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# UNITED STATES SECURITIES AND
EXCHANGE COMMISSIONWashington, D.C. 20549

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FORM 10-K

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|                                             |  |                                                                                         
|-------------------------------------------- |  | ----------------------------------------------------------------------------------------
|(Mark One)                                   |  |                                                                                         
|þ                                            |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
|For the fiscal year ended September 30, 2005
|OR                                          
|                                            
| ̈                                            |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

# 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
incorporation or organization) |  | (I.R.S. Employer Identification No.) | 
| |                                                                |  |                                      | 
| | 750 University Avenue, Los Gatos, California                   |  | 95032                                | 
| | (Address of principal executive offices)                       |  | (Zip Code)                           | 

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

Securities registered
pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:Common Stock, $0.001 Par Value(Title of Class)

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. YESþ
NO ̈

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. ̈

Indicate
by check mark whether the Registrant is an  accelerated  filer as defined in Rule 12b-2
of the Act). YESþ
NO ̈

The
aggregate market value of the voting and non-voting common equity held by non-affiliates
of the Registrant as of December 5, 2005 was $66,432,656 (based upon the closing
price reported on the NASDAQ National Market System 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 5, 2005, was 13,655,180.

# DOCUMENTS INCORPORATED
BY REFERENCE

Parts
of the Proxy Statement for Registrants 2006 Annual Meeting of Shareholders to be
held February 13, 2006 (the Proxy Statement) are incorporated by reference
into Part III of this Form 10-K Report.

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|         |                                                                                                                         
|-------- | ------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                         
|PART I  
|         | Item 1. Business                                                                                                        
|         | Item 2. Properties                                                                                                      
|         | Item 3. Legal Proceedings                                                                                               
|         | Item 4. Submission of Matters to a Vote of Security Holders                                                             
|PART II 
|         | Item 5. Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
|         | Item 6. Selected Financial Data                                                                                         
|         | Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations                           
|         | Item 7A. Quantitative and Qualitative Disclosure About Market Risk                                                      
|         | Item 8. Financial Statements and Supplementary Data                                                                     
|         | REPORT OF INDEPENDENT AUDITORS                                                                                          
|         | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                            
|         | Item 9A. Controls and Procedures                                                                                        
|PART III
|         | Item 10. Directors and Executive Officers of the Registrant                                                             
|         | Item 11. Executive Compensation                                                                                         
|         | Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters                 
|         | Item 13. Certain Relationships and Related Transactions                                                                 
|         | Item 14. Principal Accountant Fees and Services                                                                         
|PART IV 
|         | Item 15. Exhibits and Financial Statement Schedules                                                                     
|         | SIGNATURES                                                                                                              
|         | INDEX TO EXHIBITS                                                                                                       
|         | EXHIBIT 21.1                                                                                                            
|         | EXHIBIT 23.1                                                                                                            
|         | EXHIBIT 31.1                                                                                                            
|         | EXHIBIT 31.2                                                                                                            
|         | EXHIBIT 32.1                                                                                                            
|         | EXHIBIT 32.2                                                                                                            

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Page

|           |  |                                                                                                             |  |   
|---------- |  | ----------------------------------------------------------------------------------------------------------- |  | --
|           |  |                                                                                                             |  |   
|PART I    
|Item 1.    |  | Business                                                                                                    |  | 1 
|Item 2.    |  | Properties                                                                                                  |  | 12
|Item 3.    |  | Legal Proceedings                                                                                           |  | 12
|Item 4.    |  | Submission of Matters to a Vote of Security Holders                                                         |  | 12
|PART II    |  |                                                                                                             |  |   
|Item 5.    |  | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securites |  | 15
|Item 6.    |  | Selected Financial Data                                                                                     |  | 17
|Item 7.    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                       |  | 18
|Item 7A.   |  | Quantitative and Qualitative Disclosure About Market Risk                                                   |  | 41
|Item 8.    |  | Financial Statements and Supplementary Data                                                                 |  | 42
|Item 9.    |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                        |  | 65
|Item 9A.   |  | Controls and Procedures                                                                                     |  | 65
|PART III  
|Item 10.   |  | Directors and Executive Officers of the Registrant                                                          |  | 66
|Item 11.   |  | Executive Compensation                                                                                      |  | 66
|Item 12.   |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters              |  | 66
|Item 13.   |  | Certain Relationships and Related Transactions                                                              |  | 66
|Item 14.   |  | Principal Accountant Fees and Services                                                                      |  | 66
|PART IV   
|Item 15.   |  | Exhibits and Financial Statement Schedules                                                                  |  | 67
|           |  |                                                                                                             |  |   
|SIGNATURES |  |                                                                                                             |  | 69

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# 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, 2004 private
placement; (xxiv) our belief that employee relations are good; (xxv) the fluctuating market price
for 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 under the
heading Trends, Risks and Uncertainties within the section of this report entitled
Item 7. Managements Discussion and Analysis of Financial Condition and Results
of Operations and reports filed by hi/fn, inc. with the Securities and Exchange
Commission, specifically Forms 8-K, 10-Q and S-8. 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 Microsystems, Inc., (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s) 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. 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
and development tools that help reduce 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

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networks (VPNs),
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 to improve the
performance and capacity of a wide range of disk and tape back-up systems.

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.
Hifns network processor technology, acquired from International Business Machines
Corporation (IBM), complements our security processor business and expands our
product offerings to include programmable, yet deterministic, devices that perform
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. We are building upon this architecture to deliver the next generation
processors, which will continue to offer high-end performance and features, along with a
comprehensive software development toolkit.

# 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 and efficient communication utilizing 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 (LANs) to
enterprise-wide networks spanning multiple LANs and wide area networks (WANs).
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

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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.

# 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 packet processors 
semiconductor devices and software  designed to enable secure, high-bandwidth
network connectivity and comprehensive differentiation of business-critical application
network traffic from other general purpose network traffic. 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.

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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, 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 differentiation services to their
customers.

Hifns
line of compression processors targeted at back-up storage applications provides storage
equipment vendors with high-performance implementations of our patented compression technology,
doubling the capacity and performance of mid- to high-end 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 7.
Managements Discussion and Analysis of Financial Condition and Results of Operations
 Trends, Risks and Uncertainties  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, 2005, we had a backlog of semiconductor orders representing $8.5 million of
products deliverable to customers over the 6 months following the placement of these
orders. At September 30, 2004, we had a backlog of $10.4 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, encryption/compression processors, public key
processors, network processors and flow classification 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.

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

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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.

In
fiscal 2005, we introduced a new family of board level products. These products are
targeted at OEMs that may not have the expertise or resources to design their own
boards or the time to complete the necessary integration of the boards into their
systems. The Hifn eXceLeration 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
FlowThrough 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 growing 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.

Network
Processors. Hifns network processors (NPs) are programmable network
processing devices 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 hardware and software tools giving additional value to our
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. With most of the
common networking functions implemented in performance optimized code, ASO dramatically
reduces development time and costs to help give network equipment OEMs the edge they need
to stay ahead of the competition. We also offer reference designs and hardware that enable
our customers to quickly bring to market routers, switches and network security
appliances.

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Network
Flow Classification Products. Hifns MeterFlow products provide
comprehensiveapplication 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 9630HXL-PCIe, Virtual Tape
Library (VTL), compression board. The 9630HXL-PCIe optimizes VTLs for backup and restore
operations utilizing the industry standard LZS compression algorithm, while providing a
high-assurance solution in an easy to integrate board.

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, 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

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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.

# 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 fifteen (15) 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 7. Managements Discussion
and Analysis of Financial Condition and Results of Operations  Trends, Risks and
Uncertainties  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 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 7. Managements Discussion and Analysis of Financial Condition and Results
of Operations  Trends, Risks and Uncertainties  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 7. Managements Discussion and Analysis of
Financial Condition and Results of Operations  Trends, Risks and Uncertainties
 We Face Risks Associated With Our International Business Activities.

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# 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 (currently there are nine
such countries). 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 7. Managements Discussion and Analysis
of Financial Condition and Results of Operations  Trends, Risks and Uncertainties
 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 7. Managements Discussion and Analysis of Financial Condition and Results
of Operations  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 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.

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

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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 7.
Managements Discussion and Analysis of Financial Condition and Results of Operations
 Trends, Risks and Uncertainties  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, 2005, our research and development staff consisted of 153 employees. Our
research and development expenditures were $21.7 million in the fiscal year ended
September 30, 2005, $22.4 million in the fiscal year ended September 30, 2004 and $20.3
million in the fiscal year ended September 30, 2003, representing 47%, 53% and 99% 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, of certain assets of IBM in
December 2003, of NetOctave in September 2002 and of Apptitude in August 2000 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

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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 assure 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 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 7. Managements Discussion and Analysis of Financial Condition and
Results of Operations  Trends, Risks and Uncertainties  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 49%, 41% and 23% of our net revenues
for fiscal years ended September 30, 2005, 2004 and 2003, respectively. Semiconductor
sales to Quantum Corporation, through its manufacturing subcontractor, represented 11%,
14% and 34% of our net revenues for fiscal years ended September 30, 2005, 2004 and 2003,
respectively. Semiconductor sales to Huawei Technologies, Inc., an OEM producer of
networking equipment, represented 10% and 14% of our net revenues for fiscal years ended
September 30, 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, 2005, a combined decrease of 38% in sales to Cisco
and Huawei 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 7. Managements Discussion and Analysis of Financial
Condition and Results of Operations  Trends, Risks and Uncertainties  We
Depend Upon A Small Number Of Customers.

Sales
to customers within the United States
totaled $16.2 million for 2005. Sales to customers outside the United States
totaled $30.2 million, comprised of $18.8 million and $7.5 million in
sales to Hong Kong and the rest of the Asia Pacific region, respectively, and $2.2 million in sales to North America and $1.7
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

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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
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 semiconductor 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
and Philips Semiconductor. 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

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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 7. Managements
Discussion and Analysis of Financial Condition and Results of Operations  Trends,
Risks and Uncertainties  We Depend Upon Independent Manufacturers And Limited
Sources Of Supply.

# Employees

As
of September 30, 2005, Hifn employed a total of 198 full-time employees. Of the total
number of employees, 153 were employed in research and development, 21 in sales and
marketing, eight in operations and 16 in finance and administration. 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 7. Managements Discussion and Analysis of
Financial Condition and Results of Operations  Trends, Risks and Uncertainties
 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 (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.

# 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 14,600 square feet
of space for our design and operations center in Carlsbad, California, under a lease that
expires in June 2010; 4,200 square feet of design space in Framingham, Massachusetts,
under a lease that expires in November 2006; 3,400 and 11,300 square feet of design space
in Morrisville, North Carolina, under leases that expire in March 2006 and April 2009,
respectively; 11,900 square feet of design space in Hangzhou, Peoples Republic of
China under leases that expire February 2006 through November 2006; and small field sales
offices in Charlotte, North Carolina and Westford, Massachusetts. 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.

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# EXECUTIVE AND OTHER
OFFICERS OF HIFN

The
following table sets forth certain information concerning the executive and other officers
of the Company as of September 30, 2005:

|Name                     |  | Age |  | Position                                                        
|------------------------ |  | --- |  | ----------------------------------------------------------------
|Christopher G. Kenber    |  | 61  |  | Chairman, President and Chief Executive Officer                 
|William R. Walker        |  | 64  |  | Vice President of Finance, Chief Financial Officer and Secretary
|Russell S. Dietz         |  | 42  |  | Vice President and Chief Technical Officer                      
|Kamran Malik, Ph.D       |  | 53  |  | Vice President of Engineering                                   
|Thomas A. Moore          |  | 48  |  | Vice President of Sales, Marketing and Operations               
|Douglas L. Whiting, Ph.D |  | 49  |  | Chief Scientist and Director                                    

Christopher G. Kenber has
served as Hifns President, Chief Executive Officer and a           director since
August 2000 and as Chairman of the Board of Directors since           October 2001. He
joined Hifn from Apptitude, Inc. where he was President and           Chief Executive
Officer since 1998. Mr. Kenber has held a number of CEO           positions with
companies in the high-technology area as well as consulting to           several venture
capital funds. Prior to his tenure with Apptitude, he was the           Chief Executive
Officer of Aonix, Inc., a developer of object-oriented software           tools.
Previously, Mr. Kenber was Executive Vice President of Ingres           Corporation,
and a Senior Vice President at MICOM Systems. Mr. Kenber spent           17 years at
IBM Corporation, where he held multiple sales and marketing           positions. Mr. Kenber
has a degree in Psychology and Philosophy from Oxford           University.

William
R. Walkerhas 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

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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.

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# 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 National 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 sales prices for the Common Stock as reported on the Nasdaq National Market
for the periods indicated below:

|                                      | High | Low
|------------------------------------- | ---- | ---
|Fiscal Year Ended September 30, 2005: |      |    
|Fourth Quarter                        |      |    
|Third Quarter                         |      |    
|Second Quarter                        |      |    
|First Quarter                         |      |    
|Fiscal Year Ended September 30, 2004: |      |    
|Fourth Quarter                        |      |    
|Third Quarter                         |      |    
|Second Quarter                        |      |    
|First Quarter                         |      |    

On
December 5, 2005, the reported last sale price of Common Stock on the Nasdaq
National Market was $5.77 per share and there were approximately 637 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

The
following table provides information about the repurchase of our common stock during and
through the year ended September 30, 2005:

|Period               |  | Total
Number
of Shares
Purchased |  | Average
Price Paid
Per Share |  | Total Number of
Shares Purchased
as Part of Publicly
Announced Stock
Repurchase Plan |  | Maximum Approximate
Dollar Value of Shares
That May Yet Be
Purchased Under the
Stock Repurchase Plan | 
|-------------------- |  | -------------------------------- |  | ---------------------------- |  | ------------------------------------------------------------------------------------ |  | ---------------------------------------------------------------------------------------------------- | 
|May 1 - May 31       |  |                                  |  | 422,700                      |  | $5.95                                                                                |  |                                                                                                      | 
|June 1 - June 30     |  |                                  |  | -                            |  | -                                                                                    |  |                                                                                                      | 
|July 1 - July 30     |  |                                  |  | 120,200                      |  | 6.14                                                                                 |  |                                                                                                      | 
|August 1 - August 30 |  |                                  |  | 149,994                      |  | 6.66                                                                                 |  |                                                                                                      | 
|                     |  |                                  |  |                              | 
|Total                |  |                                  |  | 692,894                      |  | 6.14                                                                                 |  |                                                                                                      | 
|                     |  |                                  |  |                              | 

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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 timing and
amount of repurchases under this program will depend on market conditions and corporate
and regulatory considerations. The purchase is funded from available working capital. The
stock repurchase program expires on April 25, 2006.

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# 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, | 
|------------------------------------------------------ | ------------------------ | 
|
|
|Statement of Operations Data:                          |                          | 
|Net revenues                                           |                          | 
|Costs and operating expenses:                         
|Cost of revenues                                       |                          | 
|Research and development                               |                          | 
|Sales and marketing                                    |                          | 
|General and administrative                             |                          | 
|Amortization of intangibles and goodwill               |                          | 
|Impairment of intangibles and goodwill                 |                          | 
|Purchased in-process research & development            |                          | 
|                                                       |                          | 
|Loss from operations                                   |                          | 
|Interest income, net                                   |                          | 
|Other income (expense), net                            |                          | 
|Provision for (benefit from) income taxes              |                          | 
|                                                       |                          | 
|Net loss                                               |                          | 
|                                                       |                          | 
|Net loss per share, basic and diluted                  |                          | 
|Weighted average shares outstanding, basic and diluted |                          | 

|                                | September 30, | 
|------------------------------- | ------------- | 
|
|
|Balance Sheet Data:             |               | 
|Cash and short-term investments |               | 
|Total assets                    |               | 
|Working capital                 |               | 
|Total debt                      |               | 
|Total stockholders' equity      |               | 

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# 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 Trends, Risks and
Uncertainties 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 Microsystems, Inc., (collectively referred to as
Hifn, we, us or our) is a network- and
storage-security market leader that supplies most major network equipment manufacturers
(OEMs) 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. 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 and development
tools that help reduce 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s), switches, broadband access equipment, network
interface cards, firewalls and back-up storage devices.

Our
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 to improve the performance and
capacity of a wide range of disk and tape back-up systems.

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.
Hifns network processor technology, acquired from International Business Machines
Corporation (IBM), complements our security processor business and expands our
product offerings to include programmable, yet deterministic, devices that perform
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. We are building upon this architecture to deliver the next generation
processors, which will continue to offer high-end performance and features, along with a
comprehensive software development toolkit.

Revenues
from Cisco Systems, Inc., through its manufacturing subcontractor, represented 49%, 41%
and 23% of our net revenues for fiscal years ended September 30, 2005, 2004 and 2003,
respectively. Revenues from Quantum Corporation, through its manufacturing subcontractors,
represented 11%, 14% and 34% of our net revenues for fiscal years ended September 30,
2005, 2004 and 2003, respectively. Revenues from Huawei Technologies, Inc., an OEM
manufacturer of networking equipment, represented 10% and 14% of our net revenues for
fiscal years ended September 30, 2005 and 2004, respectively. International sales
comprised 65%, 68% and 67% of net revenues for fiscal 2005, 2004 and 2003,
respectively, and we anticipate that international sales will continue to grow in the
future.

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In
September 2004, Hifn acquired intellectual property 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 research and development expense for the completion of certain
development milestones at predefined deadlines.

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.

In
September 2002, Hifn acquired certain assets and intellectual property valued at $677,000
for cash consideration of approximately $2.2 million, including acquisition related costs.
Assets acquired include fixed assets, core technology and workforce comprising of 15
engineers that joined us on October 1, 2002. Additionally, we acquired in-process research
and development of approximately $1.1 million, which was expensed at the time of the
acquisition.

In
August 2000, Hifn acquired Apptitude, a provider of embedded Internet traffic analysis
solutions, through a merger of Apptitude with and into a wholly owned subsidiary of Hifn.
The aggregate purchase consideration was $58.5 million, consisting of $20 million in cash
and $38.5 million in stock. In exchange, we received tangible assets and assumed
liabilities as well as intangible assets including developed and core technology,
workforce and patents. Additionally, we acquired in-process research and development which
was expensed at the time of the acquisition.

During
the fourth quarter of fiscal 2003, 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 $3.9
million. During the fourth quarter of fiscal 2002, we determined that customer preferences
with respect to the architecture upon which the Apptitude technology would be delivered
had shifted. As a result, we significantly lowered our estimates of expected future
revenues and cash flows from the Apptitude technology. The expected future cash flows,
undiscounted and without interest charges, was less than the carrying amount of the assets
associated with Apptitude and an impairment charge was triggered under Financial
Accounting Standards Board (FASB) Statement of Financial Accounting Standards
No. 121 (SFAS 121), Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to Be Disposed Of. Accordingly, we estimated the fair
value of the Apptitude assets, using the present value of estimated expected future cash
flows and a discount rate commensurate with the risks involved. We recorded an impairment
charge of $27.4 million, representing the amount by which the carrying amount of the
goodwill and developed technology exceeded their fair value. The remaining carrying value
of goodwill at September 30, 2005 was approximately $1.0 million. We adopted Statement of
Financial Accounting Standards No. 142 (SFAS 142), Goodwill and Other
Intangible Assets, during the first quarter of fiscal 2003, which effectively
replaces SFAS 121. In accordance with SFAS 142, the remaining carrying value of goodwill
is not amortized, but is subject to annual impairment testing.

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

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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.

# Critical Accounting
Policies

The
financial statements 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 of 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
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, 2005 was
$347,000 and included approximately $72,000 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 years 2005 and 2004, we recognized gross
margin benefits of           $137,000 and $560,000, respectively, as a result of the sale
of inventories that

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had been previously written down. As
of September 30, 2005, inventories of $2.1 million that were previously 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 fourth quarter of fiscal 2003, the Companys product plans changed as a
result of a shift in customer feature requirements and demand. Consequently, long-lived
and intangibles assets associated with terminated projects were impaired and a charge of
$3.9 million was recorded. The impairment charge was based on the present value of
management estimates of future cash flows. Changes in these estimates could have a
material impact on the impairment charge and any resulting impairment loss could have a
material adverse impact on our financial condition and results of operations.

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, 2005. Asset impairment charges could have a material effect on our
consolidated financial position and results of operations.

Use
of  Estimates.  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.
During fiscal 2003, we recognized a tax benefit of $1.8 million related to carry back of
net operating losses to prior years. During fiscal 2002, we recorded a net tax expense of
$6.0 million to establish a valuation allowance against deferred tax assets. 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.

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# 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, | 
|---------------------------------------------- | ------------------------ | 
|
|Net revenues:                                  |                          | 
|Processors                                     |                          | 
|Software licenses and other                    |                          | 
|                                               |                          | 
|Total net revenues                             |                          | 
|                                               |                          | 
|Costs and operating expenses:                 
|Cost of revenues - processors                  |                          | 
|Cost of revenues - software licenses and other |                          | 
|Research and development                       |                          | 
|Sales and marketing                            |                          | 
|General and administrative                     |                          | 
|Amortization of intangibles                    |                          | 
|Impairment of intangibles                      |                          | 
|Purchased in-process research & development    |                          | 
|                                               |                          | 
|Total costs and operating expenses             |                          | 
|                                               |                          | 
|Loss from operations                           |                          | 
|Interest and other income, net                 |                          | 
|                                               |                          | 
|Loss before income taxes                       |                          | 
|Provision for (benefit from) income taxes      |                          | 
|                                               |                          | 
|Net loss                                       |                          | 
|                                               |                          | 

# Years Ended September
30, 2005, 2004 and 2003

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, |  |  
|--------------------------- | ------------------------ |  | -
|
|
|                            |                          |  |  
|Processors                  |                          |  | $
|Software licenses and other |                          |  |  
|                            |                          |  |  
|                            |                          |  | $
|                            |                          |  |  

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.

Net
revenues increased by $21.7 million in fiscal 2004 as compared to net revenues in fiscal
2003. The increase in net revenues reflects an increase in sales of data compression and
encryption processors of $7.6 million coupled with incremental revenues of $11.2 million generated
from the sale of network processors related to the

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technology acquired from IBM in the
first quarter of fiscal 2004, as well as an increase in revenues from software licenses
and royalties of $2.9 million.

Semiconductor
and software sales to Cisco, an OEM producer of networking equipment, comprised 49%, 41%
and 23% of revenues for fiscal years 2005, 2004 and 2003, respectively. Semiconductor
sales to Quantum, an OEM producer of high-performance tape storage devices, through its
manufacturing subcontractor, comprised 11%, 14% and 34% of revenues in fiscal years 2005,
2004 and 2003, respectively. Semiconductor sales to Huawei, an OEM producer of networking
equipment, comprised 10% and 14% of revenues in fiscal years 2005 and 2004, respectively.
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, |  |  
|--------------------------- | ------------------------ |  | -
|
|
|                            |                          |  |  
|Processors                  |                          |  | $
|Software licenses and other |                          |  |  
|                            |                          |  |  
|                            |                          |  | $
|                            |                          |  |  

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 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. Cost of processor revenues as a percentage of net processor revenues decreased
four percentage points for fiscal 2004 as compared to the same period in fiscal 2003 as a
result of the mix of processor products sold during the respective periods. Additionally,
because allocated cost of revenues overhead cost remained at relatively the same level in both 2004 and
2003, greater revenues in fiscal 2004 meant an overall decrease in cost as a percentage of revenues for
fiscal 2004. During fiscal 2005, 2004 and
2003, we sold $139,000 and $560,000 and $780,000, 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 increasing trend in such costs,
in absolute dollars, is attributable to the increase in both the labor rates and 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, |  | 2005 vs.2004 |        | 2004 vs.2003 |  
|------------------------------- | ------------------------ |  | ------------ | ------ | ------------ | -
|
|Research & development expenses |                          |  | $            | 21,721 |              | $
|As a percentage of net revenues |                          |  |              | 47%    |              |  

Research
and development expenses consist primarily of salaries, employee benefits, overhead,
outside contractors and non-recurring engineering fees. Such 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,

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$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 and twenty-three additional engineers during fiscal 2005.

Research
and development expenses increased $2.1 million in fiscal 2004 as compared to fiscal 2003
and mainly reflects an increase in consulting costs of $1.1 million, which is comprised of
$545,000 in transition services costs related to the transfer of the technical designs of
the IBM network processors, $430,000 in samples testing and new product development and
$125,000 in costs related to the establishment of a network security laboratory in China.
Additionally, salaries and benefits expense increased $874,000, including accrued
severance costs of $370,000 related to a reduction in force in June 2004, and
fourteen additional engineers during the period. Adding further to the increase was the
purchase of low value engineering equipment for headcount additions and software tools
aggregating $181,000 and an increase in engineering materials expense of $264,000 as a
result of the timing of product testing and development. These increases were offset by a
reduction in non-recurring engineering expenses of $578,000 as a result of the timing
associated with tape-out, mask activities and product qualification testing.

Research
and development expenses in fiscal 2004 and 2003 also included amortization of deferred
stock-based compensation related to the acquisition of Apptitude of $133,000 and $309,000,
respectively.

We
expect our research and development expenses to increase in coming
periods on an absolute basis as we continue to develop products targeted at meeting market
needs. We currently have three projects in development with anticipated production dates
ranging from mid-2006 through late 2007. However, we cannot assure that our product
development programs will be successful or that products resulting from such programs will
achieve market acceptance.

Sales
and Marketing.

|                                | Year Ended September 30, |  | 2005 vs.2004 |       | 2004 vs.2003 |  
|------------------------------- | ------------------------ |  | ------------ | ----- | ------------ | -
|
|Sales & marketing expenses      |                          |  | $            | 7,515 |              | $
|As a percentage of net revenues |                          |  |              | 16%   |              |  

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 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.

The
increase in sales and marketing expenses in fiscal 2004 of $113,000 over the same period
in fiscal 2003. The increase primarily reflects the net effect of an increase in sales
representative commissions of $484,000, due to a higher level of sales made through sales
representatives and the cost of terminating a sales representative arrangement, and
$114,000 in sales conference and travel expenses, offset by a decrease in allocated
building expenses of $266,000 and in salaries and benefits costs of $204,000,
corresponding with reduced headcount.

General
and Administrative.

|                                  | Year Ended September 30, |  | 2005 vs.2004 |       | 2004 vs.2003 |  
|--------------------------------- | ------------------------ |  | ------------ | ----- | ------------ | -
|
|General & administrative expenses |                          |  | $            | 5,332 |              | $
|As a percentage of net revenues   |                          |  |              | 11%   |              |  

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General
and  administrative  expenses are comprised  primarily of salaries for  administrative
 and corporate services personnel,  legal and other professional fees. Such expenses
increased $840,000,  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.

The
 increase  in general and  administrative  expenses in fiscal 2004 as compared to fiscal
2003 of $630,000 were a result of  increases in salaries and benefits  expenses of
$277,000,  in legal  expenses of $175,000  mainly due to costs  related to patent
 applications  and  processing  and in accounting  expenses of $178,000  related to
accounting  services for foreign  offices and for services  related to the transition of
the IBM network  processor customers into Hifn.

Amortization
of Intangibles.

|                                | Year Ended September 30, |  | 2005 vs.2004 |       | 2004 vs.2003 |  
|------------------------------- | ------------------------ |  | ------------ | ----- | ------------ | -
|
|Amortization of intangibles     |                          |  | $            | 3,296 |              | $
|As a percentage of net revenues |                          |  |              | 7%    |              |  

Amortization
of intangibles relate to acquired technology, workforce and patents. Amortization of
intangibles increased $234,000 in fiscal 2005 as compared to fiscal 2004. The increase is
the net effect of 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.

Amortization
of intangibles increased $1.7 million in fiscal 2004 as compared to fiscal 2003. The
increase is the net effect of $2.4 million in amortization of developed and core
technology and contract backlog related to the IBM network processor technology acquired
in December 2003 offset by a reduction in amortization of previously capitalized
intangible assets as they reached their estimated useful lives.

Impairment
of Intangibles.

|                                | Year Ended September 30, |  | 2005 vs.2004 |   | 2004 vs.2003 |  
|------------------------------- | ------------------------ |  | ------------ | - | ------------ | -
|
|Impairment of intangibles       |                          |  | $            | - |              | $
|As a percentage of net revenues |                          |  |              | - |              |  

During
the fourth quarter of fiscal 2003, our product plans changed as a result of a shift in
customer feature requirements and demand. Consequently, intangible assets associated with
terminated projects were impaired and we recorded a charge of $3.9 million to write down
developed and licensed technologies.

Purchased
In-Process Research and Development.

|                                            | Year Ended September 30, |  | 2005 vs.2004 |   | 2004 vs.2003 |  
|------------------------------------------- | ------------------------ |  | ------------ | - | ------------ | -
|
|Purchased in-process research & development |                          |  | $            | - |              | $
|As a percentage of net revenues             |                          |  |              | - |              |  

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

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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 and
estimated to be completed in early 2006 at an estimated cost of $5 million, and future
development of the network processor (with further increase in speed) which was
approximately 15% complete and estimated to be completed in late 2006 at an estimated
cost of $4 million. 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. Failure to
bring these products to market in a timely manner could result in a loss of market share
or a lost opportunity to capitalize on emerging markets, and could have a material
adverse impact on our business and operating results. 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
exist.

Interest
and Other Income, Net.

|                                | Year Ended September 30, |  | 2005 vs.2004 |       | 2004 vs.2003 |  
|------------------------------- | ------------------------ |  | ------------ | ----- | ------------ | -
|
|Interest income                 |                          |  | $            | 1,264 |              | $
|Interest expense                |                          |  |              | (71   | )            |  
|Other expense, net              |                          |  |              | (51   | )            |  
|                                |                          |  |              |       |              |  
|Interest & other income, net    |                          |  | $            | 1,142 |              | $
|                                |                          |  |              |       |              |  
|As a percentage of net revenues |                          |  |              | 2%    |              |  

Interest
and other income, net, increased $669,000 in fiscal 2005 as compared to fiscal 2004 and
decreased $71,000 in fiscal 2004 as compared to fiscal 2003. The increase in fiscal 2005
was primarily a result of a higher average cash balance during the period 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. The decrease in net interest income in fiscal 2004 as compared to fiscal
2003 was the result of a shift in the investment mix from stock instruments to commercial
paper and municipal bonds, lower average cash and short-term investments balance during
the period as well as a decrease in market interest rates.

Income
Taxes.

|                                          | Year Ended September 30, |  | 2005 vs.2004 |              | 2004 vs.2003 |  
|----------------------------------------- | ------------------------ |  | ------------ | ------------ | ------------ | -
|
|Provision for (benefit from) income taxes |                          |  | $            | 90           |              | $
|As a percentage of net revenues           |                          |  |              | 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, 2005 and
2004. The provision for income taxes for fiscal 2005 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.

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# Liquidity and Capital
Resources

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

|                                                     | Year Ended September 30, | 
|---------------------------------------------------- | ------------------------ | 
|
|
|Net cash used in operating activities                |                          | 
|Net cash provided by (used in) operating activities  |                          | 
|Net cash provided by (used in) financing activities  |                          | 
|                                                     |                          | 
|Net increase (decrease) in cash and cash equivalents |                          | 
|                                                     |                          | 

Operating
Activities. 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 $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 in prepaid maintenance and licenses resulting from the
non-renewal of license and maintenance arrangements 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, an increase
in other assets of $163,000 related to licensed
technologies for integration into products under development 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
$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 increase 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 result of increased revenues. Also contributing to net cash used in
operating activities was an increase in other assets of $415,000 related to licensed technologies
for integration into products under development and 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.

In
fiscal 2003, net cash used in operating activities of approximately $11.5 million was
comprised of net loss as adjusted for non-cash items including provision for the
impairment of intangibles of $3.9 million, amortization of intangibles and of deferred
stock compensation of $2.7 million, depreciation and amortization costs of $2.3 million
and decreases in prepaids and other current assets of $1.0 million, in inventories of
$349,000 and an increase in accounts payable of $186,000.
These adjustments were offset by an increase in accounts receivable of $527,000 and in
other assets of $513,000 and a
decrease in accrued expenses and other current liabilities of $630,000.

Investing
Activities. 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

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million utilizing the proceeds from
the private placement financing and the purchase of property and equipment of $931,000.
Cash used in investing activities in fiscal 2003 was $1.5 million, resulting from the net
purchase of short-term investments of $388,000 and the acquisition of $1.1 million in
property and equipment. The Company anticipates its property and equipment purchases in
fiscal year 2006 will approximate those in the preceding three years.

Financing
Activities. 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 being 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. Cash provided by financing activities in fiscal 2003 of $972,000 reflects
proceeds from stock option exercises and stock purchase plan purchases of $1.7 million
offset by installment payments on acquired software licenses of $775,000.

The
Companys inventory balance at September 30, 2005 reflected an increase of $85,000 as compared to
the balance as of September 30, 2004. The increase 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. The Companys
inventory turns for the year ended September 30, 2005 were 6.8 times as
compared to 9.5 times for the year ended September 30, 2004. The Companys accounts
receivable balance, which is contingent upon the timing of product shipment within the
respective periods, decreased $582,000 to $5.1 million, as of September 30, 2005,
reflecting lower customer purchase levels and revenues in September 2005 as compared to
September 2004.

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 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 timing and
amount of repurchases under the program depends upon market conditions and corporate and
regulatory considerations. The purchase is funded from available

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working capital. The stock
repurchase program expires on April 25, 2006. During fiscal 2005, the Company repurchased
692,894 shares under the program at a cost of $4.3 million

# 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, 2005 are as follows:

|                                   | Payments Due By Period | 
|---------------------------------- | ---------------------- | 
|
|
|Operating lease commitments        |                        | 
|Inventory purchases                |                        | 
|Non-recurring engineering expenses |                        | 
|                                   |                        | 
|Totals                             |                        | 
|                                   |                        | 

# 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, 2005.

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, 2005. 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.

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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, 2005. 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.

# 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.

Trends, Risks and
Uncertainties

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:

# 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.

# 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 this market. 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;
|- | ------------------------

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| | 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 may 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.

Semiconductor
and software sales to Cisco Systems, Inc., an OEM producer of networking equipment,
through its manufacturing subcontractors, comprised 49%, 41% and 23% of our net revenues
for fiscal years ended September 30, 2005, 2004 and 2003, respectively. Semiconductor
sales to Quantum Corporation, through its manufacturing subcontractor, represented 11%,
14% and 34% of our net revenues for fiscal years ended September 30, 2005, 2004 and 2003,
respectively. Semiconductor sales to Huawei Technologies, Inc., an OEM producer of
networking equipment, represented 10% and 14% of our net revenues for fiscal year ended
September 30, 2005 and 2004, respectively.

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, 2005, sales to
Huawei and Cisco decreased 83% and 26%, 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 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;
|- | --------------------------------------------------------------

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| | 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. In fact, 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 higher 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 that
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 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.
|- | ---------------------------------------------------------

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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 or 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 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

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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.

Additionally,
our success in integrating the acquired assets and intellectual property into our business
depends upon our ability to merge the acquired assets into our ongoing and future
operations, including maintaining a continuing relationship with IBMs established
customer base and our third party supplier, in this case, IBM. Without the successful
integration of this significant asset acquisition, there can be no assurance that we will
be able to maintain the revenue and profit performance levels we have experienced thus far
with the existing network processors. If we fail to integrate the follow-on products into
our operations successfully, our business, financial condition and results of operations
could suffer.

# 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. During fiscal 2001, we wrote off excess inventory of $3.4 million
as a result of a significant decrease in forecasted demand for our products. 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

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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 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;
|- | ------

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| | 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 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 fifteen (15) 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;
|- | ------------------------------

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| | 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.

# 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.

# 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.

We
sell most of our products to customers in the United States. If our international sales
increase, particularly in light of decreased export restrictions, we may encounter 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

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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.

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.

# 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;
|- | ------------------------------------------

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| | 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.
|- | ----------------------------------------------------------------------------

# The Common Stock Sold In
Our Private Offering Increased, While The Common Stock Purchased Under Our Repurchase Program
Decreased, The Supply Of Our Common Stock On The Public Market, Which May Cause Our
Stock Price To Decline.

On
April 9, 2004, the Registration Statement on Form S-3 relating to the sale of 2,200,000
shares of our Common Stock in a private equity offering on February 6, 2004 was declared
effective. The shares of Common Stock becoming eligible for immediate and unrestricted
resale into the public market at any time could adversely affect the market price of our
Common Stock and the presence of these additional shares of Common Stock in the public
market may further depress our stock price.

On
April 25, 2005, our Board of Directors authorized a stock repurchase program for the
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 is dependent upon market conditions and corporate and regulatory
considerations. The stock repurchase program expires on April 25, 2006. In fiscal year
2005, 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 increase or decrease in
our levels of repurchase could affect the market price of our Common Stock.

# 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, 2005. 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.

# Recent Accounting
Pronouncements

In
May 2005, as part of a broader attempt to eliminate differences with the
International Accounting Standards Board, the Financial Accounting Standards Board (FASB) issued Statement of Financial
Accounting Standards No. 154 (SFAS 154), Accounting Changes and
Error Corrections, which replaces Accounting Principles Board Opinion No. 20
(APB 20), Accounting Changes, and FASB Statement of Financial
Accounting Standards No. 3, Reporting Accounting Changes in Interim Financial
Statements. APB 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 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 is not
expected to have a material effect on the Companys financial statements.

In
March 2005, the FASB issued Financial  Interpretation No. 47 (FIN 47),  Accounting
for Conditional Asset Retirement  Obligations.  FIN 47  clarifies  that an entity
 must  record a  liability  for a  conditional  asset

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retirement  obligation if the fair
value of the obligation can be reasonably  estimated.  FIN 47 also clarifies when an
entity would have sufficient  information to reasonably  estimate the fair value of an
asset  retirement  obligation. FIN 47 is effective no later than the end of the
fiscal year ending  after  December 15, 2005.  The adoption of this statement is not
expected to have a material effect on the Companys financial statements.

In
December 2004, the FASB issued Statement of Financial Accounting Standards No.
123(R) (SFAS 123(R)), Share-Based Payment, an amendment to Statement
of Financial Accounting Standards No. 123 (SFAS No. 123), Accounting for
Stock-Based Compensation and Statement on Financial Accounting Standards No. 95,
Statement of Cash Flows. The revised standard addresses the accounting for
share-based payment transactions in which a company receives employee services in exchange
for either equity instruments of the company or liabilities that are based on the fair
value of the companys equity instruments or that may be settled by the issuance of
such equity instruments. Under the new standard, companies will no longer be able to
account for share-based compensation transactions using the intrinsic method in accordance
with APB 25. Instead, companies will be required to account for such transactions using a
fair-value method and recognize the expense in the consolidated statement of income. The
effective date for SFAS 123(R), as amended on April 14, 2005, is for annual periods
beginning after June 15, 2005 and will be implemented by the Company in the first quarter
of fiscal 2006. The Company will recognize stock-based compensation expense on a straight-line
basis over the requisite service period using the modified prospective method. Currently, we disclose the pro forma net income
(loss) and related pro forma income (loss) per share information in accordance with SFAS
123 and Statement on Financial Accounting Standards No. 148, Accounting for
Stock-Based Compensation CostsTransition and Disclosure. The adoption of SFAS 123(R)
 will have a significant adverse impact on the results of
operations of the Company, although it will have no impact on the overall financial position. The precise impact of
the adoption of SFAS 123(R) cannot be predicted at this time because it will depend on the levels of share-based
payments granted in the future. However, had the Company adopted SFAS 123(R) using the modified retrospective
application for all prior periods, the impact of that standard would have approximated the impact of SFAS 123 as
described under the Accounting for Stock-Based Compensation section in Note 1. SFAS 123(R) also requires the
benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather
than as an operating cash flow as required under current literature. This requirement will reduce net operating cash
flows and increase net financing cash flows in periods after adoption. While the Company cannot estimate what those
amounts will be in the future because they depend on, among other things, when employees exercise stock options, the
amount of operating cash flows recognized for such excess tax deductions were zero for all periods presented.

In
March 2005, the Securities and Exchange  Commission  issued Staff Accounting  Bulletin
No. 107 (SAB 107), which  provides  guidance on the  implementation  of
SFAS 123(R) Share-Based  Payment (see
 discussion  below).  In particular,  SAB 107 provides key guidance  related to
valuation methods (including  assumptions such as expected  volatility and expected
term), the accounting for income tax effects of share-based  payment  arrangements upon
adoption of SFAS 123(R), the modification of employee share options prior to the
adoption of SFAS 123(R), the  classification  of  compensation  expense,
 capitalization  of compensation cost related to share-based  payment  arrangements,
 first-time  adoption of SFAS 123(R) in an interim  period,  and disclosures in
Managements Discussion and Analysis subsequent to the adoption of SFAS 123(R). The
Company will apply the principles of SAB 107 in conjuntion with its adoption of SFAS 123(R).

In
 December  2004,  the FASB  issued  Statement  of  Financial  Accounting  Standards  No.
153 (SFAS 153), Exchanges of Non-monetary  Assetsan  Amendment of APB Opinion
No. 29, which eliminates the exception for non-monetary exchanges of similar  productive
 assets and replaces it with a general  exception for exchanges of non-monetary  assets
that do not have  commercial  substance.  A non-monetary  exchange has commercial
 substance if the future cash flows of the entity are  expected  to change  significantly
 as a result of the  exchange.  SFAS 153 will be  effective  for non-monetary  asset
exchanges  occurring in fiscal periods beginning after June 15, 2005. The adoption of
this statement is not expected to have a material effect on the Companys financial
statements.

In
November 2004, the FASB issued Financial  Accounting  Standards No. 151 (SFAS 151),
 Inventory  Costsan Amendment of Accounting  Research  Bulletin  (ARB) No. 43,
 Chapter 4, which  clarifies the  accounting  for abnormal amounts of idle facility
expense,  freight,  handling costs and wasted material  (spoilage).  SFAS 151
requires that those items be  recognized  as  current-period  charges.  In addition,
 SFAS 151 requires  that  allocation of fixed production overheads to the costs of
conversion be based on the normal capacity of the production  facilities.  SFAS 151
will be effective for inventory  costs incurred in fiscal years  beginning after June 15,
2005. The adoption of this statement is not expected to have a material effect on the
Companys financial statements.

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# 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, 2005 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, cost of manufacturing and marketing are transacted in U.S. dollars.
Accordingly, our results of operations are not subject to foreign exchange rate
fluctuations. To date, we have not incurred gains and losses from such fluctuations.

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# Item 8. Financial
Statements and Supplementary Data

# INDEX TO CONSOLIDATED
FINANCIAL STATEMENTS

|                              |                                                                                                       |  |      
|----------------------------- | ----------------------------------------------------------------------------------------------------- |  | -----
|                              |                                                                                                       |  |      
|Financial Statements:        
|                              | Report of Independent Registered Public Accounting Firm                                               |  | 43-44
|                              | Consolidated Balance Sheets as of September 30, 2005 and 2004                                         |  | 45   
|                              | Consolidated Statements of Operations for the years ended September 30, 2005, 2004 and 2003           |  | 46   
|                              | Consolidated Statements of Stockholders' Equity for the years ended September 30, 2005, 2004 and 2003 |  | 47   
|                              | Consolidated Statements of Cash Flows for the years ended September 30, 2005, 2004 and 2003           |  | 48   
|                              | Notes to Consolidated Financial Statements                                                            |  | 49-64
|Financial Statement Schedule:
|                              | Schedule II Valuation and Qualifying Accounts for the years ended September 30, 2005, 2004 and 2003   |  | 70   

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# REPORT OF INDEPENDENT REGISTERED
PUBLIC ACCOUNTING FIRM

To the Board of Directors and
Stockholders of hi/fn, inc.:

We
have  completed an integrated  audit of hi/fn,  inc.s 2005  consolidated  financial
 statements  and of its internal control  over  financial  reporting  as of  September
 30, 2005 and audits of its 2004 and 2003  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 financial 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, 2005 and 2004, and the results of their  operations and
their cash flows for each of the three years in the period ended  September 30, 2005 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.

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,
 2005 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, 2005, 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

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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 LLP

San Jose, CaliforniaDecember
14, 2005

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HIFN, INC.CONSOLIDATED BALANCE
SHEETS(in thousands, except
share and per share amounts)

|                                                                             | September 30, | 
|---------------------------------------------------------------------------- | ------------- | 
|
|                                                                             |               | 
|ASSETS                                                                      
|CURRENT ASSETS:                                                              |               | 
|Cash and cash equivalents                                                    |               | 
|Short-term investments                                                       |               | 
|Accounts receivable, net of allowance for doubtful                          
|accounts of $104 and $259, respectively                                      |               | 
|Inventories                                                                  |               | 
|Prepaid expenses and other current assets                                    |               | 
|                                                                             |               | 
|Total current assets                                                         |               | 
|Property and equipment, net                                                  |               | 
|Intangible assets, net                                                       |               | 
|Other assets                                                                 |               | 
|                                                                             |               | 
|                                                                             |               | 
|                                                                             |               | 
|LIABILITIES AND STOCKHOLDERS EQUITY                                        
|CURRENT LIABILITIES:                                                        
|Accounts payable                                                             |               | 
|Accrued expenses and other current liabilities                               |               | 
|                                                                             |               | 
|Total current liabilities                                                    |               | 
|                                                                             |               | 
|Commitments 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;              
|14,215,000 and 13,868,000 shares issued and 13,522,000 and                  
|13,868,000 shares outstanding, respectively                                  |               | 
|Additional paid-in capital                                                   |               | 
|Accumulated other comprehensive loss                                         |               | 
|Accumulated deficit                                                          |               | 
|Treasury stock, 693,000 and 0 shares, respectively, at cost                  |               | 
|                                                                             |               | 
|Total stockholders' equity                                                   |               | 
|                                                                             |               | 
|                                                                             |               | 
|                                                                             |               | 

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

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HIFN, INC.CONSOLIDATED
STATEMENTS OF OPERATIONS(in thousands, except
per share data)

|                                               | Year Ended September 30, | 
|---------------------------------------------- | ------------------------ | 
|
|Net revenues:                                  |                          | 
|Processors                                     |                          | 
|Software licenses and other                    |                          | 
|                                               |                          | 
|Total net revenues                             |                          | 
|                                               |                          | 
|Costs and operating expenses:                 
|Cost of revenues - processors                  |                          | 
|Cost of revenues - software licenses and other |                          | 
|Research and development                       |                          | 
|Sales and marketing                            |                          | 
|General and administrative                     |                          | 
|Amortization of intangibles                    |                          | 
|Impairment of intangibles                      |                          | 
|Purchased in-process research & development    |                          | 
|                                               |                          | 
|Total costs and operating expenses             |                          | 
|                                               |                          | 
|Loss from operations                           |                          | 
|Interest income                                |                          | 
|Interest expense                               |                          | 
|Other expense, net                             |                          | 
|                                               |                          | 
|Loss before income taxes                       |                          | 
|Provision for (benefit from) income taxes      |                          | 
|                                               |                          | 
|Net loss                                       |                          | 
|                                               |                          | 
|Net loss per share:                            |                          | 
|Basic and diluted                              |                          | 
|                                               |                          | 
|Shares used in computing net loss per share:   |                          | 
|Basic and diluted                              |                          | 
|                                               |                          | 

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

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HIFN, INC.CONSOLIDATED
STATEMENTS OF STOCKHOLDERS EQUITY(in thousands)

|                                   | Common Stock |  | Deferred
Stock-
BasedCompen- |        | AdditionalPaid-In |   | Accumulated
OtherCompre- |  | Accumulated |      | Treasury |   | TotalStockholders |  
|---------------------------------- | ------------ |  | ---------------------------- | ------ | ----------------- | - | ------------------------ |  | ----------- | ---- | -------- | - | ------------------ | -
|
|Balance at September 30, 2002      |              |  |                              | 10,492 |                   | $ | 10                       |  | $           | (593 | )        | $ | 123,265            |  
|Issuance of common stock upon      |              | 
|exercise of options                |              |  |                              | 249    |                   |   | 1                        |  |             | -    |          |   | 965                |  
|Amortization of deferred stock-   
|based compensation                 |              |  |                              | -      |                   |   | -                        |  |             | 355  |          |   | -                  |  
|Reduction in deferred              |              | 
|stock-based compensation due to    |              | 
|terminations                       |              |  |                              | -      |                   |   | -                        |  |             | 100  |          |   | (100               | )
|Issuance of common stock for      
|class action litigation settlement |              |  |                              | 285    |                   |   | -                        |  |             | -    |          |   | 2,700              |  
|Issuance of common stock under     |              | 
|employee stock purchase plan       |              |  |                              | 175    |                   |   | -                        |  |             | -    |          |   | 781                |  
|Net loss                           |              |  |                              | -      |                   |   | -                        |  |             | -    |          |   | -                  |  
|                                   |              |  |                              |        |                   |   |                          |  |             |      |          |   |                    |  
|Balance at September 30, 2003      |              |  |                              | 11,201 |                   |   | 11                       |  |             | (138 | )        |   | 127,611            |  
|Net loss                           |              |  |                              | -      |                   |   | -                        |  |             | -    |          |   | -                  |  
|Unrealized loss on financial       |              | 
|instruments                        |              |  |                              | -      |                   |   | -                        |  |             | -    |          |   | -                  |  
|                                   |              |  |                              |        |                   |   |                          |  |            
|Comprehensive loss                 |              |  |                              |        |                   |   |                          |  |             |      |          |   |                    |  
|                                   |              |  |                              |        |                   |   |                          |  |            
|Issuance of common stock upon      |              | 
|exercise of options                |              |  |                              | 361    |                   |   | 1                        |  |             | -    |          |   | 2,475              |  
|Amortization of deferred stock-   
|based compensation                 |              |  |                              | -      |                   |   | -                        |  |             | 138  |          |   | -                  |  
|Issuance of common stock in        |              | 
|relation to private placement      |              | 
|financing, net of $2,100 in        |              | 
|issuance costs                     |              |  |                              | 2,200  |                   |   | 2                        |  |             | -    |          |   | 30,868             |  
|Issuance of common stock under    
|employee stock purchase plan       |              |  |                              | 106    |                   |   | -                        |  |             | -    |          |   | 546                |  
|                                   |              |  |                              |        |                   |   |                          |  |             |      |          |   |                    |  
|Balance at September 30, 2004      |              |  |                              | 13,868 |                   |   | 14                       |  |             | -    |          |   | 161,500            |  
|Net loss                           |              |  |                              | -      |                   |   | -                        |  |             | -    |          |   | -                  |  
|Unrealized gain on financial       |              | 
|instruments                        |              |  |                              | -      |                   |   | -                        |  |             | -    |          |   | -                  |  
|                                   |              |  |                              |        |                   |   |                          |  |            
|Comprehensive loss                 |              |  |                              |        |                   |   |                          |  |             |      |          |   |                    |  
|                                   |              |  |                              |        |                   |   |                          |  |            
|Repurchase of common stock,        |              | 
|at cost                            |              |  |                              | (693   | )                 |   | -                        |  |             | -    |          |   | -                  |  
|Issuance of common stock upon     
|exercise of options                |              |  |                              | 161    |                   |   | -                        |  |             | -    |          |   | 962                |  
|Issuance of common stock under     |              | 
|employee stock purchase plan       |              |  |                              | 186    |                   |   | -                        |  |             | -    |          |   | 1,022              |  
|                                   |              |  |                              |        |                   |   |                          |  |             |      |          |   |                    |  
|Balance at September 30, 2005      |              |  |                              | 13,522 |                   | $ | 14                       |  | $           | -    |          | $ | 163,484            |  
|                                   |              |  |                              |        |                   |   |                          |  |             |      |          |   |                    |  

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

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HIFN, INC.CONSOLIDATED
STATEMENTS OF CASH FLOWS(in thousands)

|                                                                            | Year Ended September 30, | 
|--------------------------------------------------------------------------- | ------------------------ | 
|
|Cash flows from operating activities:                                       |                          | 
|Net loss                                                                    |                          | 
|Adjustments to reconcile net loss to net cash used in operating activities: |                          | 
|Depreciation and amortization                                               |                          | 
|Write-down of fixed assets                                                  |                          | 
|Loss on disposal of fixed assets                                            |                          | 
|Amortization of intangible assets                                           |                          | 
|Impairment of intangible assets                                             |                          | 
|Amortization of deferred stock-based compensation                           |                          | 
|Purchased in-process research and development                               |                          | 
|Allowance for doubtful accounts                                             |                          | 
|Changes in assets and liabilities:                                         
|Accounts receivable                                                         |                          | 
|Inventories                                                                 |                          | 
|Prepaid expenses and other current assets                                   |                          | 
|Other assets                                                                |                          | 
|Accounts payable                                                            |                          | 
|Accrued expenses and other current liabilities                              |                          | 
|                                                                            |                          | 
|Net cash used in operating activities                                       |                          | 
|                                                                            |                          | 
|Cash flows from investing activities:                                      
|Sales of short-term investments                                             |                          | 
|Purchases of short-term investments                                         |                          | 
|Purchases of intellectual property                                          |                          | 
|Purchases of property and equipment                                         |                          | 
|                                                                            |                          | 
|Net cash provided by (used in) investing activities                         |                          | 
|                                                                            |                          | 
|Cash flows from financing activities:                                      
|Proceeds from issuance of common stock for stock option                    
|exercises and employee stock purchase plan, net                             |                          | 
|Proceeds from issuance of common stock in relation                         
|to private placement financing, net of costs                                |                          | 
|Repurchase of common stock, at cost                                         |                          | 
|Installment payments on acquisition of software licenses                    |                          | 
|                                                                            |                          | 
|Net cash provided by (used in) financing activities                         |                          | 
|                                                                            |                          | 
|Net increase (decrease) in cash and cash equivalents                        |                          | 
|Cash and cash equivalents at beginning of period                            |                          | 
|                                                                            |                          | 
|Cash and cash equivalents at end of period                                  |                          | 
|                                                                            |                          | 

Supplemental cash flow
information (Note 7)

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

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# 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 Microsystems, Inc., (collectively referred to as
the Company or Hifn) is a network- and storage-security market
leader that supplies most major network equipment manufacturers (OEMs) 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 (VPNs), 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 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 timing and
amount of repurchases under this program is dependent upon market conditions and corporate
and regulatory considerations. The purchases are funded from available working capital.
The stock repurchase program expires on April 25, 2006. In fiscal year 2005, the Company
repurchased a total of 692,894 shares under the program, which shares are held in
treasury stock, at a cost of $4.3 million.

The
Company has an accumulated deficit of $102.5 million as of September 30, 2005 and has incurred
a net loss of $5.2 million during the year ended September 30, 2005. 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, 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.

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# 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.

# 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, 2005, 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 2005, 2004 and 2003. 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 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, 2005, three customers accounted for 32%, 15% and 12%,
respectively, of total accounts receivable. The same three customers accounted for 17%, 11% and 11%,
respectively, and two other customers accounted for 36% and
10%, respectively, of total accounts receivable at September 30, 2004. 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 2005, 2004 and 2003.

# 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.

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# 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.

During
the fourth quarter of fiscal 2003, our product plans changed as a result of a shift in
customer feature requirements and demand and, as a result, we concluded that impairment
indicators existed and that certain long-lived and intangible assets associated with
terminated projects were impaired and we recorded a charge of $3.9 million to write down
developed and licensed technologies. During the fourth quarter of 2002, prior to the
implementation of Statement of Financial Accounting Standards No. 142 (SFAS
142), Goodwill and Other Intangible Assets, the Company also determined
that customer preferences with respect to the architecture upon which the Apptitude
technology would be delivered had shifted. As a result, management significantly lowered
its estimates of expected future revenues and cash flows from the Apptitude technology.
The expected future cash flows, undiscounted and without interest charges, were less than
the carrying amount of the assets associated with Apptitude and an impairment charge was
triggered under Statement of Financial Accounting Standards No. 121 (SFAS
121), Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of. Accordingly, the Company estimated the fair value of the
Apptitude assets, using the present value of estimated expected future cash flows and a
discount rate commensurate with the risks involved. The Company recorded an impairment
charge of $27.4 million, representing the amount by which the carrying amount of the
goodwill and developed technology exceeded their estimated fair value.

The
excess of the cost of acquired companies over the net amounts assigned to assets acquired
and liabilities assumed is recorded as goodwill. As of September 30, 2005, the Company has
goodwill of $1.0 million. With the issuance by the Financial Accounting Standards Board
(FASB) of 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

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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

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, 2005 or 2004.

# Stock-Based Compensation

The
Company accounts 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 are as follows:

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|                                        | Year Ended September 30, | 
|--------------------------------------- | ------------------------ | 
|
|
|Net loss:                               |                          | 
|As reported                             |                          | 
|Add:  stock-based employee compensation
|recorded in the Statement of Operations |                          | 
|Less: fair value of stock-based         |                          | 
|employee compensation                   |                          | 
|                                        |                          | 
|Pro forma                               |                          | 
|                                        |                          | 
|Net loss per share:                     |                          | 
|Basic and diluted                      
|As reported                             |                          | 
|Pro forma                               |                          | 

The
fair value of stock-based employee compensation for fiscal 2005 includes approximately
$6.6 million related to the accelerated vesting of stock options on August 23, 2005. See
Note 8 for discussions on the accelerated vesting of stock options and the assumptions used in computing the fair value of option
grants for purposes of these disclosures.

# 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 for all our subsidiaries. Gains or losses from
transactions of foreign subsidiaries are included in interest and other income, 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 154), Accounting Changes and
Error Corrections, which replaces Accounting Principles Board Opinion No. 20
(APB 20), Accounting Changes, and FASB Statement of Financial
Accounting Standards No. 3, Reporting Accounting Changes in Interim Financial
Statements. APB 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 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 is not
expected to have a material effect on the Companys financial statements.

In
March 2005, the FASB issued Financial  Interpretation No. 47 (FIN 47),  Accounting
for Conditional Asset Retirement  Obligations.  FIN 47  clarifies  that an entity
 must  record a  liability  for a  conditional  asset retirement  obligation if the
fair value of the obligation can be reasonably  estimated.  FIN 47 also clarifies
when an entity would have sufficient  information to reasonably  estimate the fair value
of an asset  retirement  obligation. FIN 47 is effective no later than the end of the
fiscal year ending  after  December 15, 2005.  The adoption of this statement is not
expected to have a material effect on the Companys financial statements.

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In
December 2004, the FASB issued Statement of Financial Accounting Standards No.
123(R) (SFAS 123(R)), Share-Based Payment, an amendment to Statement
of Financial Accounting Standards No. 123 (SFAS 123), Accounting for
Stock-Based Compensation and Statement on Financial Accounting Standards No. 95,
Statement of Cash Flows. The revised standard addresses the accounting for
share-based payment transactions in which a company receives employee services in exchange
for either equity instruments of the company or liabilities that are based on the fair
value of the companys equity instruments or that may be settled by the issuance of
such equity instruments. Under the new standard, companies will no longer be able to
account for share-based compensation transactions using the intrinsic method in accordance
with APB 25. Instead, companies will be required to account for such transactions using a
fair-value method and recognize the expense in the consolidated statement of income. The
effective date for SFAS 123(R), as amended on April 14, 2005, is for annual periods
beginning after June 15, 2005 and will be implemented by the Company in the first quarter of fiscal
2006. The Company will recognize stock-based compensation expense on a straight-line basis over
the requisite service period using the modified prospective method. Currently, we disclose the pro forma net income
(loss) and related pro forma income (loss) per share information in accordance with SFAS
123 and Statement on Financial Accounting Standards No. 148, Accounting for
Stock-Based Compensation CostsTransition and Disclosure. The adoption of SFAS 123(R) will have a significant adverse impact on the results
of operations of the Company, although it will have no impact on the overall financial position. The precise
impact of the adoption of SFAS 123(R) cannot be predicted at this time because it will depend on the levels
of share-based payments granted in the future. However, had the Company adopted SFAS 123(R) using the
modified retrospective application for all prior periods, the impact of that standard would have approximated the
impact of SFAS 123 as described under the Accounting for Stock-Based Compensation section in Note 1. SFAS
123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported
as a financing cash flow, rather than as an operating cash flow as required under current literature. This
requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption.
While the Company cannot estimate what those amounts will be in the future because they depend on, among other
things, when employees exercise stock options, the amount of operating cash flows recognized for such excess tax
deductions were zero for all periods presented.

In
March 2005, the Securities and Exchange  Commission  issued Staff Accounting  Bulletin
No. 107 (SAB 107), which  provides  guidance on the  implementation  of  SFAS No. 123(R) (see
 discussion  above).  In particular,  SAB 107 provides key guidance  related to
valuation methods (including  assumptions such as expected  volatility and expected
term), the accounting for income tax effects of share-based  payment  arrangements upon
adoption of SFAS 123(R), the modification of employee share options prior to the
adoption of SFAS 123(R), the  classification  of  compensation  expense,
 capitalization  of compensation cost related to share-based  payment  arrangements,
 first-time  adoption of SFAS 123(R) in an interim  period,  and disclosures in
Managements Discussion and Analysis subsequent to the adoption of SFAS 123(R).
The Company will apply the principles of SAB 107 in conjunction with its adoption of SFAS 123(R).

In
 December  2004,  the FASB  issued  Statement  of  Financial  Accounting  Standards  No.
153 (SFAS 153), Exchanges of Non-monetary  Assetsan  Amendment of APB Opinion
No. 29, which eliminates the exception for non-monetary exchanges of similar  productive
 assets and replaces it with a general  exception for exchanges of non-monetary  assets
that do not have  commercial  substance.  A non-monetary  exchange has commercial
 substance if the future cash flows of the entity are  expected  to change  significantly
 as a result of the  exchange.  SFAS 153 will be  effective  for non-monetary  asset
exchanges  occurring in fiscal periods beginning after June 15, 2005. The adoption of
this statement is not expected to have a material effect on the Companys financial
statements.

In
November 2004, the FASB issued Financial  Accounting  Standards No. 151 (SFAS 151),
 Inventory  Costsan Amendment of Accounting  Research  Bulletin  (ARB) No. 43,
 Chapter 4, which  clarifies the  accounting  for abnormal amounts of idle facility
expense,  freight,  handling costs and wasted material  (spoilage).  SFAS 151
requires that those items be  recognized  as  current-period  charges.  In addition,
 SFAS 151 requires  that  allocation of fixed production overheads to the costs of
conversion be based on the normal capacity of the production  facilities.  SFAS 151
will be effective for inventory  costs incurred in fiscal years  beginning after June 15,
2005. The adoption of this statement is not expected to have a material effect on the
Companys financial statements.

# 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 | 
|Workforce                     | 
|                              | 
|                              | 
|                              | 

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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                                     | 
|Purchased in-process research and development | 
|                                              | 
|                                              | 
|                                              | 

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 (IBM)s
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                 | 
|Contract backlog                              | 
|Fixed assets                                  | 
|Inventory                                     | 
|Purchased in-process research and development | 
|                                              | 
|                                              | 
|                                              | 

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 and estimated to
be completed in early 2006 at an estimated cost of $5 million, and future development of
the network processor (with further increase in speed) which was approximately 15%
complete and estimated to be completed in late 2006 at an estimated cost of $4 million.
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

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period of two and fours years,
respectively. 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. Technological feasibility was subsequently established during
October 2004 after the Company continued to develop the acquired technology at a cost
consistent with expectations. Acquired fixed assets amounted to $122,000.

# NOTE 4  BALANCE
SHEET DETAILS

|                                                                             |  | September 30, |  
|---------------------------------------------------------------------------- |  | ------------- | -
|
|
|Property and equipment:                                                      |  |               |  
|Computer equipment                                                           |  |               |  
|Furniture and fixtures                                                       |  |               |  
|Leasehold improvements                                                       |  |               |  
|Office equipment                                                             |  |               |  
|                                                                             |  |               |  
|                                                                             |  |               |  
|Less: accumulated depreciation                                               |  |               |  
|                                                                             |  |               |  
|                                                                             |  |               |  
|                                                                             |  |               |  
|Intangible assets:                                                          
|Developed and core technology                                                |  |               |  
|Workforce                                                                    |  |               |  
|Patents                                                                      |  |               |  
|                                                                             |  |               |  
|                                                                             |  |               |  
|Less: accumulated amortization                                               |  |               |  
|                                                                             |  |               |  
|                                                                             |  |               |  
|Goodwill                                                                     |  |               |  
|                                                                             |  |               |  
|                                                                             |  |               |  
|                                                                             |  |               |  
|The estimated future amortization expense related to intangible assets as of
|September 30, 2005 is as follows:                                           
|Fiscal year ending September 30,                                            
|2006                                                                         |  |               | $
|2007                                                                         |  |               |  
|2008                                                                         |  |               |  
|2009                                                                         |  |               |  
|                                                                             |  |               |  
|Total estimated amortization                                                 |  |               | $
|                                                                             |  |               |  
|Other assets:                                                               
|Design tools and other licensed intellectual property                        |  |               |  
|Refundable deposits                                                          |  |               |  
|                                                                             |  |               |  
|                                                                             |  |               |  
|                                                                             |  |               |  
|Accrued expenses and other current liabilities:                             
|Accrued vacant facility lease cost                                           |  |               |  
|Accrued non-recurring engineering costs                                      |  |               |  
|Compensation and employee benefits                                           |  |               |  
|Deferred revenue                                                             |  |               |  
|Income taxes payable                                                         |  |               |  
|Other                                                                        |  |               |  
|                                                                             |  |               |  
|                                                                             |  |               |  
|                                                                             |  |               |  

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# NOTE 5  SHORT-TERM
INVESTMENTS

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

|                                    | September 30, 2005 |  | September 30, 2004 |       
|----------------------------------- | ------------------ |  | ------------------ | ------
|
|
|
|Corporate securities                |                    |  | $                  | 7,766 
|Government agency obligations       |                    |  |                    | 2,398 
|Money market securities             |                    |  |                    | 33,402
|                                    |                    |  |                    |       
|Total available-for-sale securities |                    |  | $                  | 43,566
|                                    |                    |  |                    |       

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

|                                | September 30, | 
|------------------------------- | ------------- | 
|
|
|Included in:                    |               | 
|Cash and cash equivalents       |               | 
|Short-term investments          |               | 
|                                |               | 
|                                |               | 
|                                |               | 
|Contractual maturities:        
|Due in less than one year       |               | 
|Due after one through two years |               | 
|                                |               | 
|                                |               | 
|                                |               | 

# 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 and their weighted shares equivalents were
excluded from the computation of diluted earnings because of their anti-dilutive impact to
the following periods:

|                                             | Year Ended September 30,
|-------------------------------------------- | ------------------------
|
|Outstanding options to purchase common stock | 4,161,531               
|Weighted average exercise price              | $10.50                  

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# NOTE 7 
SUPPLEMENTAL CASH FLOW INFORMATION

|                                                             | Year Ended September 30, | 
|------------------------------------------------------------ | ------------------------ | 
|
|
|Supplemental cash flow information:                          |                          | 
|Cash paid during the year for interest                       |                          | 
|Cash paid during the year for income taxes                   |                          | 
|Cash received during the year from refund of income taxes    |                          | 
|Supplemental non-cash investing and financing activities:   
|Common stock issued in settlement of class action litigation |                          | 
|Acquisition of software licenses                             |                          | 

# NOTE 8  STOCK
OPTIONS AND EMPLOYEE BENEFITS

# Employee Stock Option
Plan

The
1996 Equity Incentive Plan (the 1996 Plan) had 4,949,900 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 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. 123(R) 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

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acquired upon the exercise of the
options until the date on which the shares would have vested under the options original
vesting terms 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 |  | Options
Outstanding |            | Weighted Average
Exercise Price (per
share) of Options
Outstanding | 
|----------------------------- | --------------------------- |  | ------------------- | ---------- | ------------------------------------------------------------------ | 
|Balance at September 30, 2002 |                             |  |                     | 2,060,612  |                                                                    | 
|Additional shares authorized  |                             |  |                     | 500,000    |                                                                   
|Options granted               |                             |  |                     | (900,574   | )                                                                  | 
|Options exercised             |                             |  |                     | -          |                                                                    | 
|Options cancelled             |                             |  |                     | 474,731    |                                                                    | 
|                              |                             |  |                     |            |                                                                   
|Balance at September 30, 2003 |                             |  |                     | 2,134,769  |                                                                    | 
|Options granted               |                             |  |                     | (1,277,878 | )                                                                  | 
|Options exercised             |                             |  |                     | -          |                                                                    | 
|Options cancelled             |                             |  |                     | 350,909    |                                                                    | 
|                              |                             |  |                     |            |                                                                   
|Balance at September 30, 2004 |                             |  |                     | 1,207,800  |                                                                    | 
|Options granted               |                             |  |                     | (549,600   | )                                                                  | 
|Options exercised             |                             |  |                     | -          |                                                                    | 
|Options cancelled             |                             |  |                     | 358,611    |                                                                    | 
|                              |                             |  |                     |            |                                                                   
|Balance at September 30, 2005 |                             |  |                     | 1,016,811  |                                                                    | 
|                              |                             |  |                     |            |                                                                   

The
following table summarizes options outstanding at September 30, 2005 and related weighted
average exercise prices and lives as follows:

|  | Options Outstanding and Exercisable |  | Options Vested
and Exercisable
|- | ----------------------------------- |  | ------------------------------
|
|$ | 0.60 - $4.12                        |  |                               
|  | 4.82 - 6.00                         |  |                               
|  | 6.01 - 6.66                         |  |                               
|  | 6.74 - 8.99                         |  |                               
|  | 9.00 -10.94                         |  |                               
|  | 11.01 -13.94                        |  |                               
|  | 14.69 -15.99                        |  |                               
|  | 16.00 -19.00                        |  |                               
|  | 26.75 - 49.94                       |  |                               
|  | 69.88 - 125.50                      |  |                               
|  |                                     |  |                               
|  | 0.60 - 125.50                       |  |                               
|  |                                     |  |                               

Options
 exercisable as of September 30, 2005 include  172,400 shares,  with a weighted average
exercise price of $10.88,  related to accelerated  options held by the Companys
executive officers for which a holding period was imposed as  described above.
 Options  exercisable  as of  September  30,  2004  and 2003  were  2,519,077  and
 2,202,635, respectively, with weighted average exercise prices of $11.81 and $12.00,
respectively.

-59-

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Table of Contents

The
following information relates to the options granted and the assumptions used to determine
the fair value of each stock option granted during the respective periods:

|                                               | Year Ended September 30, | 
|---------------------------------------------- | ------------------------ | 
|
|Weighted average fair value of options granted |                          | 
|Estimated life                                 |                          | 
|Risk-free interest rate                        |                          | 
|Expected stock price volatility                |                          | 
|Dividend yield                                 |                          | 

# 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 900,000. 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,
185,297, 105,976 and 174,265 shares were issued during fiscal 2005, 2004 and 2003, respectively, at weighted
average prices of $5.52, $5.15 and $4.48 per share, respectively. As of September 30, 2005, there
were 288,483 shares available for future purchases under the ESPP.

The
following information relates to the common stock issued and the assumptions used to
determine the fair value of the shares issued during the respective periods:

|                                             | Year Ended September 30, | 
|-------------------------------------------- | ------------------------ | 
|
|Weighted average fair value of shares issued |                          | 
|Estimated life                               |                          | 
|Risk-free interest rate                      |                          | 
|Expected stock price volatility              |                          | 
|Dividend yield                               |                          | 

# 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 2005 and amortization of $138,000
and $355,000 was recognized during fiscal years ended September 30, 2004 and 2003,
respectively.

# 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.

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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, | 
|------------------------ | ------------------------ | 
|
|
|                         |                          | 
|United States            |                          | 
|Foreign                  |                          | 
|                         |                          | 
|Loss before income taxes |                          | 
|                         |                          | 

The
components of the provision for (benefit from) income taxes were as follows:

|                                          | Year Ended September 30, | 
|----------------------------------------- | ------------------------ | 
|
|
|Current:                                  |                          | 
|Federal                                   |                          | 
|State                                     |                          | 
|Foreign                                   |                          | 
|                                          |                          | 
|Provision for (benefit from) income taxes |                          | 
|                                          |                          | 

The components
of deferred taxes are as follows:

|                                | September 30, | 
|------------------------------- | ------------- | 
|
|
|Net operating loss              |               | 
|Property and equipment          |               | 
|Inventory valuation accounts    |               | 
|Accruals and reserves           |               | 
|Research and development credit |               | 
|Amortization of intangibles     |               | 
|                                |               | 
|Total deferred tax asset        |               | 
|Deferred tax liability          |               | 
|Valuation allowance             |               | 
|                                |               | 
|                                |               | 
|                                |               | 

As
of September 30, 2005, the Company had approximately $62.6 million of federal and $24.0
million of state net operating loss carryforwards available to offset future taxable
income. The Company also had approximately $4.1 million of federal and $4.5 million of
state research and development tax credit carryforwards. These tax attributes expire in
varying amounts between 2005 and 2025. 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 $8.9 million of the valuation allowance relates to income tax
benefits, arising from disqualifying dispositions related to the exercise of stock options
and ESPP stock purchases, which will be credited directly to stockholders equity if
the associated deferred tax assets are realized.

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

|                                        | Year Ended September 30, | 
|--------------------------------------- | ------------------------ | 
|
|
|Tax at federal statutory rate           |                          | 
|State taxes, net of federal tax benefit |                          | 
|Stock compensation                      |                          | 
|Research and development credits        |                          | 
|Foreign tax credits                     |                          | 
|Net operating loss carryback refund     |                          | 
|Change in valuation allowance           |                          | 
|Foreign taxes                           |                          | 
|Other                                   |                          | 
|                                        |                          | 
|                                        |                          | 
|                                        |                          | 

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 Companys products which may be different from
the geographic locations of the Companys end customers.

|                    | Year Ended September 30, | 
|------------------- | ------------------------ | 
|
|
|North America:      |                          | 
|United States       |                          | 
|Other               |                          | 
|                    |                          | 
|Total North America |                          | 
|                    |                          | 
|Asia:              
|Hong Kong           |                          | 
|Malaysia            |                          | 
|Singapore           |                          | 
|Japan               |                          | 
|Thailand            |                          | 
|Taiwan              |                          | 
|Other               |                          | 
|                    |                          | 
|Total Asia          |                          | 
|                    |                          | 
|Europe and other    |                          | 
|                    |                          | 
|Total               |                          | 
|                    |                          | 

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# Major Customers

Revenues
from Cisco Systems, Inc., an original equipment producer of networking equipment, through
its manufacturing subcontractors, represented 49%, 41% and 23% of the Companys net
revenues for fiscal years ended September 30, 2005, 2004 and 2003, respectively. Revenues
from Quantum Corporation, through its manufacturing subcontractor, represented 11%, 14%
and 34% of the Companys net revenues for fiscal years ended September 30, 2005, 2004
and 2003, respectively. Revenues from Huawei Technologies, Inc., also a producer of
networking equipment, represented 10% and 14% of net revenues for fiscal years ended
September 30, 2005 and 2004, respectively. No other customers accounted for more than 10%
of revenues in the periods presented.

# Property and Equipment

As
of September 30, 2005, the Company had net property and equipment of $1.2 million and
$601,000 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 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, 2005 are as follows (in thousands):

|                                 | Operating
Lease
Commitments |  | Inventory
Purchases |       | Non-recurring
Engineering
Expenses |   | Total
Contractual
Obligations | 
|-------------------------------- | --------------------------- |  | ------------------- | ----- | ---------------------------------- | - | ----------------------------- | 
|Fiscal year ending September 30, |                             |  |                     |       |                                    |   |                               | 
|2006                             |                             |  | $                   | 1,944 |                                    | $ | 2,585                         | 
|2007                             |                             |  |                     | 1,868 |                                    |   | -                             | 
|2008                             |                             |  |                     | 1,215 |                                    |   | -                             | 
|2009                             |                             |  |                     | 937   |                                    |   | -                             | 
|2010                             |                             |  |                     | 317   |                                    |   | -                             | 
|                                 |                             |  |                     |       |                                    |   |                               | 
|                                 |                             |  | $                   | 6,281 |                                    | $ | 2,585                         | 
|                                 |                             |  |                     |       |                                    |   |                               | 

Total
rental expense under operating leases was $3.0 million, $3.1 million and $3.3 million for
fiscal years ended September 30, 2005, 2004 and 2003, respectively. As of September 30,
2005, included in the Companys accrued liabilities was $1.8 million for vacant
facility lease costs for lease commitments of $871,000, $906,000 and $228,000 for fiscal
years 2006, 2007 and 2008, 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.

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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, 2005.

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, 2005. 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, 2005. 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 | 
|---------------------------------------------- | ------------------ | 
|
|
|Fiscal 2005:                                   |                    | 
|Net revenues                                   |                    | 
|Total costs and operating expenses             |                    | 
|Net loss                                       |                    | 
|Net loss per share, basic and diluted          |                    | 
|Fiscal 2004:                                   |                    | 
|Net revenues                                   |                    | 
|Total costs and operating expenses             |                    | 
|Net income (loss)                              |                    | 
|Net income (loss) per share, basic and diluted |                    | 

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# 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 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.   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,  2005.  PricewaterhouseCoopers
 LLP, an  independent  registered  public accounting firm, has audited  managements
 assessment of the effectiveness of the Companys internal control over financial  reporting as of September 30, 2005, 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 2005
 that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting.

-65-

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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 the fiscal year ended September 30, 2005. 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 the fiscal year ended September 30, 2005.

# 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 the fiscal year ended September 30, 2005.

# Item 13. Certain
Relationships and Related Transactions

The
information required by this item is incorporated by reference from Hifns Proxy
Statement for the fiscal year ended September 30, 2005.

# Item 14. Principal
Accountant Fees and Services

The
information required by this item is incorporated by reference from Hifns Proxy
Statement for the fiscal year ended September 30, 2005.

-66-

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Table of Contents

# PART IV

# Item 15. Exhibits,
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 70.
|-- |  | ----------------------------------------------------------

|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.                                                                                  
|21.1           |  | Subsidiaries of the Registrant                                                                                                                             
|23.1           |  | Consent of PricewaterhouseCoopers LLP, independent registered public accounting firm.                                                                      

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|     |  |                                                                                                                                                   
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------
|     |  |                                                                                                                                                   
|24.1 |  | Power of Attorney (see page 53).                                                                                                                  
|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, 2005.
|- | ----------------------------------------------------------------------------------------------------------

|^^ | Incorporated
by reference from Registrants Report on Form 10-Q (File No. 0-24765)
filed with the SEC on August 3, 2005.
|-- | ------------------------------------------------------------------------------------------------------------------------

|    |  |                                                 |  |   
|--- |  | ----------------------------------------------- |  | --
|(b) |  | Exhibits:  See Item 15(a) above.                |  |   
|    |  |                                                 |  |   
|(c) |  | Financial Statement Schedules                   |  |   
|    |  | Schedule II - Valuation and Qualifying Accounts |  | 70

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# 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, inc.                                                                                                  
|------------------------ |  | -------------------------------------------------------------------------------------------------------------
|Dated: December 14, 2005 |  | /s/  CHRISTOPHER G. KENBER
Christopher G. KenberChairman, President and Chief Executive Officer

# POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS,
that each person whose signature appears below constitutes and appoints Christopher G.
Kenber 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, 2005.

|Signature                 |  | Title                                                        
|------------------------- |  | -------------------------------------------------------------
|/s/ CHRISTOPHER G. KENBER |  | Chairman, President andChief Executive Officer               
|(Christopher G. Kenber)   |  | (Principal Executive Officer)                                
|/s/ WILLIAM R. WALKER     |  | Vice President, Finance, ChiefFinancial Officer and Secretary
|(William R. Walker)       |  | (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/ ALBERT E. SISTO       |  | Director                                                     
|(Albert E. Sisto)         |  |                                                              

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Table of Contents

HIFN, INC.

SCHEDULE II

VALUATION AND
QUALIFYING ACCOUNTS

|                                  | Balance at
beginning of
period |  | Additions
charged tocosts and
expenses |     | Deductions |   | Balance
at end
of period | 
|--------------------------------- | ------------------------------ |  | -------------------------------------- | --- | ---------- | - | ------------------------ | 
|
|Deducted from accounts receivable |                                |  |                                        |     |            |   |                          | 
|Allowance for doubtful accounts:  |                                | 
|Year ended September 30, 2005     |                                |  | $                                      | 259 |            | $ | -                        | 
|Year ended September 30, 2004     |                                |  |                                        | 205 |            |   | 57                       | 
|Year ended September 30, 2003     |                                |  |                                        | 164 |            |   | 75                       | 

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# 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.                                                                                  
|21.1           |  | Subsidiaries of the Registrant                                                                                                                             
|23.1           |  | Consent of PricewaterhouseCoopers LLP, independent registered public accounting firm.                                                                      
|24.1           |  | Power of Attorney (see page 53).                                                                                                                           
|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.
|- | --------------------------------------------------------------------------------------------------------------------------------------------------

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|** | 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, 2005.
|- | ----------------------------------------------------------------------------------------------------------

|^^ | Incorporated
by reference from Registrants Report on Form 10-Q (File No. 0-24765)
filed with the SEC on August 3, 2005.
|-- | ------------------------------------------------------------------------------------------------------------------------