(R). These increases, in salaries and benefit, were partially
        offset by a decrease in headcount of thirty five people as part of the June
        2006
        restructure.





Research
      and development expenses decreased $697,000 in fiscal 2005 as compared to fiscal
      2004. The decrease is attributable to decreases of $478,000 in non-recurring
      engineering costs associated with tape-out, mask activities and qualification
      testing of products under development, $214,000 in engineering and consulting
      services (which reflects the net effect of a reduction of $481,000 in consulting
      fees related to the transition and transfer of the technical designs of the
      IBM
      network processors and $633,000 in other services as outsourced projects were
      completed, offset by an increase of $900,000 in engineering services for
      milestone deliveries related to the pattern matching technology development),
      $587,000 in software tools and maintenance expense, which is a result of the
      consolidation of certain software tools and maintenance arrangements coupled
      with the termination of any such arrangements related to completed projects.
      These decreases were offset by an increase of $650,000 in salaries and benefits
      expense mainly as a result of a combination of higher average salary rates
      on
      twenty-three additional engineers hired during fiscal 2005.





In
      June,
      2006 we instituted a reduction in force which primarily effected the research
      and development activity and therefore expect a reduction in our research and
      development expenses in the next fiscal period. In addition, a number of
      projects were cancelled which reduced research and development expense in the
      fourth fiscal quarter of 2006. Research and development activities will continue
      but at a reduced monetary level with much of the product development being
      conducted in lower cost areas. However, we cannot assure that our product
      development programs will be successful or that products resulting from such
      programs will achieve market acceptance.





-31-
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          of Contents**


*Sales
      and Marketing.*




**Year
                  Ended September 30,**(dollars
                  in thousands)
              **2006**
              
              **2005**
              
              **2004**
              
              **2006
                  vs. 2005**
                **Change**
              
              **2005
                  vs. 2004**
                **Change**Sales
                  & marketing expenses
              $7,382
              
              $7,515
              
              $7,324
              
              (2)%
              
              3%As
                  a percentage of net revenues
              17%
              
              16%
              
              17%







Sales
      and
      marketing expenses consist primarily of salaries, commissions and benefits
      of
      sales, marketing and support personnel as well as consulting, advertising,
      promotion and overhead expenses. Such expenses decreased $133,000 in fiscal
      2006
      over the same period in fiscal 2005. The decrease is the net effect of a
      decrease in sales representative commissions of $268,000 due to lower sales,
      $80,000 in building expenses due to the expiration of a lease and $15,000 in
      miscellaneous and other expenses. The decrease was partially offset by increased
      salaries and benefits of $167,000 due to a combination of higher average salary
      rates in connection with the employee performance reviews at the beginning
      of
      the fiscal year (partially offset by a reduction in headcount) and $172,000
      in
      stock-based compensation expense as a result of the adoption of SFAS 123(R)
      and
      an increase in tradeshow expenses of $63,000.





Sales
      and
      marketing expenses increased $191,000 in fiscal 2005 over the same period in
      fiscal 2004. The increase is the net effect of an increase in salaries and
      benefits of $128,000 due to salary increases in connection with the employee
      performance reviews at the beginning of the fiscal year coupled with an increase
      of $66,000 in travel expenses as a result of increased international and sales
      conference related travels.





*General
      and Administrative.*


**Year
                  Ended September 30,**(dollars
                  in thousands)
              **2006**
              
              **2005**
              
              **2004**
              
              **2006
                  vs. 2005 Change**
              
              **2005
                  vs. 2004**
                **Change**General
                  & administrative expenses
              $6,984
              
              $5,332
              
              $4,492
              
              31%
              
              19%As
                  a percentage of net revenues
              16%
              
              11%
              
              11%




General
      and administrative expenses are comprised primarily of salaries for
      administrative and corporate services personnel, legal and other professional
      fees. Such expenses increased $1.7 million in fiscal 2006. The increase
      primarily relates to an increase in salaries and benefits of $740,000 as a
      result of a combination of higher average salary rates in connection with the
      employee performance reviews at the beginning of the fiscal year, executive
      bonuses and $341,000 as a result of the adoption of SFAS 123(R), $436,000 in
      building expenses due to the closure of our Carlsbad location, which was
      partially offset by a reduction in lease cost due to the expiration of a lease
      and $476,000 in professional services, miscellaneous and other expenses, mainly
      due to the reduction in reserves for professional services and bad debt in
      June
      2005, together with some professional services incurred during fiscal year
      2006.





General
      and administrative expenses increased $840,000 in fiscal 2005, primarily as
      a
      result of an increase in accounting and outside consulting services costs of
      $672,000 for work related to internal control documentation and compliance
      with
      Section 404 of the Sarbanes-Oxley Act of 2002 and an increase in salaries and
      benefits of $168,000 in connection with the employee performance reviews at
      the
      beginning of the fiscal year.





*Amortization
      of Intangibles.*




**Year
                  Ended September 30,**(dollars
                  in thousands)
              **2006**
              
              **2005**
              
              **2004**
              
              **2006
                  vs. 2005**
                **Change**
              
              **2005
                  vs. 2004**
                **Change**Amortization
                  of intangibles
              $3,161
              
              $3,296
              
              $3,062
              
              (4)%
              
              8%As
                  a percentage of net revenues
              7%
              
              7%
              
              8%




Amortization
      of intangibles relate to acquired technology, workforce and patents.
      Amortization of intangibles decreased $135,000 in fiscal 2006 as compared to
      fiscal 2005 as a result of the full amortization of previously capitalized
      intangible assets related
      to the Apptitude and C-Sky asset acquisitions.




Amortization
      of intangibles increased $234,000 in fiscal
      2005 as compared to fiscal 2004. The increase is the net effect
      of


-32-
 **Table
          of Contents**


an
      increase of $580,000 in amortization of developed and core technology related
      to
      the pattern matching technology assets acquired in September 2004, offset by
      a
      reduction in amortization of previously capitalized intangible assets related
      to
      the Apptitude and NetOctave asset acquisitions as they reached their estimated
      useful lives.





*Impairment
      of Assets.*


**Year
                  Ended September 30,**(dollars
                  in thousands)
              **2006**
              
              **2005**
              
              **2004**
              
              **2006
                  vs. 2005**
                **Change**
              
              **2005
                  vs. 2004**
                **Change**Impairment
                  of assets
              $292
              
              $
                  -
              
              $
                  -
              
              N/A
              
              -As
                  a percentage of net revenues
              1%
              
              -
              
              -




On
      June
      28, 2006 the company implemented a restructuring plan to be more focused on
      the
      strategy in the networking and storage markets and resulted in the termination
      of certain engineering projects. The terminated projects resulted in the
      impairment of certain software assets of $292,000.





*Purchased
      In-Process Research and Development.*





**Year
                Ended September 30,**(dollars
                in thousands)
            **2006**
            
            **2005**
            
            **2004**
            
            **2006
                vs. 2005**
              **Change**
            
            **2005
                vs. 2004**
              **Change**Purchased
                in-process research & development
            $
                -
            
            $
                -
            
            $4,230
            
            -
            
            (100)%As
                a percentage of net revenues
            -
            
            -
            
            10%




Purchased
      in-process research and development in fiscal 2004 include $893,000 related
      to
      the purchase of certain assets for embedded processor technology and $3.3
      million related to the purchase of certain assets and intellectual property
      for
      programmable network processors designed for network traffic related to the
      IBM
      network processor product line. The allocated amount of $3.3 million, related
      to
      two projects, was determined by management based on established valuation
      techniques in the semiconductor industry and was expensed upon acquisition
      because technological feasibility had not been established and no alternative
      future uses exist. The acquired technology includes development work on the
      next
      generation network processor (increasing speed and density while reducing die
      size) which was approximately 85% complete, but the project was cancelled as
      part of the June 28, 2006 restructure. The fair value of the projects containing
      in-process technology in development was determined using the income approach,
      which discounts expected future cash flows to present value. The discount rates
      used in the present value calculations was derived from a weighted-average
      cost
      of capital analysis adjusted to reflect additional risks inherent in the
      development life cycle including the failure to achieve technical viability,
      rapid changes in customer markets and required standards for new products as
      well as potential competition in the market for such products. The allocated
      value related to the purchase of certain assets for embedded processor
      technology of $893,000 was determined by management based on established
      valuation techniques and was expensed upon acquisition because technological
      feasibility had not been established and no alternative future uses
      existed.





*Interest
      and Other Income, Net* .


**Year
                  Ended September 30,**(dollars
                  in thousands)
              **2006**
              
              **2005**
              
              **2004**
              
              **2006
                  vs. 2005**
                **Change**
              **2005
                  vs. 2004**
                **Change**Interest
                  income
              $
              1,927
              
              $
              1,264
              
              $
              580
              
              52%
              
              118%Interest
                  expense
              
              (11
              )
              
              (71
              )
              
              (55
              )
              85%
              
              29%Other
                  expense, net
              
              (54
              )
              
              (51
              )
              
              (52
              )
              (6)%
              
              (2)%Interest
                  & other income, net
              $
              1,862
              
              $
              1,142
              
              $
              473
              
              63%
              
              141%As
                  a percentage of net revenues
              
              4%
              
              
              2%
              
              
              1%







Interest
      and other income, net, increased $720,000 in fiscal 2006 as compared to fiscal
      2005 and increased $669,000 in fiscal 2005
      as
      compared to fiscal 2004. The increase in fiscal 2006 was primarily as a result
      the timing in purchases of higher-average-yield instruments to take advantage
      of
      rising interest rates. The increase in fiscal 2005 was primarily a result of
      a
      higher average cash balance during the periods due to additional cash generated
      from the private financing completed in February 2004 as well as the timing
      in
      purchases of higher-average-yield instruments to take advantage of rising
      interest rates.


-33-
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          of Contents**




*Income
      Taxes.*


**Year
                  Ended September 30,**(dollars
                  in thousands)
              **2006**
              
              **2005**
              
              **2004**
              
              **2006
                  vs. 2005 Change**
              
              **2005
                  vs. 2004 Change**Provision
                  for income taxes
              $
                  41
              
              $
                  90
              
              $
                  -
              
              (54)%
              
              N/AAs
                  a percentage of net revenues
              Less
                  than 1%
              
              Less
                  than 1%
              
              -







We
      recognize income tax expense based on an asset and liability approach that
      requires recognition of deferred tax assets and liabilities related to future
      tax consequences of events recognized in both our financial statements and
      income tax returns. Prior to fiscal 2003, we recorded a full valuation allowance
      for our deferred tax assets. In fiscal 2003, we recognized a tax benefit of
      $1.8
      million related to carry back of net operating losses to prior years. As a
      result of continuing losses over a longer period than previously expected,
      we
      have not recognized tax benefits for the years ended September 30, 2006, 2005
      and 2004. The provision for income taxes for fiscal 2006 reflects taxes on
      our
      non-U.S. operations. We continue to consider future taxable income and ongoing
      prudent and feasible tax planning strategies in assessing the valuation
      allowance.





**Liquidity
      and Capital Resources**





A
      summary
      of the sources and uses of cash and cash equivalents is as follows:


**Year
                  Ended September 30,****2006**
              
              **2005**
              
              **2004**(in
                  thousands)Net
                  cash used in operating activities
              
              $
              (5,490
              )
              
              (1,479
              )
              
              (6,351
              )Net
                  cash provided by (used in) operating activities
              
              
              1,328
              
              
              10,807
              
              
              (50,913
              )Net
                  cash provided by (used in) financing activities
              
              
              1,420
              
              
              (2,965
              )
              
              33,000Net
                  increase (decrease) in cash and cash equivalents
              
              $
              (2,742
              )
              $
              6,363
              
              $
              (24,264
              )
  *Operating
        Activities* .
        Net
        cash used in operating activities was $5.5 million for fiscal 2006 resulting
        from net loss during the period of $8.7 million, adjusted for non-cash items
        including depreciation and amortization of fixed assets of $1.8 million,
        amortization of intangibles related to acquired technologies of $3.2 million,
        an
        impairment of certain software assets in the amount of $292,000, stock-based
        compensation expenses of $977,000, a loss of $38,000 on the disposition of
        fixed
        assets and the net change in assets and liabilities comprised of a decrease
        in
        accounts receivable of $454,000, reflecting a shift in the timing of shipments
        and payments during the last quarter of fiscal 2006 as compared to fiscal
        2005,
        an increase in accounts payable of $148,000 as a result of the timing of
        purchases and a decrease in inventories of $108,000, net of $950,000 in
        additions to the provision for excess and obsolete inventory. Contributing
        to
        cash used in operations was an increase in prepaid expenses and other current
        assets of $768,000, mainly due to the addition of prepaid maintenance and
        licenses agreements in China, an increase in other assets of $178,000, mainly
        as
        a result of additions in licensed software and a decrease in accrued expenses
        and other current liabilities of $2.8 million reflecting a reduction in accrued
        vacant facility lease cost in accordance with scheduled amortization and
        payments as well as for non-recurring engineering cost.





In
      fiscal
      2005, net cash used in operating activities was $1.5 million for fiscal 2005
      resulting from net loss during the period of $5.2 million, adjusted for non-cash
      items including depreciation and amortization of fixed assets of $1.5 million,
      amortization of intangibles related to acquired technologies of $3.3 million
      and
      the net change in assets and liabilities comprised of a decrease in accounts
      receivable of $582,000, reflecting lower revenue levels during the last month
      of
      fiscal 2005 as compared to the last month of fiscal 2004, a decrease in prepaid
      expenses and other current assets of $185,000 due to reductions in prepaid
      rent,
      resulting from the overall decrease in facility square footage and monthly
      rental cost, and prepaid maintenance and licenses resulting from the non-renewal
      of license and maintenance agreements related to completed projects, and an
      increase in accrued expenses and other current liabilities of $262,000
      reflecting the net effect of an increase in deferred income and revenues which
      relate to the timing of customer purchases of license and maintenance contracts
      amortizable over the service or license term and distributor sell-through of
      purchased processors, offset by a reduction in accrued vacant facility lease
      cost in accordance with scheduled amortization. Contributing to cash used in
      operations was an increase in inventories of $85,000, a decrease in other assets
      of $163,000, mainly as a result of a decrease in licensed software and a
      decrease in accounts payable of $1.9 million as a result of the timing of
      purchases of inventory and software maintenance tools.




In
      fiscal 2004, net cash used in operating activities
      was $6.4 million and was the result of net loss of $10.9 million, adjusted
      for
      non-cash items including purchased in-process research and development of $4.2
      million, depreciation and amortization of fixed assets of $2.0 million,
      amortization of intangibles related to acquired technologies of $3.1 million,
      which includes $2.4 million in amortization of the acquired backlog and
      technology related to the IBM network processor product line, amortization
      of
      deferred stock compensation of $138,000 and loss on disposal of leasehold
      improvements of $175,000 related to an expired lease, as well as an increases
      in
      accounts payable of $1.7 million attributable to purchases of inventory,
      corresponding with increased revenues. These adjustments were offset by
      increases in accounts receivable of $3.0 million and inventories of $1.6
      million, as a


-34-
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          of Contents**





result
      of
      increased revenues. Also contributing to net cash used in operating activities
      was a decrease in accrued expenses and other current liabilities of $1.9 million
      as a result of a reduction in deferred revenues and accrued non-recurring
      engineering costs.





*Investing
      Activities* .
      Net
      cash provided by investing activities in fiscal 2006 of $1.3 million reflects
      the net sale of short-term investments of $2.9 million offset by the purchase
      of
      property and equipment of $1.6 million. Net cash provided by investing
      activities in fiscal 2005 of $10.8 million reflects the net sale of short-term
      investments of $12.0 million as the Company shifted its portfolio mix from
      government agency obligations to higher-yielding instruments like corporate
      obligations and commercial paper as interest rates were increasing, and the
      purchase of property and equipment of $1.2 million for office and computer
      equipment. Net cash used in investing activities in fiscal 2004 of $50.9 million
      reflects the purchase of certain assets and intellectual property for $18.7
      million, including $15.9 million related to the IBM network processor product
      line and $1.8 million related to the purchase of pattern matching technology,
      the net purchase of short-term investments of $31.3 million utilizing the
      proceeds from the private placement financing and the purchase of property
      and
      equipment of $931,000.





*Financing
      Activities.* Cash
      provided by financing activities in fiscal 2006 was $1.4 million and was the
      result of cash proceeds from the issuance of common stock for stock option
      exercises and employee stock purchase plan purchases which aggregated $1.6
      million offset by installment payments on acquired software licenses of
      $219,000. Cash used in financing activities in fiscal 2005 was $3.0 million
      and
      was the result of the repurchase of approximately 693,000 of our outstanding
      common stock for $4.3 million and installment payments on acquired software
      licenses of $696,000, offset by cash proceeds from the issuance of common stock
      for stock option exercises and employee stock purchase plan purchases which
      aggregated $2.0 million. Cash provided by financing activities in fiscal 2004
      was $33.0 million and was comprised of net proceeds from the private placement
      financing of $30.9 million, cash proceeds from the issuance of common stock
      for
      stock option exercises and employee stock purchase plan purchases which
      aggregated $3.0 million offset by installment payments on acquired software
      licenses of $892,000. On February 6, 2004, the Company entered into a securities
      purchase agreement with certain investors for the private placement of 2.2
      million shares of the Company’s common stock at a price of $15.00 per share for
      aggregate proceeds of $30.9 million, net of expenses of approximately $2.1
      million. The net proceeds are used for working capital and general corporate
      purposes, and may be used for strategic purposes in connection with selected
      acquisitions that may be considered in the future to expand its product and
      service offerings. The shares were issued and paid for on February 6, 2004.




The
      Company’s inventory balance at September 30, 2006 reflected a decrease of
      $108,000 as compared to the balance as of September 30, 2005. The decrease
      in
      inventory was a result of the timing of inventory purchases relative to
      manufacturer lead-time coupled with anticipated shipment schedules to fill
      customer orders for the succeeding quarter offset by an increase in our reserve
      for excess and obsolete inventory of $950,000. The Company’s inventory turns for
      the year ended September 30, 2006 were 7.2 times as compared to 6.8 times for
      the year ended September 30, 2005. The Company’s accounts receivable balance,
      which is contingent upon the timing of product shipment within the respective
      periods, decreased $457,000 to $4.6 million, as of September 30, 2006,
      reflecting a shift in the timing of shipments and payments during the last
      quarter of fiscal 2006 as compared to fiscal 2005.





The
      Company uses a number of independent suppliers to manufacture substantially
      all
      of its products. As a result, the Company relies on these suppliers to allocate
      to the Company a sufficient portion of foundry capacity to meet the Company’s
      needs and deliver sufficient quantities of the Company’s products on a timely
      basis. These arrangements allow the Company to avoid utilizing its capital
      resources for manufacturing facilities and work-in-process inventory and to
      focus substantially all of its resources on the design, development and
      marketing of its products.





The
      Company requires substantial working capital to fund its business, particularly
      to finance accounts receivable and inventory, and for investments in property
      and equipment. The Company’s need to raise capital in the future will depend on
      many factors including the rate of sales growth, market acceptance of the
      Company’s existing and new products, the amount and timing of research and
      development expenditures, the timing and size of acquisitions of businesses
      or
      technologies, the timing of the introduction of new products and the expansion
      of sales and marketing efforts. We believe that our existing cash resources
      will
      fund any anticipated operating losses, purchases of capital equipment and
      provide adequate working capital for the next twelve months. Our liquidity
      is
      affected by many factors including, among others, the extent to which we pursue
      additional capital expenditures, the level of our product development efforts,
      and other factors related to the uncertainties of the industry and global
      economies. Accordingly, there can be no assurance that events in the future
      will
      not require us to seek additional capital sooner or, if so required, that such
      capital
      will be available at all or on terms acceptable to us. 
 *Common
        Stock Repurchase.*  On
        April
        25, 2005, the Company’s Board of Directors authorized a stock repurchase program
        whereby the Company could repurchase shares of the Company’s common stock with
        an aggregate fair market value of up to $10 million from time to time through
        open market and privately negotiated transactions at prices determined by
        management. The timing and amount of repurchases under this program were
        dependent upon market conditions and corporate and regulatory considerations.
        The purchases were funded from available working capital. The stock repurchase
        program expired on April 25, 2006. The Company did not repurchase any shares
        during fiscal year 2006. As of the expiration date of the program a total
        of
        692,894 shares have been repurchased under the program, which shares are
        held in
        treasury stock, at a cost of $4.3 million.


-35-
 **Table
          of Contents**


**Contractual
      Obligations**




The
      Company occupies its facilities under several non-cancelable operating leases
      that expire at various dates through June 2010, and which contain renewal
      options. Additionally, contractual obligations were also entered into related
      to
      non-recurring engineering services and inventory purchases. Payment obligations
      for such commitments as of September 30, 2006 are as follows:




**Payments
                  Due By Period****Contractual
                  Obligations**
              
              **Total**
              
              **Less
                  than**
                **1
                  year**
              
              **1
                  - 3**
                **years**
              
              **3
                  - 5**
                **years**
              
              **More
                  than 5 years**(in
                  thousands)Operating
                  lease commitments
              
              $
              5,181
              
              $
              2,106
              
              $
              2,509
              
              $
              546
              
              $
              20Inventory
                  purchases
              
              
              3,491
              
              
              3,491
              
              
              -
              
              
              -
              
              
              -Non-recurring
                  engineering expense
              
              
              510
              
              
              510
              
              
              -
              
              
              -
              
              
              -Totals
              
              $
              9,182
              
              $
              6,107
              
              $
              2,509
              
              $
              546
              
              $
              20


**Guarantees**





In
      November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”),
“Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including
      Indirect Guarantees of Indebtedness of Others.”  FIN 45 requires that a
      liability be recorded in the guarantor’s balance sheet upon issuance of a
      guarantee. In addition, FIN 45 requires disclosures about the guarantees that
      an
      entity has issued, including a reconciliation of changes in the entity’s product
      warranty liabilities. The initial recognition and initial measurement provisions
      of FIN 45 are applicable on a prospective basis to guarantees issued or modified
      after December 31, 2002. The disclosure requirements of FIN 45 are effective
      for
      financial statements of interim or annual periods ending after December 15,
      2002. Agreements that we have determined to be within the scope of FIN 45
      include hardware and software license warranties, indemnification arrangements
      with officers and directors and indemnification arrangements with customers
      with
      respect to intellectual property. To date, the Company has not incurred material
      costs in relation to any of the above guarantees and, accordingly, adoption
      of
      this standard did not have a material impact on its financial position, results
      of operations or cash flows.





As
      permitted under Delaware law, the Company has agreements that provide
      indemnification of officers and directors for certain events or occurrences
      while the officer or director is, or was serving, at the Company’s request in
      such capacity. The indemnification period is effective for the officer’s or
      director’s lifetime. The maximum potential amount of future payments that the
      Company could be required to make under these indemnification agreements is
      unlimited; however, the Company has a Director and Officer insurance policy
      that
      limits its exposure and enables the Company to recover a portion of any future
      amounts paid. All of the indemnification agreements were grandfathered under
      the
      provisions of FIN 45 as they were in effect prior to December 31, 2002. As
      a
      result of the insurance policy coverage, the Company believes the estimated
      fair
      value of the potential liability under these agreements is minimal. Accordingly,
      the Company has not recorded any liabilities for these agreements as of
      September 30, 2006.




The
      Company enters into standard indemnification agreements in the ordinary course
      of business. Pursuant to these agreements, the Company indemnifies, holds
      harmless, and agrees to reimburse the indemnified party, generally business
      partners or customers, for losses suffered or incurred in connection with
      patent, copyright or other intellectual property infringement claims by any
      third party with respect to the Company’s products. The term of these
      indemnification agreements is generally perpetual, effective after execution
      of
      the agreement. The maximum potential amount of future payments the Company
      could
      be required to make under these indemnification agreements is unlimited. To
      date, the Company has not incurred costs to defend lawsuits or settle claims
      related to these indemnification agreements. Accordingly, the Company has not
      recorded any liabilities for these agreements as of September 30, 2006. However,
      the Company may, in the future, record charges related to indemnification
      obligations and, depending upon the nature of any such lawsuit or claim, the
      estimated fair value of such indemnification obligations may be material.




The
        Company warrants that its hardware products are free from defects in material
        and workmanship under normal use and service and that its hardware and software
        products will perform in all material respects in accordance with the standard
        published specifications in effect at the time of delivery of the licensed
        products to the customer. The warranty periods generally range from three
        months
        to one year for software and one year for hardware. Additionally, the Company
        warrants that its maintenance services will be performed consistent with
        generally accepted industry standards through completion of the agreed upon
        services. The Company’s policy is to provide for the estimated cost of product
        and service warranties based on specific warranty claims and claim history
        as a
        charge to cost of revenues. To date, the Company has not incurred significant
        expense under its product or service warranties. As a result, the Company
        has
        not recorded an accrual related to product or warranty services as of September
        30, 2006. The Company assesses the need for a warranty accrual every quarter.
        There is no assurance that a warranty accrual will not be necessary in the
        future.


-36-
 **Table
          of Contents**




**Off-Balance
      Sheet Arrangements**





The
      Company has no off-balance sheet arrangements that have or are reasonably likely
      to have a current or future effect on the Company’s financial condition,
      revenues or expenses, results of operations, liquidity, capital expenditures
      or
      capital resources that may be material to investors.





**Recent
      Accounting Pronouncements**





In
      May 2005, as part of a broader attempt to eliminate differences with the
      International Accounting Standards Board, the FASB issued Statement of Financial
      Accounting Standards No. 154 (“SFAS No. 154”), “Accounting Changes and
      Error Corrections,” which replaces Accounting Principles Board Opinion
      No. 20 (“APB No. 20”), “Accounting Changes,” and FASB Statement of
      Financial Accounting Standards No. 3, “Reporting Accounting Changes in
      Interim Financial Statements.” Opinion No. 20 had required that changes in
      accounting principles be recognized by including the cumulative effect of the
      change in the period in which the new accounting principle was adopted. SFAS
      No. 154 requires retrospective application of the change to prior periods’
financial statements, unless it is impracticable to determine the
      period-specific effects of the change. The Statement is effective for fiscal
      years beginning after December 15, 2005. The adoption of this statement did
      not have a material effect on the Company’s financial statements.





In
      July
      2006, the FASB issued FASB Interpretation 48, “Accounting for Income Tax
      Uncertainties” (FIN 48). FIN 48 defines the threshold for recognizing the
      benefits of tax return positions in the financial statements as
“more-likely-than-not” to be sustained by the tax authority. The recently issued
      literature also provides guidance on the recognition, measurement and
      classification of income tax uncertainties, along with any related interest
      and
      penalties. FIN 48 also includes guidance concerning accounting for income tax
      uncertainties in interim periods and increases the level of disclosures
      associated with any recorded income tax uncertainties. FIN 48 is effective
      for
      the fiscal years beginning after December 15, 2006. The differences between
      the
      amounts recognized in the statements of financial position prior to the adoption
      of FIN 48 and the amounts reported after adoption will be accounted for as
      a
      cumulative-effect adjustment recorded to the beginning balance of retained
      earnings .
      We are
      evaluating the impact, if any, of adopting the provisions of FIN 48 on our
      financial position and results of operations.





In
      July
      2006, the FASB issued EITF
      Issue No. 06-3 ,
“How
      Taxes Collected from Customers Remitted to Governmental Authorities Should
      be
      Presented in the Income Statement (that is, Gross versus Net Presentation).” The
      adoption of EITF No. 06-3 did not have an impact on the Company’s consolidated
      financial statements.




In
      September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS
      157”), which clarifies the definition of fair value, establishes guidelines for
      measuring fair value, and expands disclosures regarding fair value
      measurements.  SFAS 157 does not require any new fair value measurements
      and eliminates inconsistencies in guidance found in various prior accounting
      pronouncements.  SFAS 157 will be effective for the Company on October
      1, 2008. The Company is currently evaluating the impact of adopting SFAS 157
      on
      its financial position, cash flows, and results of operations.





In
      September 2006, the Securities and Exchange Commission (“SEC”) released Staff
      Accounting Bulletin No. 108, “Considering the Effects of Prior Year
      Misstatements when Quantifying Misstatements in Current Year Financial
      Statements” (“SAB 108”). SAB 108 provides interpretive guidance on the
      SEC’s views on how the effects of the carryover or reversal of prior year
      misstatements should be considered in quantifying a current year misstatement.
      The provisions of SAB 108 will be effective for the Company for the fiscal
      year
      ending September 30, 2007. The adoption of SAB 108 is not expected to have
      a
      material effect on its financial position, cash flows, and results of
      operations.


**Item
      7A.** ***Quantitative
      and Qualitative Disclosures About Market Risk***





*Interest
      Rate Risk.* We do
      not use derivative financial instruments in our investment portfolio. We
      maintain a conservative investment policy, which focuses on safety and principal
      preservation of our invested funds. Our investment portfolio is generally
      comprised of commercial paper and municipal bonds. We place investments in
      instruments that meet high credit quality standards. These securities are
      subject to interest rate risk, and could decline in value if interest rates
      fluctuate. Due to the short duration and conservative nature of our investment
      portfolio, we do not expect any material loss with respect to our investment
      portfolio. A 10% move in interest rates as of September 30, 2006 would have
      an
      immaterial effect on our pre-tax earnings and the carrying value of our
      investments over the next fiscal year.





*Foreign
      Currency Exchange Rate Risk.* All
      of
      our sales and the majority of cost of manufacturing and marketing are transacted
      in U.S. dollars. Accordingly, our results of operations are not subject to
      any
      significant foreign exchange rate fluctuations. To date, we have not incurred
      any significant gains and losses from such fluctuations.





-37-
 **Table
            of Contents**


**Item
      8.**  ***Financial
      Statements and Supplementary Data***











**INDEX
      TO CONSOLIDATED FINANCIAL STATEMENTS**







Financial
                Statements:
            PageReport
                of Independent Registered Public Accounting Firm
            39Consolidated
                Balance Sheets as of September 30, 2006 and 2005
            40Consolidated
                Statements of Operationsfor the years ended September 30, 2006, 2005 and 2004
            41Consolidated
                Statements of Stockholders’ Equityfor the years ended September 30, 2006, 2005 and 2004
            42Consolidated
                Statements of Cash Flowsfor the years ended September 30, 2006, 2005 and 2004
            43Notes
                to Consolidated Financial Statements
            44Financial
                Statement Schedule:Schedule
                II Valuation and Qualifying Accountsfor the years ended September 30, 2006, 2005 and 2004
            65







-38-
 **Table
          of Contents**





**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
      FIRM**




To **** the
        Board
        of Directors and Stockholders of hi/fn, inc.:
 
 We
        have
        completed integrated audits of hi/fn, inc.’s 2006 and 2005 consolidated financial statements and of its internal control over financial reporting
        as of
        September 30, 2006 and an audit of its 2004 consolidated financial statements in accordance with the standards of the Public Company
        Accounting Oversight Board (United States). Our opinions, based on our audits,
        are presented below.
 
 Consolidated
        f inancial
        statements and financial statement schedule
 
 In
        our
        opinion, the consolidated financial statements listed in the accompanying index present fairly, in
        all
        material respects, the financial position of hi/fn, inc. and
        its
        subsidiaries **** at  September
        30, 2006  and
        2005,
        and the results of their operations and their cash
        flows for each of the three years in the period ended  September
        30, 2006  in
        conformity with accounting principles generally accepted in the United States
        of
        America. In addition, in our opinion, the financial statement schedule listed
        in
        the accompanying index presents fairly, in all material respects, the
        information set forth therein when read in conjunction with the related
        consolidated financial statements. These financial statements and financial
        statement schedule are the responsibility of the Company’s management. Our
        responsibility is to express an opinion on these financial statements and
        financial statement schedule based on our audits. We conducted our audits
        of
        these statements in accordance with the standards of the Public Company
        Accounting Oversight Board (United States). Those standards require that
        we plan
        and perform the audit to obtain reasonable assurance about whether the financial
        statements are free of material misstatement. An audit of financial statements
        includes examining, on a test basis, evidence supporting the amounts and
        disclosures in the financial statements, assessing the accounting principles
        used and significant estimates made by management, and evaluating the overall
        financial statement presentation. We believe that our audits provide a
        reasonable basis for our opinion.
  As
        discussed in Note 2 to the consolidated financial statements, the Company
        changed the manner in which it accounts for share-based compensation in fiscal
        2006.
 
 Internal
        control over financial reporting
 
 Also,
        in
        our opinion, management’s assessment, included in Management’s Report on
        Internal Control Over Financial Reporting appearing under Item 9A, that the
        Company maintained effective internal control over financial reporting as
        of
        September 30, 2006 based on criteria established in *Internal
        Control - Integrated Framework* issued
        by the Committee of Sponsoring Organizations of the Treadway Commission (COSO),
        is fairly stated, in all material respects, based on those criteria.
        Furthermore, in our opinion, the Company maintained, in all material respects,
        effective internal control over financial reporting as of September 30, 2006,
        based on criteria established in *Internal
        Control - Integrated Framework* issued
        by the COSO. The Company’s management is responsible for maintaining effective
        internal control over financial reporting and for its assessment of the
        effectiveness of internal control over financial reporting. Our responsibility
        is to express opinions on management’s assessment and on the effectiveness of
        the Company’s internal control over financial reporting based on our audit. We
        conducted our audit of internal control over financial reporting in accordance
        with the standards of the Public Company Accounting Oversight Board (United
        States). Those standards require that we plan and perform the audit to obtain
        reasonable assurance about whether effective internal control over financial
        reporting was maintained in all material respects. An audit of internal control
        over financial reporting includes obtaining an understanding of internal
        control
        over financial reporting, evaluating management’s assessment, testing and
        evaluating the design and operating effectiveness of internal control, and
        performing such other procedures as we consider necessary in the circumstances.
        We believe that our audit provides a reasonable basis for our opinions.
 
 A
        company’s internal control over financial reporting is a process designed to
        provide reasonable assurance regarding the reliability of financial reporting
        and the preparation of financial statements for external purposes in accordance
        with generally accepted accounting principles. A company’s internal control over
        financial reporting includes those policies and procedures that (i) pertain
        to the maintenance of records that, in reasonable detail, accurately and
        fairly
        reflect the transactions and dispositions of the assets of the company;
        (ii) provide reasonable assurance that transactions are recorded as
        necessary to permit preparation of financial statements in accordance with
        generally accepted accounting principles, and that receipts and expenditures
        of
        the company are being made only in accordance with authorizations of management
        and directors of the company; and (iii) provide reasonable assurance
        regarding prevention or timely detection of unauthorized acquisition, use,
        or
        disposition of the company’s assets that could have a material effect on the
        financial statements.
 
 Because
        of its inherent limitations, internal control over financial reporting may
        not
        prevent or detect misstatements. Also, projections of any evaluation of
        effectiveness to future periods are subject to the risk that controls may
        become
        inadequate because of changes in conditions, or that the degree of compliance
        with the policies or procedures may deteriorate.
 
 
 /s/
        PricewaterhouseCoopers
 
 San
        Jose,
        California
 December
        14, 2006


-39-
 **Table
            of Contents**
  **HIFN,
        INC**
 **CONSOLIDATED
        BALANCE**
 (in
        thousands, except share and per share amounts)


**September
                  30,****2006**
              
              **2005****ASSETS**CURRENT
                  ASSETS:Cash
                  and cash equivalents
              
              $
              20,437
              
              $
              23,179Short-term
                  investments
              
              
              18,340
              
              
              21,261Accounts
                  receivable, net of allowance for doubtful
                accounts
                  of $107 and $104, respectively
              
              
              4,614
              
              
              5,071Inventories
              
              
              2,028
              
              
              2,136Prepaid
                  expenses and other current assets
              
              
              1,571
              
              
              803Total
                  current assets
              
              
              46,990
              
              
              52,450Property
                  and equipment, net
              
              
              2,356
              
              
              1,846Intangible
                  assets, net
              
              
              6,881
              
              
              10,042Other
                  assets
              
              
              1,249
              
              
              2,113$
              57,476
              
              $
              66,451**LIABILITIES
                  AND STOCKHOLDERS’ EQUITY**CURRENT
                  LIABILITIES:Accounts
                  payable
              
              $
              1,672
              
              $
              1,743Accrued
                  expenses and other current liabilities
              
              
              5,119
              
              
              7,952Total
                  current liabilities
              
              
              6,791
              
              
              9,695COMMITMENTS
                  AND CONTINGENCIES(Note 11)STOCKHOLDERS’
                  EQUITY:Convertible
                  preferred stock, $0.001 par value; 10,000,000 shares
                  authorized;
                none
                  issued and outstanding
              
              
              —
              
              
              —Common
                  stock, $0.001 par value; 100,000,000 shares authorized;
                14,599,000
                  and 14,215,000 shares issued; and 13,906,000 and
                13,522,000
                  outstanding, respectively
              
              
              14
              
              
              14Additional
                  paid-in capital
              
              
              166,100
              
              
              163,484Accumulated
                  other comprehensive loss
              
              
              (1
              )
              
              (38
              )Accumulated
                  deficit
              
              
              (111,175
              )
              
              (102,451
              )Treasury
                  stock, 693,000 and 693,000 outstanding shares, respectively, at
                  cost
              
              
              (4,253
              )
              
              (4,253
              )Total
                  stockholders’ equity
              
              
              50,685
              
              
              56,756$
              57,476
              
              $
              66,451





The
      accompanying notes are an integral part of these consolidated financial
      statements.




-40-
 **Table
            of Contents**


HIFN,
      INC **CONSOLIDATED
        STATEMENTS OF OPERATIONS**


(in
      thousands, except per share data)


**Year
                  Ended September 30,****2006**
              
              **2005**
              
              **2004**Net
                  revenues:Processors
              
              $
              40,262
              
              $
              42,055
              
              $
              35,773Software
                  licenses and other
              
              
              3,502
              
              
              4,339
              
              
              6,369Total
                  net revenues
              
              
              43,764
              
              
              46,394
              
              
              42,142Costs
                  and operating expenses:Cost
                  of revenues - processors
              
              
              15,001
              
              
              14,246
              
              
              11,477Cost
                  of revenues - software licenses and other
              
              
              506
              
              
              552
              
              
              480Research
                  and development
              
              
              20,983
              
              
              21,721
              
              
              22,418Sales
                  and marketing
              
              
              7,382
              
              
              7,515
              
              
              7,324General
                  and administrative
              
              
              6,984
              
              
              5,332
              
              
              4,492Amortization
                  of intangibles
              
              
              3,161
              
              
              3,296
              
              
              3,062Impairment
                  of assets
              
              
              292
              
              
              —
              
              
              —Purchased
                  in-process research & development
              
              
              —
              
              
              —
              
              
              4,230Total
                  costs and operating expenses
              
              
              54,309
              
              
              52,662
              
              
              53,483Loss
                  from operations
              
              
              (10,545
              )
              
              (6,268
              )
              
              (11,341
              )Interest
                  income
              
              
              1,927
              
              
              1,264
              
              
              580Interest
                  expense
              
              
              (11
              )
              
              (71
              )
              
              (55
              )Other
                  expense, net
              
              
              (54
              )
              
              (51
              )
              
              (52
              )Loss
                  before income taxes
              
              
              (8,683
              )
              
              (5,126
              )
              
              (10,868
              )Provision
                  for income taxes
              
              
              41
              
              
              90
              
              
              —Net
                  loss
              
              $
              (8,724
              )
              $
              (5,216
              )
              $
              (10,868
              )Net
                  loss per share:Basic
                  and diluted
              
              $
              (0.63
              )
              $
              (0.38
              )
              $
              (0.84
              )Shares
                  used in computing net loss per share:Basic
                  and diluted
              
              
              13,769
              
              
              13,887
              
              
              12,993





The
      accompanying notes are an integral part of these consolidated financial
      statements.


-41-
 **Table
              of
              Contents**


**HIFN,
        INC**
 **CONSOLIDATED
        STATEMENTS OF STOCKHOLDERS’ EQUITY**
 (in
        thousands)
  **Common
                  Stock****Shares**
              
              **Amount**
              
              **Deferred
                  Stock-Based Compen-sation**
              
              **Additional
                  Paid-In Capital**
              
              **Accumulated
                  Other Comprehensive Loss**
              
              **Accumulated
                  Deficit**
              
              **Treasury
                  Stock**
              
              **Total
                  Stockholders’ Equity****Balance
                  at September 30, 2003**
              
              **11,201**
              
              **$**
              **11**
              
              **$**
              **(138**
              **)**
              **$**
              **127,611**
              
              **$**
              **-**
              
              **$**
              **(86,367**
              **)**
              **$**
              **-**
              
              **$**
              **41,117**Net
                  loss
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (10,868
              )
              
              -
              
              
              (10,868
              )Unrealized
                  loss on financial instruments
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (50
              )
              
              -
              
              
              -
              
              
              (50
              )Comprehensive
                  loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (10,918
              )Issuance
                  of common stock upon exercise of options
              
              361
              
              
              1
              
              
              -
              
              
              2,475
              
              
              -
              
              
              -
              
              
              -
              
              
              2,476Amortization
                  of deferred stock-based compensation
              
              -
              
              
              -
              
              
              138
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              138Issuance
                  of common stock in relation to private placement financing, net
                  of $2,100
                  in issuance costs
              
              2,200
              
              
              2
              
              
              -
              
              
              30,868
              
              
              -
              
              
              -
              
              
              -
              
              
              30,870Issuance
                  of common stock under employee stock purchase plan
              
              106
              
              
              -
              
              
              -
              
              
              546
              
              
              -
              
              
              -
              
              
              -
              
              
              546**Balance
                  at September 30, 2004**
              
              **13,868**
              
              **$**
              **14**
              
              **$**
              **-**
              
              **$**
              **161,500**
              
              **$**
              **(50**
              **)**
              **$**
              **(97,235**
              **)**
              **$**
              **-**
              
              **$**
              **64,229**Net
                  loss
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (5,216
              )
              
              -
              
              
              (5,216
              )Unrealized
                  gain on financial instruments
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              12
              
              
              -
              
              
              -
              
              
              12Comprehensive
                  loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (5,204
              )Repurchase
                  of common stock, at cost
              
              (693
              )
              
              -
              
              
              -
              
              
              
              
              
              -
              
              
              -
              
              
              (4,253
              )
              
              (4,253
              )Issuance
                  of common stock upon exercise of options
              
              161
              
              
              -
              
              
              -
              
              
              962
              
              
              -
              
              
              -
              
              
              -
              
              
              962Issuance
                  of common stock under employee stock purchase plan
              
              186
              
              
              -
              
              
              -
              
              
              1,022
              
              
              -
              
              
              -
              
              
              -
              
              
              1,022**Balance
                  at September 30, 2005**
              
              **13,522**
              
              **$**
              **14**
              
              **$**
              **-**
              
              **$**
              **163,484**
              
              **$**
              **(38**
              **)**
              **$**
              **(102,451**
              **)**
              **$**
              **(4,253**
              **)**
              **$**
              **56,756**Net
                  loss
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (8,724
              )
              
              -
              
              
              (8,724
              )Unrealized
                  gain on financial instruments
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              37
              
              
              -
              
              
              -
              
              
              37Comprehensive
                  loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (8,687
              )Stock-based
                  compensation
              
              -
              
              
              -
              
              
              -
              
              
              977
              
              
              
              
              
              
              
              
              
              
              
              977Issuance
                  of common stock upon exercise of options
              
              176
              
              
              -
              
              
              -
              
              
              705
              
              
              -
              
              
              -
              
              
              -
              
              
              705Issuance
                  of common stock under employee stock purchase plan
              
              208
              
              
              -
              
              
              -
              
              
              934
              
              
              -
              
              
              -
              
              
              -
              
              
              934**Balance
                  at September 30, 2006**
              
              **13,906**
              
              **$**
              **14**
              
              **$**
              **-**
              
              **$**
              **166,100**
              
              **$**
              **(1**
              **)**
              **$**
              **(111,175**
              **)**
              **$**
              **(4,253**
              **)**
              **$**
              **50,685**


The
      accompanying notes are an integral part of these consolidated financial
      statements.


-42-
 **Table
          of Contents**


**HIFN,
      INC.**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


(in
      thousands)




**Year
                  Ended September 30,****2006**
              
              **2005**
              
              **2004**Cash
                  flows from operating activities:Net
                  loss
              
              $
              (8,724
              )
              $
              (5,216
              )
              $
              (10,868
              )Adjustments
                  to reconcile net loss to net cash used in operating
                  activities:Depreciation
                  and amortization
              
              
              1,832
              
              
              1,544
              
              
              2,049Loss
                  on disposal of fixed assets
              
              
              38
              
              
              -
              
              
              175Amortization
                  of intangible assets
              
              
              3,161
              
              
              3,296
              
              
              3,062Asset
                  impairment
              
              
              292
              
              
              -
              
              
              -Stock-based
                  compensation expense
              
              
              977
              
              
              -
              
              
              -Provision
                  for excess and obsolete inventory
              
              
              950
              
              
              -
              
              
              -Amortization
                  of deferred stock-based compensation
              
              
              -
              
              
              -
              
              
              138Purchased
                  in-process research and development
              
              
              -
              
              
              -
              
              
              4,230Allowance
                  for doubtful accounts
              
              
              3
              
              
              -
              
              
              57Changes
                  in assets and liabilities:Accounts
                  receivable
              
              
              454
              
              
              582
              
              
              (2,995
              )Inventories
              
              
              (842
              )
              
              (85
              )
              
              (1,629
              )Prepaid
                  expenses and other current assets
              
              
              (768
              )
              
              185
              
              
              37Other
                  assets
              
              
              (178
              )
              
              (163
              )
              
              (415
              )Accounts
                  payable
              
              
              148
              
              
              (1,884
              )
              
              1,699Accrued
                  expenses and other current liabilities
              
              
              (2,833
              )
              
              262
              
              
              (1,891
              )Net
                  cash used in operating activities
              
              
              (5,490
              )
              
              (1,479
              )
              
              (6,351
              )Cash
                  flows from investing activities:Sales
                  and maturities of short-term investments
              
              
              25,959
              
              
              41,948
              
              
              28,508Purchases
                  of short-term investments
              
              
              (23,001
              )
              
              (29,981
              )
              
              (59,780
              )Purchases
                  of intellectual property
              
              
              -
              
              
              -
              
              
              (18,710
              )Purchases
                  of property and equipment
              
              
              (1,630
              )
              
              (1,160
              )
              
              (931
              )Net
                  cash provided by (used in) investing activities
              
              
              1,328
              
              
              10,807
              
              
              (50,913
              )Cash
                  flows from financing activities:Proceeds
                  from issuance of common stock for stock option exercises and employee
                  stock purchase plan, net
              
              
              1,639
              
              
              1,984
              
              
              3,022Proceeds
                  from issuance of common stock in relation to private placement
                  financing,
                  net of costs
              
              
              -
              
              
              -
              
              
              30,870Repurchase
                  of common stock, at cost
              
              
              -
              
              
              (4,253
              )
              
              -Installment
                  payments on acquisition of software licenses
              
              
              (219
              )
              
              (696
              )
              
              (892
              )Net
                  cash provided by (used in) financing activities
              
              
              1,420
              
              
              (2,965
              )
              
              33,000Net
                  increase (decrease) in cash and cash equivalents
              
              
              (2,742
              )
              
              6,363
              
              
              (24,264
              )Cash
                  and cash equivalents at beginning of period
              
              
              23,179
              
              
              16,816
              
              
              41,080Cash
                  and cash equivalents at end of period
              
              $
              20,437
              
              $
              23,179
              
              $
              16,816
 Supplemental
        cash flow information (Note 7)





The
      accompanying notes are an integral part of these consolidated financial
      statements.





-43-
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          of Contents**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**NOTE
      1 — THE COMPANY**





hi/fn,
      inc., together with its subsidiaries, Hifn Limited, Hifn Netherlands B.V. and
      Hifn International and its subsidiary, Saian (Hangzhou) Microsystems, Co.,
      Ltd.,
      together with Hangzhou Ansai Information Technology Co., Ltd., a contractually
      controlled company of Hifn International (collectively referred to as the
“Company” or “Hifn”) is a network- and storage-security market leader that
      supplies major network original equipment manufacturers (“OEMs”) with patented
      technology to accelerate, secure and compress data. Hifn designs, develops
      and
      markets both hardware and software solutions to a targeted customer base of
      networking-, security- and storage-OEMs. The Company’s network- and
      security-processors, compression, flow classification and content search
      solutions are used in networking, security and storage equipment such as
      routers, remote access concentrators, virtual private networks (“VPNs”),
      switches, broadband access equipment, network interface cards, firewalls and
      back-up storage devices. The Company’s operating activities are primarily in the
      United States and revenues are generated from sales to customers in the United
      States, Asia and Europe.





On
      February 6, 2004, the Company entered into a securities purchase agreement
      with
      certain investors for the private placement of 2.2 million shares of the
      Company’s common stock at a price of $15.00 per share for aggregate proceeds of
      $30.9 million, net of expenses of approximately $2.1 million. The shares were
      issued and paid for on February 6, 2004. Net proceeds from the private placement
      are being used for working capital and general corporate purposes, as well
      as
      for strategic purposes in connection with selected acquisitions that may be
      considered in the future to expand its product and service offerings.





On
      April
      25, 2005, the Company’s Board of Directors authorized a stock repurchase program
      whereby the Company could repurchase shares of the Company’s common stock with
      an aggregate fair market value of up to $10 million from time to time through
      open market and privately negotiated transactions at prices determined by
      management. The timing and amount of repurchases under this program were
      dependent upon market conditions and corporate and regulatory considerations.
      The purchases were funded from available working capital. The stock repurchase
      program expired on April 25, 2006. The Company repurchased a total of 692,894
      shares under the program, which shares have been held in treasury stock, at
      a
      cost of $4.3 million.





The
      Company has an accumulated deficit of $111.2 million as of September 30, 2006
      and has incurred a net loss of $8.7 million during the year ended September
      30,
      2006. The Company believes that its existing cash resources will fund any
      anticipated operating losses, purchases of capital equipment and provide
      adequate working capital for the next twelve months. The Company’s liquidity is
      affected by many factors including, among others, the extent to which the
      Company pursues additional capital expenditures, the level of the Company’s
      product development efforts, and other factors related to the uncertainties
      of
      the industry and global economies. Accordingly, there can be no assurance that
      events in the future will not require the Company to seek additional capital
      sooner or, if so required, that such capital will be available on terms
      acceptable to the Company.





**NOTE
      2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**





**Basis
      of Presentation**





The
      consolidated financial statements include the accounts of the Company and its
      subsidiaries, Hifn Limited, Hifn Netherlands B.V. and Hifn International, and
      its subsidiary, Saian Microsystems together
      with Hangzhou Ansai Information Technology Co., Ltd., a contractually controlled
      company of Hifn International ,
      Inc.
      All significant intercompany accounts and transactions have been eliminated.
      The
      preparation of financial statements in conformity with generally accepted
      accounting principles requires management to make estimates and assumptions
      that
      affect the reported amounts of assets and liabilities at the date of the
      financial statements and reported amounts of revenues and expenses during the
      reporting period. Actual results could differ from those estimates including
      those in relation to revenue recognition, allowance for doubtful accounts,
      valuation of financial instruments, valuation of long-lived assets and goodwill,
      asset impairment, inventory valuation including excess quantities and
      obsolescence, accounting for income taxes and estimating accrued
      liabilities.





**Reclassifications**





Certain
      reclassifications have been made to the prior year consolidated financial
      statements to conform to the current year’s presentation. Such reclassifications
      had no effect on previously reported results of operations or retained
      earnings.








-44-
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          of Contents**


**Restructuring
      Charges**





On
      June
      28, 2006, the company implemented a restructuring plan to be more focused on
      the
      strategy in the networking and storage markets and to take advantage of their
      expanding development capacity in China. The actions were aimed to reduce the
      company’s cost structure, including a reduction in its North America workforce
      by 43 employees, which represented about 21% of its overall workforce at the
      time, the impact of the termination of certain engineering projects and the
      closure of the facility in Carlsbad, California.





Involuntary
      Termination Cost


**Expense**
                **Accrued**
                **June
                  30, 2006**
              
              
              **Adjustments**
              
              
              **Paid
                  as of September 30, 2006**
              
              
              **Balance
                  September 30, 2006**(in
                  thousands)Cost
                  of revenues
              
              $
              64
              
              $
              (6
              )
              $
              53
              
              $
              5Research
                  and development
              
              
              471
              
              
              (17
              )
              
              454
              
              
              -Sales
                  and marketing
              
              
              59
              
              
              
              
              
              59
              
              
              -General
                  and administrative
              
              
              24
              
              
              
              
              
              24
              
              
              -Total
              
              $
              618
              
              $
              (23
              )
              $
              590
              
              $
              5


Impairment
      Of Long-lived Assets





The
      restructure resulted in a $292,000 impairment of certain software assets related
      to projects that were terminated.




Non-recurring
      Engineering Expense Recovery




The
      cancellation of projects resulted in the reversal of previously accrued
      non-recurring engineering costs of $516,000. This reversal is reflected in
      the
      research and development line item on the Statement of Operations.




Termination
      Of Operating Lease





As
      part
      of the restructure, the company closed its facility in Carlsbad, California
      and
      ceased use of the facility as of September 30, 2006. A liability related to
      the
      Carlsbad facility of $550,000 was accrued for during the last quarter of fiscal
      year 2006, reflecting the fair value of the future lease obligations, net of
      estimated sublease income. The non-cancelable lease agreement for this facility
      terminates in June 2010. At September 30, 2006, the remaining lease obligation
      is $1.5 million, which will be paid monthly for the remainder of the lease
      contract period. Additional cost of $74,000 was incurred in the September
      quarter for the relocation of operations and equipment from the closing
      facility. At September 30, 2006, $555,000 was included in accrued expenses
      and
      other current liabilities in the accompanying balance sheet.





Net
      Restructuring Cost





Including
      the fair value of the lease obligation and relocation costs, the net expense
      for
      the restructure as of September 30, 2006 amounts to $995,000. The majority
      of
      the expenses, with the exception of the lease, were paid during the last quarter
      of fiscal year 2006. These payments were funded by available cash on
      hand.




**Cash
      and Cash Equivalents**





The
      Company considers all highly liquid investments with a maturity of three months
      or less at the time of purchase to be cash equivalents. These investments
      consist primarily of commercial paper with maturities less than 90 days, which
      are readily convertible to cash and are stated at cost, which approximates
      market.





**Short-Term
      Investments**





The
      Company’s short-term investments consist of funds on deposit with liquid asset
      managers that were invested principally in corporate and government agency
      obligations and commercial paper. At September 30, 2006, all short-term
      investments were classified as available-for-sale and carried at market value.
      Realized gains or losses are determined based on specific identification and
      are
      reflected in interest income.  Realized gains or losses were not
      significant in fiscal 2006, 2005, and 2004.  Net unrealized gains or losses
      are recorded directly in stockholders' equity as other comprehensive income
      or
      loss.




**Concentration
        of Credit Risk**




Financial instruments,
      which potentially subject
      the Company to credit risk, consist principally of cash and cash equivalents,
      short-term investments and trade accounts receivable. The Company’s cash
      equivalents and short-term investments


-45-
 **Table
          of Contents**


are
      invested in commercial paper and corporate and government agency obligations
      with high credit quality financial institutions.





Substantially
      all of the Company’s customers are OEMs or the manufacturing subcontractors of
      OEMs, which results in concentrated credit risk with respect to the Company’s
      trade receivables. At September 30, 2006, three customers accounted for 25%,
      21%
      and 14%, respectively, of total accounts receivable. The same three customers
      accounted for 32%, 15% and 12%, respectively, of total accounts receivable
      at
      September 30, 2005. Management believes that its credit policies which include
      credit evaluations of customers and, where necessary, imposition of stricter
      credit restrictions, substantially mitigate such concentrated credit risk.
      Allowance for doubtful accounts is determined based upon specific identification
      of potentially uncollectible accounts. Bad debt expenses were not significant
      in
      fiscal 2006, 2005 and 2004.





**Concentration
      of Suppliers**





We
      subcontract all semiconductor manufacturing of our processors on a turnkey
      basis, with our suppliers delivering fully assembled and tested products based
      on our proprietary designs. We do not have long-term manufacturing agreements
      with any of our subcontract manufacturers. Our subcontract manufacturers produce
      products for other companies and we must place orders in advance of expected
      delivery. As a result, we have only a limited ability to react to fluctuations
      in demand for our products, which could cause us to have an excess or a shortage
      of inventory of a particular product. Failure of worldwide semiconductor
      manufacturing capacity to rise along with a rise in demand could result in
      our
      subcontract manufacturers allocating available capacity to customers that are
      larger or have long-term supply contracts in place and we may be unable to
      obtain adequate foundry capacity at acceptable prices, or experience delay
      or
      interruption in supply. Additionally, volatility of economic, market, social
      and
      political conditions in countries where our semiconductor manufacturers operate
      may be unpredictable and could result in a reduction in product revenue or
      increase our cost of revenue and could adversely affect our business, financial
      condition and results of operations.





**Fair
      Value of Financial Instruments**





The
      Company’s financial instruments, including cash, cash equivalents, accounts
      receivable, accounts payable and accrued liabilities are carried at cost, which
      approximates their fair value because of the short-term maturity of these
      instruments. The Company does not hold or issue financial instruments for
      trading purposes.





**Inventories**





Inventories
      are stated at the lower of cost (determined on a first-in, first-out cost
      method) or market. Inventories are comprised solely of finished goods, which
      are
      manufactured by third party foundries for resale by the Company. The Company
      provides for obsolete, slow moving or excess inventories in the period when
      obsolete or excess inventories are first identified. Such inventory reserves
      permanently reduce the cost basis of the underlying inventory.





**Property
      and Equipment**





Property
      and equipment are stated at cost less accumulated depreciation and amortization.
      Depreciation is computed using the straight-line method over the estimated
      useful lives of the assets ranging from three to five years. Amortization of
      leasehold improvements is computed using the straight-line method over the
      shorter of the remaining lease term or the estimated useful life of the related
      improvements. The Company reviews property and equipment for impairment whenever
      events or changes in circumstances indicate that the carrying amounts of
      property and equipment may not be recoverable. Repairs and maintenance costs
      are
      expensed as incurred.





**Long-Lived
      Assets and Goodwill**





Identifiable
      finite-lived intangible assets are generally comprised of purchased intellectual
      property, core technology, workforce and patents, and are amortized on a
      straight-line basis over the estimated useful lives of the assets. Such useful
      lives range from two to five years. The Company evaluates the recovery of
      finite-lived intangible assets whenever events or changes in circumstances
      indicate that their carrying value may not be recoverable. The assessment of
      possible impairment is based on estimates of future cash flows, undiscounted
      and
      without interest charges, expected to result from the use of those assets and
      their eventual disposition. If the sum of the future cash flows is less than
      the
      carrying amounts of those assets, the Company recognizes an impairment loss
      based on the excess of the carrying amounts over the estimated fair value of
      such assets. If we determine that the carrying value may not be recoverable,
      we measure impairment by using the projected discounted cash flow method. 
 On
        June
        28, 2006 the company implemented a restructuring plan to be more focused
        on the
        strategy in the networking and storage markets and resulted in the termination
        of certain engineering projects. The terminated projects resulted in the
        impairment of certain software assets of $292,000.
 
 The
        excess of the cost of acquired companies over the net amounts assigned to
        assets
        acquired and liabilities assumed is


-46-
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          of Contents**




recorded
      as goodwill. As of September 30, 2006, the Company has goodwill of $1.0 million.
      With the issuance of the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards No. 141 (“SFAS 141”), “Business
      Combinations,” and SFAS 142, “Goodwill and Other Intangible Assets,” goodwill is
      not amortized but instead tested for impairment annually and whenever events
      or
      circumstances occur that indicate possible impairment. The Company performs
      its
      annual impairment testing each May 31. The Company currently operates as one
      reporting unit. Accordingly, the impairment test is a comparison of the
      Company’s market capitalization as measured by the price of its common stock to
      the Company’s net asset value.





**Revenue
      Recognition**





The
      Company derives revenue from the sale of processors and software license fees
      to
      OEMs and, to a lesser extent, distributors. Revenue from the sale of processors
      is recognized upon shipment when persuasive evidence of an arrangement exists,
      legal title and risk of ownership has transferred to the customer, the price
      is
      fixed or determined and collection of the resulting receivable is reasonably
      assured. Revenue from processors sold to distributors under agreements allowing
      certain rights of return is deferred until the distributor sells the product
      to
      a third party. At the time of shipment to distributors, the Company records
      a
      trade receivable for the purchase price based on the Company’s legally
      enforceable right to payment. Additionally, since legal right for the inventory
      transfers to the distributors, inventory is relieved at the carrying value
      of
      the products shipped. The related gross margin is recognized as a liability
      and
      recorded as deferred income.





Software
      license revenue is generally recognized when a signed agreement or other
      persuasive evidence of an arrangement exists, vendor-specific objective evidence
      exists to allocate a portion of the total fee to any undelivered elements of
      the
      arrangement, the software has been shipped or electronically delivered, the
      license fee is fixed or determinable and collection of resulting receivables
      is
      reasonably assured. Returns, including exchange rights for unsold licenses,
      are
      recorded based on agreed-upon return rates or historical experience and are
      deferred until the return rights expire.





The
      Company receives software license revenue from OEMs that sublicense Company
      software shipped with their products. The OEM sublicense agreements are
      generally valid for a term of one year and include rights to unspecified future
      upgrades and maintenance during the term of the agreement. License fees under
      these agreements are recognized ratably over the term of the agreement. Revenues
      from sublicenses sold in excess of the specified volume in the original license
      agreement are recognized when they are reported as sold to end customers by
      the
      OEM.





In
      instances where significant customization and modifications are made to software
      delivered to customers, the Company accounts for such arrangements in accordance
      with Statement of Position 81-1, “Accounting for Performance and Construction
      Type Contracts.”





**Research
      and Development Costs**





Research
      and development costs consist primarily of salaries, employee benefits,
      overhead, outside contractors and non-recurring engineering fees. Expenditures
      for research and development are charged to expense as incurred. Under Statement
      of Financial Accounting Standards No. 86, “Accounting for the Costs of Computer
      Software to be Sold, Leased or Otherwise Marketed,” certain software development
      costs are capitalized after technological feasibility has been established.
      The
      period from achievement of technological feasibility, which the Company defines
      as the establishment of a working model, until the general availability of
      such
      software to customers, has been short, and therefore software development costs
      qualifying for capitalization have been insignificant. Accordingly, the Company
      has not capitalized any software development costs as of September 30, 2006
      or
      2005.


**Stock-Based
        Compensation**
 
 On
        October 1,
        2005, the Company adopted Statement of Financial Accounting Standards
        No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which
        requires the measurement and recognition of compensation expense for all
        share-based payment awards, including employee stock options and employee
        stock
        purchases, based on estimated fair values. SFAS 123(R) supersedes the Company’s
        previous accounting under Accounting Principles Board Opinion No. 25,
“Accounting for Stock Issued to Employees” (“APB 25”) for periods beginning in
        fiscal 2006. In March 2005, the Securities and Exchange Commission issued
        Staff
        Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). The
        Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).
        The Company adopted SFAS 123(R) using the modified prospective transition
        method, which requires the application of the accounting standard as of October
        1, 2005, the first day of the Company’s fiscal year 2006. The Company’s
        Consolidated Financial Statements as of and for the three and nine months
        ended
        June 30, 2006, reflect the effect of SFAS 123(R).


-47-
 **Table
          of Contents**





Stock-based
      compensation expense related to employee stock options and employee stock
      purchases and recognized under SFAS 123(R) for the fiscal year ended September
      30, 2006, was $977,000. Under the modified prospective transition method, the
      Company’s Consolidated Financial Statements for prior periods need not be
      restated to reflect or include the effect of SFAS 123(R). Accordingly, there
      was
      no stock-based compensation expense related to employee stock options and
      employee stock purchases recognized during the fiscal year 2005 and 2004.




SFAS
      123(R) requires companies to estimate the fair value of share-based payment
      awards on the date of grant using an option-pricing model. The value of the
      portion of the award that is ultimately expected to vest is recognized as
      expense over the requisite service periods in the Company’s Consolidated
      Statement of Operations. Prior to the adoption of SFAS 123(R), the Company
      accounted for stock-based awards using the intrinsic value method in accordance
      with APB 25 as allowed under Statement of Financial Accounting Standards
      No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under the
      intrinsic value method, no stock-based compensation expense had been recognized
      in the Company’s Consolidated Statement of Operations because the exercise price
      of the Company’s stock options granted to employees and directors equaled the
      fair market value of the underlying stock at the date of grant.




Stock-based
      compensation expense recognized during the period is based on the value of
      the
      portion of share-based payment awards that is ultimately expected to vest during
      the period. Stock-based compensation expense recognized in the Company’s
      Consolidated Statement of Operations for fiscal 2006 include compensation
      expense for share-based payment awards granted prior to, but not yet vested
      as
      of September 30, 2005 based on the grant date fair value estimated in accordance
      with the pro forma provisions of SFAS 123 and compensation expense for the
      share-based payment awards granted subsequent to September 30, 2005 based on
      the
      grant date fair value estimated in accordance with the provisions of SFAS
      123(R). The Company attributes the value of stock-based compensation expense
      on
      a straight-line single option method, the same method used for share-based
      payment awards granted on or prior to September 30, 2005. As stock-based
      compensation expense recognized in the Consolidated Statement of Operations
      for
      fiscal 2006 is based on awards ultimately expected to vest, it has been reduced
      for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated
      at
      the time of grant and revised, if necessary, in subsequent periods if actual
      forfeitures differ from those estimates. In the Company’s pro forma information
      required under SFAS 123 for the periods prior to fiscal 2006, the Company
      accounted for forfeitures as they occurred.




The
      Company uses the Black-Scholes-Merton option-pricing model (“Black-Scholes
      model”) as its method of valuation for share-based awards granted beginning in
      fiscal 2006, the same model used for the Company’s pro forma information
      required under SFAS 123. The Company’s determination of fair value of
      share-based payment awards on the date of grant using an option-pricing model
      is
      affected by the Company’s stock price as well as assumptions regarding a number
      of subjective variables. These variables include, but are not limited to, the
      Company’s expected stock price volatility over the term of the awards as well as
      actual and projected employee stock option exercise behaviors. The Company’s
      employee stock options have certain characteristics that may differ from other
      options and changes in the subjective assumptions can materially affect the
      estimated value. Accordingly, it is management’s opinion that the existing
      valuation models may not provide an accurate measure of the fair value of the
      Company’s employee stock options. Although the fair value of employee stock
      options is determined in accordance with SFAS 123(R) and SAB 107 using an
      option-pricing model, that value may not be indicative of the fair value in
      an
      actual market transaction.




Prior
      to
      October 1, 2005, the Company accounted for its employee stock option plans
      and
      employee stock purchase plans in accordance with provisions of the Accounting
      Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to
      Employees” and Financial Accounting Standards Board Interpretation No. 44,
“Accounting for Certain Transactions Involving Stock Compensation.”
      Additional pro forma disclosures as required under Statement of Financial
      Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based
      Compensation” and Statement of Financial Accounting Standards No. 148 (“SFAS
      148”), “Accounting for Stock-Based Compensation - Transition and Disclosure”
were also provided.




**Income
        Taxes**
 
 Deferred
        tax assets and liabilities are recognized for the expected tax consequences
        of
        temporary differences between the income tax bases of assets and liabilities
        and
        the amounts reported for financial reporting purposes for all periods presented
        (see Note 9). Valuation allowances for deferred tax assets are established
        when,
        based on available objective evidence, management determines that it is more
        likely than not that the deferred tax assets will not be
        realizable.
 
 **Foreign
        Currency Translation**
 
 The
        U. S.
        dollar is the functional currency of the company’s subsidiaries. Gains or losses
        from transactions of foreign


-48-
 **Table
          of Contents**





subsidiaries
      are included in other expenses, net. Such gains and losses were not material
      for
      any of the periods presented.




**Comprehensive
      Income (Loss)**




Other
      comprehensive income (loss) is defined as the change in equity of a business
      enterprise during a period from transactions and other events and circumstances
      from non-owner sources. Comprehensive income (loss) includes unrealized gains
      and losses on the Company’s available-for-sale investments. Comprehensive income
      (loss) is disclosed in the Consolidated Statements of Stockholders’
Equity.




**Recent
      Accounting Pronouncements**





In
      May 2005, as part of a broader attempt to eliminate differences with the
      International Accounting Standards Board, the FASB issued Statement of Financial
      Accounting Standards No. 154 (“SFAS No. 154”), “Accounting Changes and
      Error Corrections,” which replaces Accounting Principles Board Opinion
      No. 20 (“APB No. 20”), “Accounting Changes,” and FASB Statement of
      Financial Accounting Standards No. 3, “Reporting Accounting Changes in
      Interim Financial Statements.” Opinion No. 20 had required that changes in
      accounting principles be recognized by including the cumulative effect of the
      change in the period in which the new accounting principle was adopted. SFAS
      No. 154 requires retrospective application of the change to prior periods’
financial statements, unless it is impracticable to determine the
      period-specific effects of the change. The Statement is effective for fiscal
      years beginning after December 15, 2005. The adoption of this statement did
      not have a material effect on the Company’s financial
      statements.


In
      July
      2006, the FASB issued FASB Interpretation 48, “Accounting for Income Tax
      Uncertainties” (FIN 48). FIN 48 defines the threshold for recognizing the
      benefits of tax return positions in the financial statements as
“more-likely-than-not” to be sustained by the tax authority. The recently issued
      literature also provides guidance on the recognition, measurement and
      classification of income tax uncertainties, along with any related interest
      and
      penalties. FIN 48 also includes guidance concerning accounting for income tax
      uncertainties in interim periods and increases the level of disclosures
      associated with any recorded income tax uncertainties. FIN 48 is effective
      for
      the fiscal years beginning after December 15, 2006. The differences between
      the
      amounts recognized in the statements of financial position prior to the adoption
      of FIN 48 and the amounts reported after adoption will be accounted for as
      a
      cumulative-effect adjustment recorded to the beginning balance of retained
      earnings. We are
      evaluating the impact, if any, of adopting the provisions of FIN 48 on our
      financial position and results of operations.





In
      July
      2006, the FASB issued EITF Issue No. 06-3, “How Taxes Collected from Customers
      Remitted to Governmental Authorities Should be Presented in the Income Statement
      (that is, Gross versus Net Presentation).” The adoption of EITF No. 06-3 did not
      have an impact on the Company’s consolidated financial statements.




In
      September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS
      157”), which clarifies the definition of fair value, establishes guidelines for
      measuring fair value, and expands disclosures regarding fair value
      measurements.  SFAS 157 does not require any new fair value measurements
      and eliminates inconsistencies in guidance found in various prior accounting
      pronouncements.  SFAS 157 will be effective for the Company on October 1,
      2008. The Company is currently evaluating the impact of adopting SFAS 157 on
      its
      financial position, cash flows, and results of operations.





In
      September 2006, the Securities and Exchange Commission (“SEC”) released Staff
      Accounting Bulletin No. 108, “Considering the Effects of Prior Year
      Misstatements when Quantifying Misstatements in Current Year Financial
      Statements” (“SAB 108”). SAB 108 provides interpretive guidance on the
      SEC’s views on how the effects of the carryover or reversal of prior year
      misstatements should be considered in quantifying a current year misstatement.
      The provisions of SAB 108 will be effective for the Company for the fiscal
      year
      ending September 30, 2007. The adoption of SAB 108 is not expected to have
      a material effect on its financial position, cash flows, and results of
      operations.





**NOTE
      3 — ACQUISITIONS**





**Asset
      Acquisition**





In
      September 2004, the Company acquired certain technology related to a pattern
      matching core for $1.8 million in cash. The purchase price of the acquisition,
      which included $40,000 in estimated acquisition related costs, was allocated
      by
      management to the identifiable assets as follows (in thousands):


Developed
                    and core technology
                
                $
                1,788Workforce
                
                
                52$
                1,840
  -49-
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  The
        identified assets are being amortized on a straight-line basis over a period
        of
        three years for developed and core technology and two years for the acquired
        workforce. The purchase agreement also provided for additional cash payments
        aggregating $900,000, contingent upon achievement of certain development
        milestones at predefined deadlines. In connection with the delivery of the
        development milestones, the Company recognized $900,000 as research and
        development cost in fiscal 2005.





In
      April
      2004, the Company acquired certain assets and intellectual property related
      to
      processor technology for $1.0 million in cash. The purchase price of the
      acquisition was allocated by management to the acquired undeveloped embedded
      processor core and the related development workforce as follows (in
      thousands):


Workforce
              
              $
              107Purchased
                  in-process research and development
              
              
              893$
              1,000




The
      acquired workforce is recorded on the balance sheet as an intangible asset
      and
      is being amortized on a straight-line basis over an estimated useful life of
      two
      years. The amount allocated to purchased in-process research and development
      was
      determined based on established valuation methods and was expensed at the time
      of the acquisition as a one-time charge because technological feasibility
      had not been established and no alternative future uses exist. The fair value
      of
      the in-process technology was determined using the cost method, which estimates
      the cost of developing a similar technology at prices applicable at the time
      of
      the appraisal.





In
      December 2003, the Company acquired certain assets, intellectual property and
      technical designs related to International Business Machines Corporation’s
      (“IBM”) network processor product line for approximately $15.9 million in cash,
      which included $200,000 in estimated acquisition related costs. The purchase
      price was allocated by management to assets acquired based on their fair values
      as follows (in thousands):


Developed
                  and core technology
              
              $
              11,769Contract
                  backlog
              
              
              649Fixed
                  assets
              
              
              48Inventory
              
              
              67Purchased
                  in-process research and development
              
              
              3,337$
              15,870




The
      acquired backlog, developed and core technology are recorded on the balance
      sheet as intangibles and other assets. Acquired backlog was fully amortized
      by
      the end of fiscal 2004 based upon fulfillment of the identifiable backlog.
      Developed and core technology is amortized on a straight-line basis over their
      estimated useful life of five years.





The
      amount allocated to purchased in-process research and development was determined
      by management after considering, among other factors, input provided by an
      independent appraisal based on established valuation techniques in the
      semiconductor industry and was expensed upon acquisition because technological
      feasibility had not been established and no alternative future uses exist.
      The
      acquired technology includes development work on the next generation network
      processor (increasing speed and density while reducing die size) which was
      approximately 85% complete ,
      but the
      project was cancelled as part of the June 28, 2006 restructure .
      The
      fair value of two projects containing in-process technology in development
      was
      determined using the income approach, which discounts expected future cash
      flows
      to present value. The discount rates used in the present value calculations
      was
      derived from a weighted-average cost of capital analysis adjusted to reflect
      additional risks inherent in the development life cycle including the failure
      to
      achieve technical viability, rapid changes in customer markets and required
      standards for new products as well as potential competition in the market for
      such products.





In
      September 2002, the Company acquired certain assets and intellectual property
      from a development stage company for cash consideration of $2.2 million. The
      Company allocated the total consideration to assets purchased and in-process
      research and development. The amounts allocated to core technology and workforce
      of $639,000 and $255,000, respectively, were recorded as intangible assets
      and
      are being amortized on a straight-line basis over a period of two and fours
      years, respectively. The full amount was amortized as of September 30, 2006.
      The
      design team of 15 engineers related to the acquired intellectual property joined
      the Company effective October 1, 2002. Purchased in-process research and
      development of $1.1 million related to processing of IPsec packets, representing
      the portion of the acquired technology that was not part of the identifiable
      core, was expensed at the time of purchase as a one-time charge because
      technological feasibility had not been established.


-50-
 **Table
          of Contents**


**NOTE
      4 — BALANCE SHEET DETAILS**


**September
                30,****2006**
            
            **2005**(in
                thousands)Property
                and equipment:Computer
                equipment
            $
            7,932
            
            $
            7,208Furniture
                and fixtures
            
            1,068
            
            
            1,050Leasehold
                improvements
            
            778
            
            
            1,043Office
                equipment
            
            911
            
            
            89610,689
            
            
            10,197Less:
                accumulated depreciation
            
            (8,333
            )
            
            (8,351
            )$
            2,356
            
            $
            1,846Intangible
                assets:Developed
                and core technology
            $
            14,196
            
            $
            14,196Workforce
            
            159
            
            
            15914,355
            
            
            14,355Less:
                accumulated amortization
            
            (8,503
            )
            
            (5,342
            )5,852
            
            
            9,013Goodwill
            
            1,029
            
            
            1,029$
            6,881
            
            $
            10,042The
                estimated future amortization expense related to intangible assets
                as of
              September
                30, 2006 is as follows:Fiscal
                year ending September 30,2007
            
            $
            2,9102008
            
            
            2,3542009
            
            
            588Total
                estimated amortization
            
            $
            5,852Other
                assets:Design
                tools and other licensed intellectual property
            $
            916
            
            $
            1,768Refundable
                deposits
            
            333
            
            
            345$
            1,249
            
            $
            2,113Accrued
                expenses and other current liabilities:Accrued
                vacant facility lease cost
            $
            1,560
            
            $
            1,785Accrued
                non-recurring engineering services and costs
            
            510
            
            
            2,883Compensation
                and employee benefits
            
            1,964
            
            
            1,857Deferred
                income and revenue
            
            641
            
            
            976Income
                taxes payable
            
            30
            
            
            90Other
            
            414
            
            
            361$
            5,119
            
            $
            7,952











**NOTE
      5 — SHORT-TERM INVESTMENTS**





Cash
      and
      cash equivalents and short-term investments classified as available-for-sale
      securities were comprised of the following:


-51-
 **Table
          of Contents**




**September
                30, 2006**
            
            **September
                30, 2005****Unrealized**
            
            
            
            
            
            **Unrealized****Cost**
            
            **Gross
                Gains**
            
            **Gross
                Losses**
            
            **Fair
                Value**
            
            **Cost**
            
            **Gross
                Gains**
            
            **Gross
                Losses**
            
            **Fair
                Value**(in
                thousands)Corporate
                securities
            
            $
            5,461
            
            $
            -
            
            $
            (8
            )
            $
            5,453
            
            $
            7,766
            
            $
            -
            
            $
            (24
            )
            $
            7,742Government
                agency obligations
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            2,398
            
            
            -
            
            
            (3
            )
            
            2,395Money
                market securities
            
            
            31,964
            
            
            7
            
            
            -
            
            
            31,971
            
            
            33,402
            
            
            1
            
            
            (12
            )
            
            33,391Total
                available-for-sale securities
            
            $
            37,425
            
            $
            7
            
            $
            (8
            )
            $
            37,424
            
            $
            43,566
            
            $
            1
            
            $
            (39
            )
            $
            43,528





The
      classification and contractual maturities of available-for-sale securities
      is as
      follows:




**September
                  30,****2006**
              
              **2005**(in
                  thousands)Included
                  in:Cash
                  and cash equivalents
              
              $
              19,084
              
              $
              22,267Short-term
                  investments
              
              
              18,340
              
              
              21,261$
              37,424
              
              $
              43,528Contractual
                  maturities:Due
                  in less than one year
              
              $
              36,444
              
              $
              43,528Due
                  from one to two years
              
              
              980
              
              
              -$
              37,424
              
              $
              43,528




**NOTE
      6 — NET LOSS PER SHARE**





Basic
      earnings per share is computed using the weighted average number of common
      shares outstanding for the period, without consideration for the dilutive impact
      of potential common shares that were outstanding during the period. Diluted
      earnings per share is computed using the weighted average number of common
      and
      common equivalent shares outstanding for the period. Common equivalent shares
      consist of incremental common shares issuable upon the exercise of stock
      options, using the treasury method, and are excluded from the calculation of
      diluted net loss per share if anti-dilutive.





Outstanding
      options to purchase shares of common stock were excluded from the computation
      of
      diluted earnings per share because of their anti-dilutive impact to the
      following periods:


**Year
                  Ended September 30,****2006**
              
              **2005**
              
              **2004**Outstanding
                  options to purchase common stock
              
              
              3,539,998
              
              
              4,161,531
              
              
              4,159,770







**NOTE
      7 — SUPPLEMENTAL CASH FLOW INFORMATION**




**Year
                  Ended September 30,****2006**
              
              **2005**
              
              **2004**(in
                  thousands)Supplemental
                  cash flow information:Cash
                  paid during the year for interest
              
              $
              11
              
              $
              76
              
              $
              -Cash
                  paid during the year for income taxes
              
              
              136
              
              
              71
              
              
              11Cash
                  received during the year from refund of income taxes
              
              
              -
              
              
              64
              
              
              174Supplemental
                  non-cash investing and financing activities:Common
                  stock issued in settlement of class action litigation
              
              
              -
              
              
              -
              
              
              -Acquisition
                  of software licenses
              
              
              -
              
              
              -
              
              
              1,393




**NOTE
      8 — STOCK OPTIONS AND EMPLOYEE BENEFITS**





**Employee
      Stock Option Plan**





The
      1996
      Equity Incentive Plan (the “1996 Plan”) had 5,449,900 shares of the Company’s
      Common Stock reserved for issuance pursuant to nonqualified and incentive stock
      options and restricted stock awards. The 1996 Plan is administered by the Board
      of Directors of the Company or its designees and provides generally that
      nonqualified stock options and restricted stock




-52-
 **Table
            of Contents**




may
      be
      awarded at a price not less than 85% of the fair market value of the stock
      at
      the date of the award. Incentive stock options must be awarded at a price not
      less than 100% of the fair market value of the stock at the date of the award,
      or 110% of fair market value for awards to more than 10% stockholders. Options
      granted under the 1996 Plan may have a term of up to 10 years. Options typically
      vest at a rate of 25% of the total grant per year over a four-year period.
      However, the Company may, at its discretion, implement a different vesting
      schedule with respect to any new stock option grant. As a result of early exercise
        features as provided for by the 1996 Plan, options granted are immediately
        exercisable subject to the Company’s repurchase rights which expire as options
        vest.




In
      connection with the acquisition of Apptitude in August 2000, the Company assumed
      the stock option plan of Apptitude (the “Apptitude Plan”). A total of 687,142
      shares of the Company’s Common Stock were reserved for issuance under the
      Apptitude Plan. Options assumed under the Apptitude Plan that are subsequently
      cancelled are not eligible for reissuance and, accordingly, have no effect
      on
      the number of options available for grant.





In
      February 2001, the Board of Directors of the Company adopted the 2001
      Nonstatutory Stock Option Plan (the “2001 Plan”) whereby 1,500,000 shares of the
      Company’s Common Stock were reserved for issuance pursuant to nonqualified stock
      options. In June 2002, an additional 500,000 shares were authorized for issuance
      under the 2001 Plan. The 2001 Plan is administered by the Company’s Board of
      Directors or its designees and provides generally that nonqualified stock
      options granted under the 2001 Plan may have a maximum life of 10 years. The
      terms and conditions of each stock option grant under the 2001 Plan are
      determined by a committee of the Board of Directors and are set forth in
      agreements between the recipient and the Company.





*Accelerated
      Vesting of Stock Options.* On
      August 23, 2005, the Company’s Board of Directors approved the vesting
      acceleration of unvested, “out-of-the-money” stock options awarded to employees
      and officers under its 1996 Equity Incentive Plan and 2001 Nonstatutory Stock
      Option Plan. The purpose of the accelerated vesting was to reduce future
      compensation expense associated with the accelerated stock options upon the
      effectiveness SFAS No. 123R of approximately $5.0 million, and because many
      of
      the outstanding options have exercise prices in excess of current market values,
      thereby, not fully achieving their original objectives of incentive compensation
      and employee retention. A total of 1,011,000 shares were accelerated under
      the
      program, with exercise prices ranging from $7.22 to $18.58, and a weighted
      average exercise price of $9.68. Options held by non-employee directors were
      excluded from the vesting acceleration. Additionally, a holding period was
      imposed on 172,400 shares underlying the accelerated options held by the
      Company’s executive officers which effectively requires executive officers to
      refrain from selling any shares acquired upon the exercise of the options until
      the date on which the shares would have vested under the options’ original
      vesting term of four years.





The
      following table summarizes the activities and related information under the
      1996
      Plan, the Apptitude Plan and the 2001 Plan:





**Options
                Available**
              **for
                Grant**
            
            **Outstanding
                Options / Quantity**
            
            **Weighted
                Average Exercise Price (per share)**
            
            **Weighted
                Average Contractual Term**
            
            **Aggregate
                Intrinsic Value (in thousands)**Balance
                at September 30, 2003
            
            
            2,134,769
            
            
            3,593,946
            
            $
            11.14Options
                granted
            
            
            (1,277,878
            )
            
            1,277,878
            
            
            10.42Options
                exercised
            
            
            —
            
            
            (361,145
            )
            
            6.85
            
            
            
            
            $
            2,197Options
                cancelled
            
            
            350,909
            
            
            (350,909
            )
            
            13.00Balance
                at September 30, 2004
            
            
            1,207,800
            
            
            4,159,770
            
            
            11.13Options
                granted
            
            
            (549,600
            )
            
            549,600
            
            
            7.50Options
                exercised
            
            
            —
            
            
            (161,293
            )
            
            5.96
            
            
            
            
            
            315Options
                cancelled
            
            
            358,611
            
            
            (386,546
            )
            
            15.00Balance
                at September 30, 2005
            
            
            1,016,811
            
            
            4,161,531
            
            
            10.50Additional
                shared authorized
            
            
            500,000Options
                granted
            
            
            (414,500
            )
            
            414,500
            
            
            6.67Options
                exercised
            
            
            —
            
            
            (175,876
            )
            
            4.00
            
            
            
            
            
            419Options
                cancelled
            
            
            818,548
            
            
            (860,157
            )
            
            11.67Balance
                at September 30, 2006
            
            
            1,920,859
            
            
            3,539,998
            
            
            10.09Fully
                vested and expected to vest at September 30, 2006
            
            
            
            
            
            3,484,093
            
            
            10.14
            
            $
            5.69
            
            
            430Fully
              vested and execisable at September 30, 2006
            
            
            
            
            
            3,099,804
            
            
            10.58
            
            
            5.64
            
            
            430





Options
      exercisable as of September 30, 2006 includes 172,400 shares, with a weighted
      average exercise price of $10.88,




-53-
 **Table
            of Contents**




related
      to accelerated options held by the Company’s executive officers for which a
      holding period was imposed as described above.




**Employee
      Stock Purchase Plan**





In
      December 1998, the Company adopted an employee stock purchase plan (the “ESPP”)
      through which qualified employees of the Company may participate in stock
      ownership of the Company. Shares of Common Stock reserved for the ESPP total
      1,400,000. The price of shares purchased under the ESPP is the lower of 85%
      of
      the fair market value of the shares on the first day of each semi-annual
      offering period, or 85% of the fair market value of the shares on the last
      day
      of the semi-annual offering period. Pursuant to the ESPP, 208,039, 185,297
      and
      105,976 shares were issued during fiscal 2006, 2005 and 2004, respectively,
      at
      weighted average prices of $4.49, $5.52 and $5.15 per share, respectively.
      As of
      September 30, 2006, there were 580,444 shares available for future purchases
      under the ESPP.




**Stock-Based
      Compensation under SFAS 123(R)**




Effective
      October 1, 2005, the Company adopted SFAS 123(R), on the modified prospective
      application method, which requires the measurement and recognition of
      compensation expense for all share-based awards made to the Company’s employees
      and directors including employee stock options and employee stock purchases
      outstanding as of and awarded after October 1, 2005. The total stock-based
      compensation expense recognized for fiscal year ended September 30, 2006, was
      allocated as follows (in thousands):




**Year
                  Ended**
                **September
                  30,**
                **2006**Cost
                  of revenues
              $
              9Research
                  and development
              
              455Sales
                  and marketing
              
              172General
                  and administrative
              
              341Total
                  stock-based compensation expense
              $
              977




As
        of
        September 30, 2006, there was approximately $1.6 million of total stock-based
        compensation expense, net of estimated forfeitures, related to
        unvested employee stock options, which is expected to be recognized over
        an
        estimated weighted average period of 2.32 years. The Company did not
        capitalize any stock-based compensation expense. The tax benefit, and the
        resulting effect on cash flows from operations and financial activities,
        related
        to stock-based compensation expense was not recognized as the Company currently
        provides a full valuation allowance for its deferred tax assets. The effect
        of
        adoption of SFAS 123(R) for the fiscal year ended September 30, 2006, was
        an
        increase in net loss of $977,000 and an increase in net loss per share of
        $0.07.
        This includes stock-based compensation expenses for ESPP of $241,000 for
        the
        fiscal year ended September 30, 2006.





The
      method of valuation for share-based awards granted beginning in fiscal 2006
      is
      the Black-Scholes model which was also the method used for the Company’s pro
      forma information required under FAS 123. The expected term of the awards
      represents the weighted-average period the stock options are expected to remain
      outstanding which assumes that the employees’ exercise behavior is a function of
      the option’s remaining contractual life and the extent to which the option is
      in-the-money (i.e., the average stock price during the period is above the
      strike price of the stock option). The Company’s expected volatility assumption
      uses the historical volatility of the Company’s stock, as applicable for the
      expected term. The Company also used its historical stock price to determine
      fair value of awards for purposes of its pro forma information under FAS 123.
      Since the Company does not pay dividends, the expected dividend yield is zero.
      The risk-free interest rate assumption is based upon observed interest rates
      appropriate for the term of the Company’s employee stock options.




The
      fair
      value of employee stock options granted and employee stock purchased were
      estimated based on the following assumptions:





**Year
                Ended September 30,****2006**
            
            **2005**
            
            **2004****Stock**
              **Options**
            **Purchase
                Plan**
            
            **Stock**
              **Options**
            **Purchase
                Plan**
            
            **Stock**
              **Options**
            **Purchase
                Plan**Weighted
                average fair value
            $3.86
            $1.43
            
            $3.63
            $2.14
            
            $6.16
            $2.85Estimated
                life
            5.44
                years
            0.49
                years
            
            3.24
                years
            0.49
                years
            
            3.74
                years
            0.48
                yearsRisk-free
                interest rate
            4.41%
            4.73%
            
            3.61%
            2.72%
            
            3.00%
            1.07%Expected
                stock price volatility
            62.4%
            33.6%
            
            59.1%
            41.5%
            
            77.7%
            66.9%Dividend
                yield
            0.0%
            0.0%
            
            0.0%
            0.0%
            
            0.0%
            0.0%




-54-
 **Table
            of Contents**




**Pro
      Forma Information under SFAS 123 for Periods Prior to Fiscal 2006**




Prior
      to
      adopting the provisions of SFAS 123(R), the Company recorded estimated
      compensation expense for employee stock options based upon their intrinsic
      value
      on the date of grant pursuant to APB 25, “Accounting for Stock Issued to
      Employees” and provided the required pro forma disclosures of SFAS 123. Because
      the Company established the exercise price based on the fair market value of
      the
      Company’s stock at the date of grant, the stock options had no intrinsic value
      upon grant, and therefore no estimated expense was recorded prior to adopting
      SFAS 123(R). Each accounting period, the Company reported the potential dilutive
      impact of stock options in its diluted earnings per common share using the
      treasury-stock method. Out-of-the-money stock options (i.e., the average stock
      price during the period was below the strike price of the stock option) were
      not
      included in diluted earnings per common share as their effect was
      anti-dilutive.





For
      purposes of pro forma disclosures under SFAS 123 for the fiscal years ended
      September 30, 2005 and 2004, the estimated fair value of the stock options
      was
      assumed to be amortized to expense over the stock options’ vesting periods. The
      pro forma effects of recognizing estimated compensation expense under the fair
      value method on net loss and net loss per share for the fiscal years ended
      September 30, 2005 and 2004, were as follows (in thousands, except per
      share data):


**Year
                  Ended September 30,****2005**
              
              **2004**(dollars
                  in thousands)Net
                  loss excluding stock-based compensation expense
              
              $
              (5,216
              )
              $
              (10,868
              )Stock-based
                  compensation expense
              
              
              (10,682
              )
              
              (8,003
              )Net
                  loss including stock-based compensation expense
              
              $
              (15,898
              )
              $
              (18,871
              )Basic
                  and diluted net loss per share excluding stock-based compensation
                  expense
              
              $
              (0.38
              )
              $
              (0.84
              )Stock-based
                  compensation expense per share
              
              $
              (0.76
              )
              $
              (0.61
              )Basic
                  and diluted net loss per share including stock-based compensation
                  expense
              
              $
              (1.14
              )
              $
              (1.45
              )


**Stock
        Repurchase Program**





On
      April
      25, 2005, the Company’s Board of Directors authorized a stock repurchase program
      whereby the Company could repurchase shares of the Company’s common stock with
      an aggregate fair market value of up to $10 million from time to time through
      open market and privately negotiated transactions at prices determined by
      management. The timing and amount of repurchases under this program were
      dependent upon market conditions and corporate and regulatory considerations.
      The purchases were funded from available working capital. The stock repurchase
      program expired on April 25, 2006. The Company did not repurchase any shares
      during the fiscal year ended September 30, 2006, however, as of September 30,
      2006, a total of 692,894 shares have been repurchased under the program, which
      shares are held in treasury stock, at a cost of $4.3 million.




**Deferred
      Stock-Based Compensation**





During
      fiscal 2000, the Company recognized deferred stock-based compensation of $8.3
      million in connection with the acquisition of Apptitude. Such deferred
      stock-based compensation was amortized over the vesting period of the related
      options, ranging from six months to four years. As all deferred stock-based
      compensation were fully amortized as of September 30, 2004, there was no related
      amortization in fiscal year 2006 and 2005 and amortization of $138,000 was
      recognized during the fiscal year ended September 30, 2004.





**Employee
      401(k) Plan**





The
      Company has a plan to provide retirement benefits for eligible employees, known
      as the Hifn 401(k) Plan (the “Plan”). As allowed under Section 401(k) of the
      Internal Revenue Code, the Plan provides tax deferred salary reductions for
      eligible employees. Participants in the Plan may make salary deferrals up to
      the
      maximum limitation allowed by the Internal Revenue Code. The Plan provides
      for
      employer contributions; however, the Company has not made any contributions
      to
      the Plan since its inception.




-55-
 **Table
            of Contents**




**NOTE
      9 — INCOME TAXES**





The
      Company accounts for income taxes under an asset and liability approach that
      requires recognition of deferred tax assets and liabilities for the expected
      future tax consequences of events that have been recognized in the Company’s
      financial statements or income tax returns.




The
      U.S.
      and foreign components of loss before income taxes were as
      follows:


**Year
                  Ended September 30,****2006**
              
              **2005**
              
              **2004**(in
                  thousands)United
                  States
              
              $
              (9,016
              )
              $
              (5,222
              )
              $
              (10,920
              )Foreign
              
              
              333
              
              
              96
              
              
              52Loss
                  before income taxes
              
              $
              (8,683
              )
              $
              (5,126
              )
              $
              (10,868
              )










The
      components of the provision for income taxes were as follows:


**Year
                  Ended September 30,****2006**
              
              **2005**
              
              **2004**(in
                  thousands)Current:Federal
              
              $
              -
              
              $
              -
              
              $
              -State
              
              
              -
              
              
              -
              
              
              -Foreign
              
              
              41
              
              
              90
              
              
              30Provision
                  for income taxes
              
              $
              41
              
              $
              90
              
              $
              30
  The
        components of deferred taxes are as follows:




**Year
                  Ended September 30,****2006**
              
              **2005**(in
                  thousands)Net
                  operating loss
              
              $
              27,144
              
              $
              22,779Property
                  and equipment
              
              
              (36
              )
              
              385Inventory
                  valuation accounts
              
              
              417
              
              
              842Accruals
                  and reserves
              
              
              1,435
              
              
              2,091Research
                  and development credit
              
              
              8,089
              
              
              7,101Amortization
                  of intangibles
              
              
              5,932
              
              
              5,428Total
                  deferred tax asset
              
              
              42,981
              
              
              38,626Deferred
                  tax liability
              
              
              -
              
              
              -Valuation
                  allowance
              
              
              (42,981
              )
              
              (38,626
              )$
              -
              
              $
              -
  As
        of
        September 30, 2006, the Company had approximately $74.0 million of federal
        and
        $30.7 million of state net operating loss carryforwards available to offset
        future taxable income. The Company also had approximately $4.4 million of
        federal and $5.6 million of state research and development tax credit
        carryforwards. These tax attributes expire in varying amounts between 2006
        and
        2026. Because of cumulative ownership changes, certain of these tax attributes
        are subject to an annual utilization limitation under Sections 382 and 383
        of
        the Internal Revenue Code.





As
      a
      result of continuing losses, management has determined that it is more likely
      than not that the Company will not realize the benefits of the deferred tax
      assets and therefore has recorded a valuation allowance to reduce the carrying
      value of the deferred tax assets to zero. Approximately $9.4 million of the
      valuation allowance relates to income tax benefits arising from the exercise
      of
      stock options which will be credited directly to stockholders equity if the
      associated deferred tax assets are realized.




-56-
 **Table
          of Contents**


A
      reconciliation of the statutory federal income tax to
      the Company’s effective tax is as follows:




**Year
                Ended September 30,****2006**
            
            **2005**
            
            **2004**(in
                thousands)Tax
                at federal statutory rate
            
            $
            (3,118
            )
            $
            (1,775
            )
            $
            (3,724
            )Stock
                compensation
            
            
            -
            
            
            -
            
            
            47Research
                and development credits
            
            
            (202
            )
            
            (742
            )
            
            (730
            )Foreign
                tax credits
            
            
            -
            
            
            -
            
            
            (24
            )Benefit
                of operating loss not recognized
            
            
            3,282
            
            
            2,594
            
            
            4,412Foreign
                taxes
            
            
            41
            
            
            90
            
            
            30Other
            
            
            38
            
            
            (77
            )
            
            19$
            41
            
            $
            90
            
            $
            30




The
      company does not provide for federal income taxes on the undistributed earnings
      of its foreign subsidiaries as such earnings are to be reinvested
      indefinitely.





**NOTE
      10 — SEGMENT AND GEOGRAPHIC INFORMATION**





The
      Company operates in one industry segment comprising the design, development
      and
      marketing of high-performance, multi-protocol packet processors - semiconductor
      devices. This determination was reached upon review of the structure of the
      Company’s internal organization, the financial information that the Company’s
      chief operating decision maker uses to make decisions about operating matters,
      such as resource allocation and performance assessment, and the structure of
      discrete financial information available.





Within
      the Company’s one operating segment, two revenue-generating activities have been
      identified for purposes of reporting: sales of processors and of software
      licenses and other. Both processors and software licenses share similar customer
      base and economic environment and share internal operating resources and assets.
      The Company does not internally report profitability for each of these
      revenue-generating activities. Decisions are based on the combined impact of
      the
      decisions and results of processors and software licenses. Therefore, while
      the
      Company has been reporting net revenues and cost of revenues for processors
      and
      software licenses separately, the Company does not consider these
      revenue-generating activities to constitute separate operating
      segments.





Sales
      by
      major geographic area are based on the geographic location of the distributor,
      manufacturing subcontractor or OEM who purchased our products which may be
      different from the geographic locations of our end customers.


**Year
                Ended September 30,****2006**
            
            **2005**
            
            **2004**(in
                thousands)North
                America:United
                States
            
            $
            16,655
            
            $
            16,177
            
            $
            13,431Other
            
            
            1,082
            
            
            2,194
            
            
            1,999Total
                North America
            
            
            17,737
            
            
            18,371
            
            
            15,430Asia:Hong
                Kong
            
            
            18,138
            
            
            18,819
            
            
            13,155Malaysia
            
            
            1,411
            
            
            2,398
            
            
            4,294Singapore
            
            
            1,429
            
            
            2,505
            
            
            2,584Japan
            
            
            1,796
            
            
            1,442
            
            
            962Thailand
            
            
            1,039
            
            
            1,058
            
            
            515Taiwan
            
            
            134
            
            
            86
            
            
            3,197Other
            
            
            39
            
            
            4
            
            
            2Total
                Asia
            
            
            23,986
            
            
            26,312
            
            
            24,709Europe
                and other
            
            
            2,041
            
            
            1,711
            
            
            2,003Total
            
            $
            43,764
            
            $
            46,394
            
            $
            42,142





-57-
 **Table
          of Contents**


**Major
      Customers**





The
      Company’s major customers are generally original equipment manufacturers with
      manufacturing subcontractors who purchase products directly from us. Our
      principal end customers and their respective contribution to net revenues for
      the respective periods are as follows:


**Year
                  Ended September 30,****2006**
              
              **2005**
              
              **2004**Cisco
                  Systems, Inc.
              
              
              50
              %
              
              49
              %
              
              41
              %Huawei
                  Technologies, Inc.
              
              
              13
              %
              
              10
              %
              
              14
              %Quantum
                  Corporation
              
              
              7
              %
              
              11
              %
              
              14
              %70
              %
              
              70
              %
              
              69
              %


No
      other
      customers accounted for more than 10% of revenues in the periods
      presented.





**Property
      and Equipment**





As
      of
      September 30, 2006, the Company had net property and equipment of $1.4
      million and $918,000 in the United States and China, respectively.





**NOTE
      11 — COMMITMENTS AND CONTINGENCIES**




**Contractual
      Obligations**


The
      Company occupies its facilities under several non-cancelable operating leases
      that expire at various dates through November 2011, and which contain renewal
      options. Additionally, contractual obligations were also entered into related
      to
      non-recurring engineering services and inventory purchases. Payment obligations
      for such commitments as of September 30, 2006 are as follows (in
      thousands):





Operating
              Lease
              Commitments****
            
            Inventory
              Purchases****
            
            ****Non-recurring
              Engineering
              Expenses
            
            Total
              Contractual
              Obligations****Fiscal
                year ending September 30,2007
            
            $
            2,106
            
            $
            3,491
            
            $
            510
            
            $
            6,1072008
            
            
            1,402
            
            
            -
            
            
            -
            
            
            1,4022009
            
            
            1,107
            
            
            -
            
            
            -
            
            
            1,1072010
            
            
            430
            
            
            -
            
            
            -
            
            
            4302011
            
            
            116
            
            
            -
            
            
            -
            
            
            1162012
            
            
            20
            
            
            -
            
            
            -
            
            
            20$
            5,181
            
            $
            3,491
            
            $
            510
            
            $
            9,182





Total
      rental expense under operating leases was $2.4 million, $3.0 million and $3.1
      million for fiscal years ended September 30, 2006, 2005 and 2004, respectively.




**Guarantees**





In
      November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”),
“Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including
      Indirect Guarantees of Indebtedness of Others.”  FIN 45 requires that a
      liability be recorded in the guarantor’s balance sheet upon issuance of a
      guarantee. In addition, FIN 45 requires disclosures about the guarantees that
      an
      entity has issued, including a reconciliation of changes in the entity’s product
      warranty liabilities. The initial recognition and initial measurement provisions
      of FIN 45 are applicable on a prospective basis to guarantees issued or modified
      after December 31, 2002. The disclosure requirements of FIN 45 are effective
      for
      financial statements of interim or annual periods ending after December 15,
      2002. Agreements that we have determined to be within the scope of FIN 45
      include hardware and software license warranties, indemnification arrangements
      with officers and directors and indemnification arrangements with customers
      with
      respect to intellectual property.
      To date, the Company has not incurred material costs in relation to any of
      the
      above guarantees and, accordingly, adoption of this standard did not have a
      material impact on its financial position, results of operations or cash flows.




As
      permitted under Delaware law, the Company has
      agreements that provide indemnification of officers and directors for certain
      events or occurrences while the officer or director is, or was serving, at
      the
      Company’s request in such capacity. The indemnification period is effective for
      the officer’s or director’s lifetime. The maximum potential amount of future
      payments that the Company could be required to make under these indemnification
      agreements is unlimited; however, the Company has a


-58-
 **Table
          of Contents**


Director
      and Officer insurance policy that limits its exposure and enables the Company
      to
      recover a portion of any future amounts paid. All of the indemnification
      agreements were grandfathered under the provisions of FIN 45 as they were in
      effect prior to December 31, 2002. As a result of the insurance policy coverage,
      the Company believes the estimated fair value of the potential liability under
      these agreements is minimal. Accordingly, the Company has not recorded any
      liabilities for these agreements as of September 30, 2006.




The
      Company enters into standard indemnification agreements in the ordinary course
      of business. Pursuant to these agreements, the Company indemnifies, holds
      harmless, and agrees to reimburse the indemnified party, generally business
      partners or customers, for losses suffered or incurred in connection with
      patent, copyright or other intellectual property infringement claims by any
      third party with respect to the Company’s products. The term of these
      indemnification agreements is generally perpetual, effective after execution
      of
      the agreement. The maximum potential amount of future payments the Company
      could
      be required to make under these indemnification agreements is unlimited. To
      date, the Company has not incurred costs to defend lawsuits or settle claims
      related to these indemnification agreements. Accordingly, the Company has not
      recorded any liabilities for these agreements as of September 30, 2006. However,
      the Company may, in the future, record charges related to indemnification
      obligations and, depending upon the nature of any such lawsuit or claim, the
      estimated fair value of such indemnification obligations may be material.





The
      Company warrants that its hardware products are free from defects in material
      and workmanship under normal use and service and that its hardware and software
      products will perform in all material respects in accordance with the standard
      published specifications in effect at the time of delivery of the licensed
      products to the customer. The warranty periods generally range from three months
      to one year for software and one year for hardware. Additionally, the Company
      warrants that its maintenance services will be performed consistent with
      generally accepted industry standards through completion of the agreed upon
      services. The Company’s policy is to provide for the estimated cost of product
      and service warranties based on specific warranty claims and claim history
      as a
      charge to cost of revenues. To date, the Company has not incurred significant
      expense under its product or service warranties. As a result, the Company has
      not recorded an accrual related to product or warranty services as of September
      30, 2006. The Company assesses the need for a warranty accrual every quarter.
      There is no assurance that a warranty accrual will not be necessary in the
      future.





**NOTE
      12 — SELECTED UNAUDITED QUARTERLY FINANCIAL DATA**





**Three
                Months Ended****September
                30**
            
            **June
                30**
            
            **March
                31**
            
            **December
                31**(in
                thousands, except per share amounts)**Fiscal
                2006:**Net
                revenues
            
            $
            9,121
            
            $
            12,252
            
            $
            11,719
            
            $
            10,672Total
                costs and operating expenses
            
            
            11,940
            
            
            14,867
            
            
            14,676
            
            
            12,826Net
                loss
            
            
            (2,341
            )
            
            (2,211
            )
            
            (2,510
            )
            
            (1,662
            )Net
                loss per share, basic and diluted
            
            
            (0.17
            )
            
            (0.16
            )
            
            (0.18
            )
            
            (0.12
            )**Fiscal
                2005:**Net
                revenues
            
            $
            8,760
            
            $
            12,039
            
            $
            13,065
            
            $
            12,530Total
                costs and operating expenses
            
            
            12,001
            
            
            13,186
            
            
            14,182
            
            
            13,293Net
                loss
            
            
            (2,915
            )
            
            (871
            )
            
            (854
            )
            
            (576
            )Net
                loss per share, basic and diluted
            
            
            (0.21
            )
            
            (0.06
            )
            
            (0.06
            )
            
            (0.04
            )




**NOTE
        13 — SUBSEQUENT EVENTS**
 
 Christopher
        G. Kenber resigned as the Chairman of the Board, President and Chief Executive
        Officer of hi/fn, inc. (the “Company”), and as a director of the Company, on
        November 9, 2006. Mr. Kenber has agreed to serve as a consultant to the Company
        to assist in the transition to new management. On November 9, 2006, Albert
        E.
        Sisto, a member of the Company’s Board of Directors (the “Board”), was appointed
        by the Board to serve as Chairman of the Board and as the Company’s interim
        Chief Executive officer until such time as Mr. Kenber’s successor is determined.





-59-
 **Table
            of Contents**





**Item
      9.** ***Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure***





Not
      applicable.





**Item
      9A.** ***Controls
      and Procedures***





(a) *Evaluation of disclosure controls and procedures.* We
      maintain disclosure controls and procedures that are designed to ensure that
      information required to be disclosed by us in reports that we file or submit
      under the Securities Exchange Act of 1934, as amended, is recorded, processed,
      summarized and reported within the time periods specified in Securities and
      Exchange Commission rules and forms and that such information is accumulated
      and
      communicated to our management, including our Chief Executive Officer and Chief
      Financial Officer, as appropriate to allow timely decisions regarding required
      disclosure.





Based
      on
      their evaluation as of the end of the period covered by this Annual Report
      on
      Form 10-K, our Chief Executive Officer and Chief Financial Officer have
      concluded that our disclosure controls and procedures as defined in Rules
      13a-15(e) and 15d-15(e) under the Securities Act of 1934, as amended, are
      effective to ensure that information that is required to be disclosed in this
      Annual Report on Form 10-K is recorded, processed, summarized and reported
      within the time periods specified in SEC rules and forms and is accumulated
      and
      communicated to our Chief Executive Officer and Chief Financial Officer, as
      appropriate to allow timely decisions regarding required
      disclosure.





(b) *Management’s
      Report on Internal Control Over Financial Reporting.* Management is responsible for establishing and maintaining adequate internal
      control over financial reporting for hi/fn, Inc. Internal control over financial
      reporting is a process to provide reasonable assurance regarding the reliability
      of financial reporting and the preparation of financial statements for external
      purposes in accordance with generally accepted accounting principles. Internal
      control over financial reporting includes policies and procedures that:
      (i) pertain to maintenance of records that, in reasonable detail,
      accurately and fairly reflect the transactions and dispositions of the assets
      of
      the company; (ii) provide reasonable assurance that transactions are
      recorded as necessary to permit preparation of financial statements in
      accordance with generally accepted accounting principles, and that receipts
      and
      expenditures of the company are being made only in accordance with
      authorizations of management and directors of the company; and
      (iii) provide reasonable assurance that unauthorized acquisition, use or
      disposition of the company’s assets that could have a material effect on
      financial statements would be prevented or detected on a timely basis.





Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Also, projections of any evaluation of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate.





Management
      evaluated the effectiveness of internal control over financial reporting based
      on the framework in *Internal
      Control — Integrated Framework* issued
      by
      the Committee of Sponsoring Organizations of the Treadway Commission. Based
      upon
      that evaluation, management concluded that the company’s internal control over
      financial reporting was effective as of September 30, 2006.
      PricewaterhouseCoopers LLP, an independent registered public accounting firm,
      has audited management’s assessment of internal control over financial reporting
      as of September 30, 2006, as stated in their report which is included under
      Item
      8.





(c)  *Changes
      in internal controls over financial reporting.* There
      was no change in our internal control over financial reporting that was
      identified in connection with our evaluation of disclosure controls and
      procedures that occurred during the last quarter of fiscal 2006 that has
      materially affected, or is reasonably likely to materially affect, our internal
      control over financial reporting.


-60-
 **Table
            of Contents**







**PART
      III**





**Item
      10.** ***Directors
      and Executive Officers of the Registrant***





The
      information required by Item 10 is incorporated by reference from Hifn’s Proxy
      Statement for its 2007 Annual Meeting of Stockholders - *Election
      of Directors* .
      The
      information required by Item 10 regarding our executive officers appears
      immediately following Item 4 under Part I of this report.





**Item
      11.** ***Executive
      Compensation***





The
      information required by this item is incorporated by reference from Hifn’s Proxy
      Statement for its 2007 Annual Meeting of Stockholders - *Executive
      Officer Compensation* .





**Item
      12.** ***Security
      Ownership of Certain Beneficial Owners and Management and Related Stockholder
      Matters***





The
      information required by this item is incorporated by reference from Hifn’s Proxy
      Statement for its 2007 Annual Meeting of Stockholders - *Security
      Ownership of Certain Beneficial Owners and Management* .





**Item
      13.** ***Certain
      Relationships and Related Transactions***





The
      information required by this item is incorporated by reference from Hifn’s Proxy
      Statement for its 2007 Annual Meeting of Stockholders - *Certain Transactions* .





**Item
      14.** ***Principal
      Accountant Fees and Services***





The
      information required by this item is incorporated by reference from Hifn’s Proxy
      Statement for its 2007 Annual Meeting of Stockholders - *Ratification
      of Appointment of Independent Registered Public Accounting Firm* .





-61-
 **Table
            of Contents**




**PART
      IV**





**Item
      15.** ***Exhibits
      and Financial Statement Schedules***





(a)
            The
                following documents are filed as a part of this
                Report:





1. **Financial
      Statements** -
      See
      Item 8 above.





2.
            **Financial
                Statement Schedule**-
                See Schedule II on page 65.





3.
            **Exhibits**-
                The exhibits listed in the accompanying “Index to Exhibits” are filed as
                part of this Annual Report on Form
                10-K.




**Exhibit**
                **Number**
              
              ******Exhibit**3.1*
              
              Form
                  of Third Amended and Restated Certificate of Incorporation of hi/fn,
                  inc.3.2*
              
              Amended
                  and Restated Bylaws of hi/fn, inc.10.1*
              
              Amended
                  and Restated 1996 Equity Incentive Plan of hi/fn, inc.10.2*
              
              Assignment,
                  Assumption and License Agreement dated as of November 21, 1996
                  between
                  Stac, Inc. and hi/fn, inc.10.3*
              
              Cross
                  License Agreement dated as of November 21, 1996 between Stac, Inc.
                  and
                  hi/fn, inc.10.4*
              
              Form
                  of Distribution Agreement.10.5*
              
              Form
                  of Employee Benefits and Other Matters Allocation
                  Agreement.10.6*
              
              Form
                  of Tax Allocation and Indemnity Agreement.10.7*
              
              Form
                  of Transitional Services Agreement.10.8*
              
              Form
                  of Indemnification Agreement.10.9*
              
              Agreement
                  dated as of April 1, 1994 between International Business Machines
                  Corporation and Stac, Inc. (Program Patent License
                  Agreement).10.10*
              
              Agreement
                  dated as of April 1, 1994 between International Business Machines
                  Corporation and Stac, Inc. (Cross License Agreement).10.11*
              
              License
                  Agreement dated as of June 20, 1994 between Microsoft Corporation
                  and
                  Stac, Inc.10.12*
              
              License
                  Agreement dated as of February 16, 1996 between Microsoft Corporation
                  and Stac, Inc.10.13*
              
              License
                  Agreement dated as of December 15, 1995 between Motorola, Inc.
                  and Stac,
                  Inc.10.14*
              
              Agreement
                  dated as of November 13, 1997 between 750 University, LLC and hi/fn,
                  inc.10.15*
              
              1998
                  Employee Stock Purchase Plan of hi/fn, inc.10.16*
              
              Form
                  of Director Change of Control Agreement.10.17*
              
              Form
                  of Employee Change of Control Agreement.10.18*
              
              Promissory
                  Note dated as of September 28, 1998 made by hi/fn, inc. in favor
                  of Stac,
                  Inc.10.19*
              
              Security
                  Agreement dated as of September 28, 1998 between Stac, Inc. and
                  hi/fn,
                  inc.10.20**
              
              Agreement
                  and Plan of Reorganization, dated May 12, 2000 between hi/fn, inc.
                  and
                  Apptitude, Inc. and amendments thereto.10.21***
              
              Apptitude,
                  Inc. 1995 Stock Option Plan.10.22+
              
              Agreement
                  dated as of October 23, 2000 between Spieker Properties, L.P. and
                  hi/fn,
                  inc.10.23+
              
              Agreement
                  dated as of October 24, 2000 between Sally Spencer and hi/fn,
                  inc.10.24++
              
              Agreement
                  dated as of April 6, 2001 between Sally Spencer and hi/fn,
                  inc.10.25+++
              
              2001
                  Nonstatutory Stock Option Plan of hi/fn, inc.10.26^
              
              Form
                  of Severance and Change of Control Agreement by and between hi/fn,
                  inc.
                  and Christopher G. Kenber.10.27^
              
              Form
                  of Severance and Change of Control Agreement by and between hi/fn,
                  inc.
                  and William R. Walker.10.28^
              
              Form
                  of Severance and Change of Control Agreement by and between hi/fn,
                  inc.
                  and each of Douglas L. Whiting, Thomas Moore, Russell Dietz and
                  Kamran
                  Malik.10.29^^
              
              Agreement
                  dated May 6, 2005 between POI-Carlsbad, Inc. and hi/fn,
                  inc.10.30^^
              
              Agreement
                  dated July 20, 2005 between 750 University, LLC and hi/fn,
                  inc.10.31
              
              Agreement
                  dated July 25, 2006 between Ocean Point Tech Centre and hi/fn,
                  inc.







-62-
 **Table
            of Contents**




10.32
              
              Agreement
                  dated September 19, 2006 between Rreef America Reit III-Z1 LC and
                  hi/fn,
                  inc.10.33
              
              Employment
                  Agreement dated November 16, 2006 between Albert E. Sisto and hi/fn,
                  inc.10.34
              
              Severance
                  and ReleaseAgreement dated November 16, 2006 between Christopher G. Kenber
                  and hi/fn,
                  inc.10.35
              
              ConsultingAgreement dated November 16, 2006 between Christopher G. Kenber
                  and hi/fn,
                  inc.10.36^^^
              
              Amended
                  and Restated 1996 Equity Incentive Plan of hi/fn, inc.10.37^^^
              
              Amended
                  and Restated 1998 Employee Stock Purchase Plan of hi/fn,
                  inc.21.1
              
              Subsidiaries
                  of the Registrant23.1
              
              Consent
                  of PricewaterhouseCoopers LLP, independent registered public accounting
                  firm.24.1
              
              Power
                  of Attorney (see page 64).31.1
              
              Certification
                  of Chief Executive Officer pursuant to Section 302(a) of the
                  Sarbanes-Oxley Act of 2002.31.2
              
              Certification
                  of Chief Financial Officer pursuant to Section 302(a) of the
                  Sarbanes-Oxley Act of 2002.32.1
              
              Certification
                  of Chief Executive Officer pursuant to 18 U.S.C. Section 1350,
                  as adopted
                  pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002.32.2
              
              Certification
                  of Chief Financial Officer pursuant to 18 U.S.C. Section 1350,
                  as adopted
                  pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002.




*
            Incorporated
                by reference from Registrant’s Registration Statement on Form 10
                (File No. 0-24765) filed with the SEC on August 7, 1998, as
                amended.





**
            Incorporated
                by reference from the exhibits to Registrant’s Report on Form 8-K
                (File No. 0-24765) filed with the SEC on August 25,
                2000.





***
            Incorporated
                by reference from Registrant’s Registration Statement on Form S-8
                (File No. 333-48232) filed with the SEC on October 19,
                2000.





+
            Incorporated
                by reference from Registrant’s Report on Form 10-K (File
                No. 0-24765) filed with the SEC on December 26,
                2000.





++
            Incorporated
                by reference from Registrant’s Report on Form 10-Q (File
                No. 0-24765) filed with the SEC on May 1,
                2001.





+++
            Incorporated
                by reference from Registrant’s Report on Form 10-Q (File
                No. 0-24765) and Registration Statement on Form S-8 (File No.
                333-61070) filed with the SEC on May 1, 2001 and May 16, 2001,
                respectively.





^
            Incorporated
                by reference from Registrant’s Current Report on Form 8-K filed with the
                SEC on May 16, 2006.





^^
            Incorporated
                by reference from Registrant’s Report on Form 10-Q (File
                No. 0-24765) filed with the SEC on August 3,
                2006.





^^^
            Incorporated
                by reference from Registrant’s 1998 Employee Stock Purchase Plan (As
                Amended) and 1996 Equity Incentive Plan (As Amended and Restated)
                on
                Form S-8 (File No.333-135987 & 333-135984)filed with the SEC on July 24,
                2006.





(b)   Exhibits:
      See Item 15(a) above.





(c)
      Financial Statement Schedules


Schedule
      II - Valuation and Qualifying Accounts (see page 65)





-63-
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            of Contents**


**SIGNATURES**





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, as amended, the registrant has duly caused this report to be signed on
      its
      behalf by the undersigned, thereunto duly authorized in the City of Los Gatos,
      State of California.





hi/fn,
                incDated:
                December 14, 2006
            
            /s/
                ALBERT E. SISTO(Albert
                E. Sisto)Chairman,
                Interim Chief Executive Officer












**POWER
      OF ATTORNEY**





KNOW
      ALL
      PERSONS BY THESE PRESENTS, that each person whose signature appears below
      constitutes and appoints Albert E. Sisto and William R. Walker, jointly and
      severally, his attorneys-in-fact, each with the power of substitution, for
      him
      in any and all capacities, to sign any amendments to this Report on Form 10-K,
      and to file the same, with exhibits thereto and other documents in connection
      therewith, with the Securities and Exchange Commission, hereby ratifying and
      confirming all that each of said attorneys-in-fact, or his substitute or
      substitutes, may do or cause to be done by virtue hereof.





Pursuant
      to the requirements of the Securities Exchange Act of 1934, as amended, this
      Report has been signed below by the following persons in the capacities and
      on
      December 14, 2006.





Signature
            
            Title/s/
                ALBERT E. SISTO
            
            Chairman,
                Interim Chief Executive Officer(Albert
                E. Sisto)
            
            (Principal
                Executive Officer)/s/
                WILLIAM R. WALKER
            
            Vice
                President, Finance, Chief Financial Officer(William
                R. Walker)
            
            and
                Secretary (Principal Financial and Accounting Officer)/s/
                DOUGLAS L. WHITING
            
            Chief
                Scientist and Director(Douglas
                L. Whiting)/s/
                DENNIS DeCOSTE
            
            Director(Dennis
                DeCoste)/s/
                TAHER ELGAMAL
            
            Director(Taher
                Elgamal)/s/
                ROBERT W. JOHNSON
            
            Director(Robert
                W. Johnson)/s/
                THOMAS LAWRENCE
            
            Director(Thomas
                Lawrence)





-64-
 **Table
          of Contents**




HIFN,
      INC.





SCHEDULE
      II





VALUATION
      AND QUALIFYING ACCOUNTS




(in
      thousands)


**Balance
                  at beginning of  period**
              
              
              **Additions
                  charged to costs and expenses**
              
              
              **Deductions**
              
              
              **Balance
                  at end of period****Deducted
                  from accounts receivable**Allowance
                  for doubtful accounts:Year
                  ended September 30, 2006
              
              $
              104
              
              
              3
              
              $
              -
              
              $
              107Year
                  ended September 30, 2005
              
              
              259
              
              
              -
              
              
              (155
              )
              
              104Year
                  ended September 30, 2004
              
              
              205
              
              
              57
              
              
              (3
              )
              
              259


-65-
 **Table
            of Contents**





**INDEX
      TO EXHIBITS**





**Exhibit**
              **Number**
            
            ******Exhibit**3.1*
            
            Form
                of Third Amended and Restated Certificate of Incorporation of hi/fn,
                inc.3.2*
            
            Amended
                and Restated Bylaws of hi/fn, inc.10.1*
            
            Amended
                and Restated 1996 Equity Incentive Plan of hi/fn, inc.10.2*
            
            Assignment,
                Assumption and License Agreement dated as of November 21, 1996 between
                Stac, Inc. and hi/fn, inc.10.3*
            
            Cross
                License Agreement dated as of November 21, 1996 between Stac, Inc.
                and
                hi/fn, inc.10.4*
            
            Form
                of Distribution Agreement.10.5*
            
            Form
                of Employee Benefits and Other Matters Allocation
                Agreement.10.6*
            
            Form
                of Tax Allocation and Indemnity Agreement.10.7*
            
            Form
                of Transitional Services Agreement.10.8*
            
            Form
                of Indemnification Agreement.10.9*
            
            Agreement
                dated as of April 1, 1994 between International Business Machines
                Corporation and Stac, Inc. (Program Patent License
                Agreement).10.10*
            
            Agreement
                dated as of April 1, 1994 between International Business Machines
                Corporation and Stac, Inc. (Cross License Agreement).10.11*
            
            License
                Agreement dated as of June 20, 1994 between Microsoft Corporation
                and
                Stac, Inc.10.12*
            
            License
                Agreement dated as of February 16, 1996 between Microsoft Corporation
                and Stac, Inc.10.13*
            
            License
                Agreement dated as of December 15, 1995 between Motorola, Inc. and
                Stac,
                Inc.10.14*
            
            Agreement
                dated as of November 13, 1997 between 750 University, LLC and hi/fn,
                inc.10.15*
            
            1998
                Employee Stock Purchase Plan of hi/fn, inc.10.16*
            
            Form
                of Director Change of Control Agreement.10.17*
            
            Form
                of Employee Change of Control Agreement.10.18*
            
            Promissory
                Note dated as of September 28, 1998 made by hi/fn, inc. in favor
                of Stac,
                Inc.10.19*
            
            Security
                Agreement dated as of September 28, 1998 between Stac, Inc. and hi/fn,
                inc.10.20**
            
            Agreement
                and Plan of Reorganization, dated May 12, 2000 between hi/fn, inc.
                and
                Apptitude, Inc. and amendments thereto.10.21***
            
            Apptitude,
                Inc. 1995 Stock Option Plan.10.22+
            
            Agreement
                dated as of October 23, 2000 between Spieker Properties, L.P. and
                hi/fn,
                inc.10.23+
            
            Agreement
                dated as of October 24, 2000 between Sally Spencer and hi/fn,
                inc.10.24++
            
            Agreement
                dated as of April 6, 2001 between Sally Spencer and hi/fn,
                inc.10.25+++
            
            2001
                Nonstatutory Stock Option Plan of hi/fn, inc.10.26^
            
            Form
                of Severance and Change of Control Agreement by and between hi/fn,
                inc.
                and Christopher G. Kenber.10.27^
            
            Form
                of Severance and Change of Control Agreement by and between hi/fn,
                inc.
                and William R. Walker.10.28^
            
            Form
                of Severance and Change of Control Agreement by and between hi/fn,
                inc.
                and each of Douglas L. Whiting, Thomas Moore, Russell Dietz and Kamran
                Malik.10.29^^
            
            Agreement
                dated May 6, 2005 between POI-Carlsbad, Inc. and hi/fn,
                inc.10.30^^
            
            Agreement
                dated July 20, 2005 between 750 University, LLC and hi/fn,
                inc.10.31
            
            Agreement
                dated July 25, 2006 between Ocean Point Tech Centre and hi/fn,
                inc.10.32
            
            Agreement
                dated September 19, 2006 between Rreef America Reit III-Z1 LC and
                hi/fn,
                inc.10.33
            
            Employment
                Agreement dated November 16, 2006 between Albert E. Sisto and hi/fn,
                inc.10.34
            
            Severance
                and ReleaseAgreement dated November 16, 2006 between Christopher G. Kenber and
                hi/fn,
                inc.10.35
            
            ConsultingAgreement dated November 16, 2006 between Christopher G. Kenber and
                hi/fn,
                inc.10.36^^^
            
            Amended
                and Restated 1996 Equity Incentive Plan of hi/fn, inc.10.37^^^
            
            Amended
                and Restated 1998 Employee Stock Purchase Plan of hi/fn,
                inc.21.1
            
            Subsidiaries
                of the Registrant23.1
            
            Consent
                of PricewaterhouseCoopers LLP, independent registered public accounting
                firm.24.1
            
            Power
                of Attorney (see page 64).31.1
            
            Certification
                of Chief Executive Officer pursuant to Section 302(a) of the
                Sarbanes-Oxley Act of 2002.




-66-
 **Table
          of Contents**


31.2
              
              Certification
                  of Chief Financial Officer pursuant to Section 302(a) of the
                  Sarbanes-Oxley Act of 2002.32.1
              
              Certification
                  of Chief Executive Officer pursuant to 18 U.S.C. Section 1350,
                  as adopted
                  pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002.32.2
              
              Certification
                  of Chief Financial Officer pursuant to 18 U.S.C. Section 1350,
                  as adopted
                  pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002.





*
            Incorporated
                by reference from Registrant’s Registration Statement on Form 10
                (File No. 0-24765) filed with the SEC on August 7, 1998, as
                amended.





** Incorporated
      by reference from the exhibits to Registrant’s Report on Form 8-K (File
      No. 0-24765) filed with the SEC on August 25, 2000.





***
            Incorporated
                by reference from Registrant’s Registration Statement on Form S-8
                (File No. 333-48232) filed with the SEC on October 19,
                2000.





+
            Incorporated
                by reference from Registrant’s Report on Form 10-K (File
                No. 0-24765) filed with the SEC on December 26,
                2000.





++
            Incorporated
                by reference from Registrant’s Report on Form 10-Q (File
                No. 0-24765) filed with the SEC on May 1,
                2001.





+++
            Incorporated
                by reference from Registrant’s Report on Form 10-Q (File
                No. 0-24765) and Registration Statement on Form S-8 (File No.
                333-61070) filed with the SEC on May 1, 2001 and May 16, 2001,
                respectively.





^
            Incorporated
                by reference from Registrant’s Current Report on Form 8-K filed with the
                SEC on May 16, 2006.





^^
            Incorporated
                by reference from Registrant’s Report on Form 10-Q (File
                No. 0-24765) filed with the SEC on August 3,
                2006.





^^^
            Incorporated
                by reference from Registrant’s 1998 Employee Stock Purchase Plan (As
                Amended) and 1996 Equity Incentive Plan (As Amended and Restated)
                on
                Form S-8 (File No.333-135987 & 333-135984)filed with the SEC on July 24,
                2006.





-67-