##### Table of Contents









UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549




---

Form 10-K



---

|           |  |                                                                                             
|---------- |  | --------------------------------------------------------------------------------------------
|(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,
    2002                                            
|          
|           |  | or                                                                                          
|o          |  | 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.     YES þ     NO o

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

The aggregate market value of the voting and
non-voting common equity held by non-affiliates of the
Registrant as of December 6, 2002 was $106,986,812 (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.

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

The number of shares outstanding of the
Registrants Common Stock as of December 6, 2002, was
10,586,590.

DOCUMENTS INCORPORATED BY REFERENCE

Parts of the Proxy Statement for
Registrants 2003 Annual Meeting of Shareholders to be held
February 24, 2003 (the Proxy Statement) are
incorporated by reference into Part III of this
Form 10-K Report.



---






---

TABLE OF CONTENTS



|                                  |                                                                                               |  |  |  |  |  |  | 
|--------------------------------- | --------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|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 and Related Stockholder Matters            
|                                  | Item 6. Selected Financial Data                                                              
|                                  | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                                  | Item 7A. Quantitative and Qualitative Disclosures About Market Risk                          
|                                  | Item 8. Financial Statements and Supplementary Data                                          
|REPORT OF INDEPENDENT ACCOUNTANTS
|                                  | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 
|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                      
|                                  | Item 13. Certain Relationships and Related Transactions                                      
|                                  | Item 14. Controls and Procedures                                                             
|PART IV                          
|                                  | Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K                     
|SIGNATURES                       
|INDEX TO EXHIBITS                
|EXHIBIT 23.1                     
|EXHIBIT 99.1                     
|EXHIBIT 99.2                     



---



##### Table of Contents



CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING
STATEMENTS

With the exception of historical facts, the
statements contained in this Annual Report on Form 10-K are
forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as
amended (the Exchange Act), and are subject to the
safe harbor provisions created by such statutes. Certain
statements contained herein, including, without limitation,
statements containing the words believes,
anticipates, estimates,
expects, and words of similar import, 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,
(referred to as Hifn, we, us
or our) is a flow classification and network
security specialist company supplying most major network
equipment manufacturers with patented technology to improve
network packet processing. Hifn designs, develops and markets
high-performance, multi-protocol packet processors 
semiconductor devices and software  that enable
secure, high-bandwidth network connectivity and efficient
storage of business information. Hifns packet processor
products 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 products are used in networking and storage equipment such
as routers, remote access concentrators, switches, broadband
access equipment, network interface cards, firewalls and back-up
storage devices.

Hifns encryption/compression and public key
processors allow network equipment vendors to add bandwidth
enhancement and security capabilities to their products. Our
encryption/compression and public key processors provide key
algorithms used in virtual private networks (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 trading partners and others 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 mid- to high-end 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 classes of service (CoS), which enables
businesses to enhance the effectiveness of using the public
Internet network. Using QoS- or CoS-enabled network equipment,
businesses can maintain more consistent and reliable
interactions with their customers and business partners.

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

1



---



##### Table of Contents



liabilities, to Hifn in exchange for 6,000,000
shares of Series A Preferred Stock and 100 shares of
Company Common Stock pursuant to a Stock Purchase Agreement.


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 three
major transitions over the past decade and it is the convergence
of these transitions that contributed to the recent increase in
global connectivity. The first 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). The second major 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. The last of these transitions
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 virtual private networks that use the public 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, businesses
are able to share internal information and run enterprise
applications across geographically dispersed facilities as well
as enable customers, suppliers and other business partners to
inexpensively link into their enterprise information systems. As
Internet protocols and infrastructure gain increasing and
widespread acceptance for global communication, new wide-area
connectivity services such as database access, transaction
processing services, audio and telephone services; as well as
video teleconferencing services; are emerging at a rapid rate.
This expansion of services and applications is further
accelerating the use of networks as global communication
systems. The emergence of e-business increased the challenges in
enabling secure access to information and applications.

The Complexity of and Need for Network
Security

Driven to provide the tremendous benefits of
connectivity and information exchange, organizations potentially
expose sensitive information and mission critical applications
to unauthorized access, both through connections to the public
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 is quickly outpacing
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, and Java and ActiveX security services and
functions. This increased complexity, along with the higher
demand placed by ever-increasing bandwidths and the increasing
number of users has driven the creation of data communications
semiconduc-

2



---



##### Table of Contents



tors specifically designed for the security task.
These high-performance security integrated circuits create the
next generation security platform for the Internet 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 security network processor products.


The Hifn Solution

Hifn is a flow classification and network
security specialist company supplying most major network
equipment vendors with patented technology to improve network
packet processing. We design, develop and market
high-performance, multi-protocol packet processors 
semiconductor devices and software  designed to
enable secure, high-bandwidth network connectivity,
comprehensive differentiation of business-critical application
network traffic from other general purpose network traffic and
efficient compression, encryption/compression and public key
cryptography, providing our customers with high-performance,
interoperable implementations of a wide variety of
industry-standard networking and storage protocols. 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 gives our products a strong competitive
advantage. By offering a wide range of high-performance
implementations of our patented, standards-compliant technology,
we are able to sell products to network and storage equipment
vendors that allow them to reduce development costs and get
their products to market faster.

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

In support of emerging VPN architectures, we have
led the industry by introducing the first network security
processors, integrating the critical functions of compression,
encryption and data authentication in compliance with the
Internet Protocol Security (IPSec) protocol.
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. Furthermore, we also license a complete
and portable software implementation of the IPSec protocol,
allowing network vendors to get to market more quickly with
their VPN implementations at a fraction of the cost of internal
software development efforts.

Businesses are increasingly dependent upon the
public Internet in conducting their normal business operations.
Unlike the traditional telecommunications network used by
businesses to communicate, the public Internet is vastly more
complex and unreliable. In addition, there is currently an
overall lack of differentiation or prioritization of
business-critical functions from general use of the Internet.
Rather, these functions are bundled together and use the same
resources throughout the public 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 public Internet.

Hifns line of compression processors
targeted at back-up storage applications provides storage
equipment vendors 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) tape 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.

3



---



##### Table of Contents



Customers and Products

A number of leading manufacturers of network and
storage equipment have designed products that incorporate our
products. To date, we have secured numerous design wins with
networking and storage equipment vendors. To qualify as a design
win, an equipment vendor must have ordered samples of our packet
processors or an evaluation 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, 2002, we had a backlog of
semiconductor orders representing $3.5 million of products
deliverable to customers over the 6 months following the
placement of these orders. At September 30, 2001, we had a
backlog of $6.9 million. Because we quote product lead
times to customers of approximately three 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 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
high-performance compression processors provide essential
bandwidth-enhancement for network equipment such as routers,
remote access concentrators, broadband access equipment and
switches. These products provide flexible bus interfaces and a
variety of memory configuration options to allow customers to
tailor their uses to meet a variety of network system
requirements. We license a line of software compression
libraries that provide similar functionality to our line of
compression processor products for low-performance applications
such as modems and ISDN links. The software products are offered
in source and object code toolkits.

Network Security
Products.The Hifn 6500 public key
processor provides acceleration of the mathematical computations
involved in public key cryptography, supporting key exchange
algorithms (such as the Rivest Shamir Adelman (RSA)
public key cryptosystem as developed by RSA Data Security, Inc.
and Diffie-Hellman) as well as digital signature algorithms
(such as RSA and the Digital Signature Algorithm
(DSA)). Hifns 7711, 7751 and 7811 encryption
processors provide essential bandwidth-enhancement and security
for network equipment such as routers, remote access
concentrators, switches and firewalls. For high-performance
security requirements, Hifns 7814, 7851 and 7854
processors are the first to incorporate the Hifn Intelligent
Packet Processing (HIPP) architecture for complete
processing from 100 to 700 megabits per second. At the
multi-gigabit speed range, Hifn provides the 8154, 8065 and 8165
members of the HIPP II family of security processors. These
devices provide public key acceleration for e-commerce
secure-session handling as well as secure packet processing for
multi-gigabit speeds. For data communication applications such
as xDSL and cable modems, the Hifn 7901, 7902 and 7951 provide
the industrys first complete broadband security processors
implementing support of data compression, encryption and
authentication algorithms. In addition, these devices also
include a public key math processor and a true hardware random
number generator (RNG) to support the public key
cryptography required for key generation, exchange and
authentication.

Network Flow Classification Products.Hifns MeterFlow products provide
comprehensive data 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 flows in network equipment devices to support the deployment
of Integrated and Differentiated Services.

4



---



##### Table of Contents



These functions are the key to enabling
firewalls, security, network address translation
(NAT) and port address translation (PAT)
transforms, QoS and CoS 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 and 9732
high-performance compression processors provide a typical
doubling of capacity and performance for mid- to high-end tape
drive products.

Evaluation Boards.To facilitate the adoption of our
semiconductor devices, we design system-level boards that
resemble actual end-products or subsystems. Our evaluation
boards include basic hardware and software that enable customers
to expedite their designs by using the evaluation boards as a
reference or by incorporating portions of them into their own
designs. These boards are used as evaluation and development
vehicles for each semiconductor device designed by Hifn.

Technology

Hifns multi-protocol packet processors,
which are high-performance compression, encryption/ compression
and public key processors, and our 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 40 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 position 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 acquisition of
Apptitude in August 2000 extended our reach into the packet
processing area. We have incorporated Apptitudes flow
classification technology into a software solution for network
equipment vendors. This technology has six patents pending that
cover the ability to discover applications within the content of
network packets and flows. MeterFlow, our flow classification
technology, 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 and are used in deploying QoS and
CoS, which enables businesses to enhance the effectiveness of
using the public 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.

5



---



##### Table of Contents



Integrated, High-Performance Packet
Processing.Hifn is continuing to
develop additional packet processing functionality, including
the implementation of advanced public key encryption algorithms,
continued 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 17 United
States patents and seven foreign patents. We also have two
pending patent applications in Japan. The issued patents and
patent applications primarily cover various aspects of our
compression, bandwidth management and rate shaping technologies
and have expiration dates ranging from 2006 to 2017. In addition
to compression, we have six pending patent applications in the
United States, four in Europe and Asia (Japan) covering our flow
classification technology. 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.

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.

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.

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.

6



---



##### Table of Contents



U.S. export regulations have been liberalized to
allow for the export of most encryption hardware, software, and
technology to foreign non-government entities after the product
receives a one-time technical review from the Commerce
Department. The technical review process generally takes
30 days from the date the government logs the application
into its computer system. In addition, the U.S. government
allows U.S. exporters to immediately ship products to both
government and non-government end-users in the European Union
(EU) and eight other friendly countries
(EU + 8) immediately upon submission of
the required technical review paperwork. If exports to
government end-users are required to countries outside of the
EU + 8 group, an individual export license is required
from the Department of Commerce. As a result of the
liberalizations, our network equipment customers may be able to
effectively compete with EU competitors. However, foreign
competitors facing less stringent controls and who may have
effectively established markets for their products prior to the
relaxation of U.S. export restrictions may be able to compete
more effectively than our network equipment customers in the
global market. Furthermore, U.S. regulations are constantly
changing and we cannot assure that the liberalizing trends will
continue, that the list of products and countries for which
export approval is required, or the regulatory policies with
respect thereto, will not be revised from time to time, or that
laws limiting the domestic use of encryption will not be
enacted. 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.

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.

Our products compete with products from companies
such as Safenet, Inc., International Business Machines
(IBM), Broadcom Corporation, Motorola, Inc. and
Philips Corporation. In 1994, Stac entered into two license
agreements with IBM where Stac granted IBM the right to use, but
not sublicense, our patented compression technology in IBM
hardware and software products. Stac also entered into a license
agreement with Microsoft in 1994 whereby Stac granted Microsoft
the right to use, but not sublicense, our compression technology
in their software products. Stacs 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. We believe that the
liberalization of U.S. export regulations will enable us and our
network equipment customers to obtain comparable footing with
our European competitors. However, we expect significant future
competition from major domestic and international semiconductor
suppliers. Several established electronics and semiconductor
suppliers have recently entered or indicated an intent to enter
the network equipment market. We may also face competition from
suppliers of products based on new or emerging technologies.
Furthermore, many of our existing and potential customers
internally develop application specific integrated circuits,
general purpose microprocessors and other devices which attempt
to perform all or a portion of the functions performed by our
products.

7



---



##### Table of Contents



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. In particular, companies such as Intel
Corporation, Agere Systems, Motorola, National Semiconductor
Corporation and Texas Instruments Incorporated 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 such as the Internet Engineering Task Force
(IETF).

As of September 30, 2002, our research and
development staff consisted of 76 employees. Our research and
development expenditures were $18.2 million in the fiscal
year ended September 30, 2002, $18.6 million in the
fiscal year ended September 30, 2001 and $14.6 million
in the fiscal year ended September 30, 2000, representing
84%, 43% and 33% 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 as well as amortization of
deferred stock compensation related to the acquisition of
Apptitude. We perform our research and product development
activities at our facilities in Los Gatos, California and
Carlsbad, California.

The acquisition of Apptitude in August 2000
further strengthened our development efforts, adding to our pool
of software expertise and intellectual properties. Furthermore,
we were able to expand our product base to include acceleration
for firewall applications, bandwith management, load balancing,
QoS and CoS. Also in August 2000, we purchased unique patented
traffic flow control technology to further enhance the bandwith
management features of Apptitudes technology.

8



---



##### Table of Contents



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

Revenues from Quantum, through its manufacturing
subcontractor, represented 35%, 36% and 36% of our net revenues
for fiscal years ended September 30, 2002, 2001 and 2000,
respectively. Revenues from Benchmark represented 11% of our net
revenues for fiscal year ended September 30, 2002 and
revenues from Lucent, through its manufacturing subcontractors,
represented 17% and 35% of our net revenues for fiscal years
ended September 30, 2001 and 2000, respectively. Our
customers are not subject to any binding obligation to order
from us. If our sales to Quantum or Benchmark decline, our
business, financial condition and results of operations could
suffer. 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 U. S. customers account for the
substantial majority of our revenues. Due to the export controls
imposed by the U. S. government until recently on encryption
products, our shipments to international customers have been
limited to compression processors and compression software. The
recent relaxation of

9



---



##### Table of Contents



controls has opened new opportunities for our
products sales around the world. In early 2000, we entered
into a distribution agreement with a worldwide electronics
distribution company which we believe provides us with the
ability to respond to significant pent-up demand for network
security products around the world. We continue to actively work
with our network equipment customers and the
U.S. government to comply with U.S. export controls to
facilitate the export of our customers products which
incorporate our encryption products. We cannot assure that we
will be successful in these efforts and that competitors outside
of the U.S. will not develop encryption products to meet the
needs of our customers, thereby reducing the opportunity for us
to sell our products. See 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.


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

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.

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 and OKI Semiconductor.
The selection of these manufacturers was based on the breadth of
available technology, quality, manufacturing capacity and
support for design tools used by us. None of our products are
currently manufactured by more than one supplier. However, we
expect that in the event one of our suppliers notifies us that
it intends to cease manufacturing a product, 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.

At any given time, we use mainstream 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 allows us to focus on
providing differentiated functionality, the primary value-add in
our products. Our current main products are manufactured using
..6, .4, .3, .25 and .18 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.

We intend to continue for the foreseeable future
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.

10



---



##### Table of Contents



We must place orders approximately 20 to
23 weeks in advance of expected delivery. As a result, we
have only a limited ability to react to fluctuations in demand
for our products, which could cause us to have an excess or a
shortage of inventory of a particular product. Failure of
worldwide semiconductor manufacturing capacity to rise along
with a rise in demand could result in our subcontract
manufacturers allocating available capacity to customers that
are larger or have long-term supply contracts in place. Our
inability to obtain adequate foundry capacity at acceptable
prices, or any delay or interruption in supply, could reduce our
product revenue or increase our cost of revenue and could harm
our business, financial condition and results of operations. See
Item 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, 2002, Hifn employed a
total of 132 full-time employees. Of the total number of
employees, 76 were employed in research and development, 31 in
sales and marketing, seven in operations and 18 in finance and
administration. In connection with the asset acquisition
completed in September 2002, we employed 15 engineers that
joined Hifn on October 1, 2002. On October 16, 2002,
the Company effected a reduction-in-force, reducing the total
number of employees to 120. Our employees are not represented by
any collective bargaining agreement and we have never
experienced a work stoppage.

Our future success is heavily dependent upon our
ability to hire and retain qualified technical, marketing, sales
and management personnel. The competition for such personnel is
intense, particularly for engineering personnel with related
security, networking and integrated circuit design expertise,
and applications support personnel with networking product
design expertise. See Item 7. Managements
Discussion and Analysis of Financial Condition and Results of
Operations  Trends, Risks and
Uncertainties  We Depend Upon Key Personnel.




Item 2.     Properties

Hifns corporate and technical headquarters
are located in Los Gatos, California. We lease approximately
34,500 and 11,500 square feet of space in Los Gatos, California,
under leases that expire in September 2005 and December 2007,
respectively. We also lease other facilities; including 15,700
square feet of space for our design and operations center in
Carlsbad, California, under leases that expire at various dates
through December 2004, and small field sales offices in
Charlotte, North Carolina and Westford, Massachusetts as well as
in Monument, Colorado. Additionally, we have international field
offices in the United Kingdom and the Netherlands.

In connection with the asset acquisition
completed in September 2002, we also added 3,600 square feet of
design center space in Framingham, Massachusetts.




Item 3.     Legal
Proceedings

In October and November 1999, six purported class
action complaints were filed in the United States District Court
for the Northern District of California (the District
Court) against Hifn and certain of its officers and
directors. On March 17, 2000, these complaints were
consolidated into In re Hi/fn, Inc. Securities Litigation
No. 99-04531 SI. The consolidated complaint was filed on
behalf of persons who purchased Hifns stock between
July 26, 1999 and October 7, 1999 (the class
period). The complaint sought unspecified money damages
and alleged that Hifn and certain of its officers and directors
violated federal securities laws in connection with various
public statements made during the class period. In August 2000,
the District Court dismissed the complaint as to all defendants,
other than Raymond J. Farnham and Hifn. In February 2001,
the District Court certified the purported class. On
May 15, 2002, the parties entered into a Memorandum of
Understanding to settle all claims in the consolidated
securities class action. Under the terms of the settlement, all
claims will be dismissed without any admission of liability or
wrongdoing by any defendant, and the shareholder class will
receive $9.5 million, comprised of $6.8 million in cash,
which was contributed by Hifns insurance carriers, and the
balance in Hifn common stock with a minimum of 270,000 shares to
be

11



---



##### Table of Contents



issued. On June 10, 2002, the District Court
entered an order preliminarily approving the Stipulation of
Settlement and providing for notice and an opportunity to object
to the shareholder class. The District Court approved the
settlement and entered a Final Judgment and Order of Dismissal
with Prejudice on September 4, 2002. In accordance with the
settlement, Hifn will issue at least 270,000 shares of Hifn
common stock, supplementing the allotment with cash or
additional shares of common stock to compensate for shortfall in
fair value below $2.7 million. To the extent that the
trading price of the common stock exceeds $10.00 at the time of
distribution, Hifn would recognize an additional litigation
settlement charge equal to the aggregate fair market value of
the 270,000 shares of common stock less the $2.7 million
already recognized.


In March 2002, two purported shareholder
derivative actions were filed, one in the United States District
Court for the Northern District of California and one in the
Superior Court of California for the County of Santa Clara (the
federal derivative action and the state
derivative action, respectively). These complaints were
filed against Hifn and certain of its current and former
officers and directors. The derivative complaints alleged
violations of California Corporations Code Section 25402,
breach of fiduciary duty and waste of corporate assets, based on
the same facts and events alleged in the class action. On
June 7, 2002, the federal court entered an order granting
plaintiffs motion to voluntarily dismiss the federal
derivative action without prejudice. On June 26, 2002, the
state court sustained Hifns demurrer, with leave to amend,
on the ground that plaintiff had failed to plead facts showing
that he was excused from making demand on Hifns board of
directors. The court also ordered limited discovery relating
solely to the issue whether demand is excused. The court did not
rule upon the demurrer to the derivative complaint filed by the
individual director defendants. Hifn and the individual director
defendants believe the allegations contained in the complaint
are without merit and intend to defend the action vigorously.






|        |                                                        
|------- | -------------------------------------------------------
|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.

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, 2002:

|                          |  |     |    |          |  |                                                                     
|------------------------- |  | --- | -- | -------- |  | --------------------------------------------------------------------
|Name                      |  | Age |    | Position
|                          |  |     |    |         
|Christopher G. Kenber     |  |     | 58 |          |  | Chairman, President and Chief Executive Officer                     
|William R. Walker         |  |     | 61 |          |  | Vice President of Finance, Chief Financial
    Officer and Secretary
|Russell S. Dietz          |  |     | 39 |          |  | Vice President and Chief Technical Officer                          
|Douglas J. Felder         |  |     | 61 |          |  | Vice President of Business Development                              
|Douglas K. Makishima      |  |     | 35 |          |  | Vice President of Marketing                                         
|John E. Metzger           |  |     | 44 |          |  | Vice President of Engineering                                       
|Thomas A. Moore           |  |     | 45 |          |  | Vice President of Sales                                             
|Douglas L. Whiting, Ph.D. |  |     | 46 |          |  | Chief Scientist and Director                                        

Christopher G. Kenberhas 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.

12



---



##### Table of Contents



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. Dietzhas
served as Vice President and Chief Technology Officer of Hifn
since August 2000. Mr. Dietz is the primary architect of
the MeterFlow and MeterWorks technology. 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) and is the technical
working chair for the Network Processing Forum.

Douglas J. Felderhas served as Vice President of Sales
of Hifn since August 2000. Mr. Felder was previously Vice
President of Business Development at Apptitude, Inc. From 1994
to 1997, Mr. Felder was Vice President of Business
Development at NetLabs, a provider of network management
software, and then at Seagate Software after NetLabs was
acquired by Seagate Technology. Mr. Felder also held Vice
President positions in sales and marketing at Chi Systems, a
software consulting group, and Zitel Corporation, which
purchased Intels Memory Systems Division. For the seven
years prior, Mr. Felder was President and owner of Data
Communications and Systems Group, a distributor of data
communications equipment. Mr. Felder received his B.S. in
Business Administration from San Jose State University.

Douglas K.
Makishima, Vice President of Marketing
of Hifn since July 2001, has over 15 years of experience in
the networking, communications and PC industries. From 1999 to
2001, Mr. Makishima was Vice President of Marketing and
Sales for ParkerVision, a wireless communications integrated
circuit (IC) company. From 1990 through 1999, he
held senior management positions with Nortel Networks, Bay
Networks, AMD and Adaptec, where he managed the marketing and
development of advanced networking and storage products. During
his engineering career, Mr. Makishima developed patented
storage IC technology. Mr. Makishima has actively
participated on several IEEE and ANSI committees focused on
networking, communications and storage standards. He is
currently a voting member of the IEEE 802.11 Wireless Networking
standards committee. He holds a B.S. in Electrical Engineering
from the University of California, and an M.B.A. from Santa
Clara University.

John E. Metzgerhas
served as Vice President of Engineering of Hifn since August
2000. Prior to joining Hifn, Mr. Metzger was Vice President
of Engineering of Apptitude, Inc. Mr. Metzger was the
co-founder, Vice President and Chief Technical Officer of
Software Decisions, Inc., which was purchased by Ungermann-Bass
(UB) in 1985. After seven years with UB, he
successfully contributed to the restart of Network Computing,
Inc., as Vice President of Development, which was acquired by
Seagate Software in 1995. He brings in-depth knowledge of
product architecture, development, integration and strategic
direction. Mr. Metzger holds a B.S. in Computer and
Communication Science from the University of Michigan.

Thomas A. Moore,
Vice President of Sales of Hifn since January 2002, has over
20 years of executive sales management, business
development and general management experience. Prior to joining
Hifn, Mr. Moore was President and CEO of Pixami, an
Internet infrastructure technology provider. For the five years
prior to Pixami, he served as President of Image Software, a
private software licensing and technology company. During the
proceeding 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

13



---



##### Table of Contents



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.





PART II






|        |                                                                              
|------- | -----------------------------------------------------------------------------
|Item 5. | Market for the Registrants Common
    Equity and Related Stockholder Matters

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
closing bid prices for the Common Stock as reported on the
Nasdaq National Market for the periods indicated below:

|                                          |                |      |   |       |  |  |   |       | 
|----------------------------------------- | -------------- | ---- | - | ----- |  |  | - | ----- | 
|                                          |                | High |   | Low  
|                                          |                |      |   |      
|Fiscal Year Ended September 30,
    2002: |                |      |   |       |  |  |   |      
|                                          | Fourth Quarter |      | $ | 7.70  |  |  | $ | 4.10  | 
|                                          | Third Quarter  |      |   | 13.72 |  |  |   | 5.46  | 
|                                          | Second Quarter |      |   | 20.50 |  |  |   | 10.20 | 
|                                          | First Quarter  |      |   | 19.30 |  |  |   | 9.52  | 
|Fiscal Year Ended September 30,
    2001: |                |      |   |       |  |  |   |      
|                                          | Fourth Quarter |      | $ | 15.40 |  |  | $ | 7.90  | 
|                                          | Third Quarter  |      |   | 20.43 |  |  |   | 12.00 | 
|                                          | Second Quarter |      |   | 37.75 |  |  |   | 12.50 | 
|                                          | First Quarter  |      |   | 68.44 |  |  |   | 22.94 | 

On December 6, 2002, the reported last sale
price of Common Stock on the Nasdaq National Market was
$6.61 per share and there were approximately
329 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.

14



---



##### Table of Contents








|        |                        
|------- | -----------------------
|Item 6. | Selected Financial Data

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

|                                             |                                             |                                          |         |        |  |         |         |         |  |         |        |        |  |   |        |        |  |   |        |       | 
|-------------------------------------------- | ------------------------------------------- | ---------------------------------------- | ------- | ------ |  | ------- | ------- | ------- |  | ------- | ------ | ------ |  | - | ------ | ------ |  | - | ------ | ----- | 
|                                             |                                             |                                         
|                                             |                                             | Year Ended September 30,                
|                                             |                                             |                                         
|                                             |                                             | 2002                                     |         | 2001   |  | 2000(1) |         | 1999(2) |  | 1998(3)
|                                             |                                             |                                          |         |        |  |         |         |         |  |        
|                                             |                                             |                                         
|                                             |                                             | (In thousands, except per share amounts)
|Statement of Operations Data:                |                                             |                                          |         |        |  |         |         |         |  |         |        |        |  |   |        |        |  |   |        |      
|Net revenues                                 |                                             | $                                        | 21,791  |        |  | $       | 43,004  |         |  | $       | 44,838 |        |  | $ | 42,351 |        |  | $ | 21,533 |      
|Costs and operating expenses:                |                                             |                                          |         |        |  |         |         |         |  |         |        |        |  |   |        |        |  |   |        |      
|                                             | Cost of revenues                            |                                          |         | 6,413  |  |         |         | 13,828  |  |         |        | 10,004 |  |   |        | 10,498 |  |   |        | 6,525 | 
|                                             | Research and development                    |                                          |         | 18,221 |  |         |         | 18,569  |  |         |        | 14,577 |  |   |        | 8,022  |  |   |        | 5,346 | 
|                                             | Sales and marketing                         |                                          |         | 8,445  |  |         |         | 9,462   |  |         |        | 8,172  |  |   |        | 5,963  |  |   |        | 3,370 | 
|                                             | General and administrative                  |                                          |         | 12,309 |  |         |         | 7,705   |  |         |        | 5,147  |  |   |        | 2,993  |  |   |        | 2,407 | 
|                                             | Amortization of intangibles and goodwill    |                                          |         | 10,480 |  |         |         | 11,093  |  |         |        | 1,619  |  |   |        | 113    |  |   |        | 57    | 
|                                             | Impairment of intangibles and goodwill      |                                          |         | 27,366 |  |         |         |        |  |         |        |       |  |   |        |       |  |   |        |      | 
|                                             | Purchased in-process research & development |                                          |         | 1,137  |  |         |         |        |  |         |        | 4,085  |  |   |        |       |  |   |        |      | 
|                                             |                                             |                                          |         |        |  |         |         |         |  |         |        |        |  |   |        |        |  |   |        |      
|Income (loss) from operations                |                                             |                                          | (62,580 | )      |  |         | (17,653 | )       |  |         | 1,234  |        |  |   | 14,762 |        |  |   | 3,828  |      
|Interest income (expense), net               |                                             |                                          | 1,067   |        |  |         | 2,700   |         |  |         | 4,211  |        |  |   | 1,720  |        |  |   | 17     |      
|Other income (expense), net                  |                                             |                                          | (72     | )      |  |         | (64     | )       |  |         | (66    | )      |  |   | (14    | )      |  |   |       |      
|Provision for (benefit from) income taxes    |                                             |                                          | 6,014   |        |  |         | (1,660  | )       |  |         | 4,381  |        |  |   | 6,587  |        |  |   | 1,627  |      
|                                             |                                             |                                          |         |        |  |         |         |         |  |         |        |        |  |   |        |        |  |   |        |      
|Net income (loss)                            |                                             | $                                        | (67,599 | )      |  | $       | (13,357 | )       |  | $       | 998    |        |  | $ | 9,881  |        |  | $ | 2,218  |      
|                                             |                                             |                                          |         |        |  |         |         |         |  |         |        |        |  |   |        |        |  |   |        |      
|Net income (loss) per share, basic           |                                             | $                                        | (6.49   | )      |  | $       | (1.32   | )       |  | $       | 0.11   |        |  | $ | 1.22   |        |  | $ | 0.35   |      
|Net income (loss) per share, diluted         |                                             | $                                        | (6.49   | )      |  | $       | (1.32   | )       |  | $       | 0.10   |        |  | $ | 1.06   |        |  | $ | 0.33   |      
|Weighted average shares outstanding, basic   |                                             |                                          | 10,417  |        |  |         | 10,141  |         |  |         | 9,017  |        |  |   | 8,115  |        |  |   | 6,308  |      
|Weighted average shares outstanding, diluted |                                             |                                          | 10,417  |        |  |         | 10,141  |         |  |         | 10,055 |        |  |   | 9,295  |        |  |   | 6,800  |      

|                                |  |                |        |      |  |      |         |      |  |      |         |  |  |   |        |  |  |   |        | 
|------------------------------- |  | -------------- | ------ | ---- |  | ---- | ------- | ---- |  | ---- | ------- |  |  | - | ------ |  |  | - | ------ | 
|                                |  |               
|                                |  | September 30, 
|                                |  |               
|                                |  | 2002           |        | 2001 |  | 2000 |         | 1999 |  | 1998
|                                |  |                |        |      |  |      |         |      |  |     
|                                |  |               
|                                |  | (In thousands)
|Balance Sheet Data:             |  |                |        |      |  |      |         |      |  |      |         |  |  |   |        |  |  |   |        | 
|Cash and short-term investments |  | $              | 54,666 |      |  | $    | 64,751  |      |  | $    | 64,815  |  |  | $ | 70,086 |  |  | $ | 4,084  | 
|Total assets                    |  |                | 72,279 |      |  |      | 126,810 |      |  |      | 131,479 |  |  |   | 83,530 |  |  |   | 16,611 | 
|Working capital                 |  |                | 44,798 |      |  |      | 70,297  |      |  |      | 66,498  |  |  |   | 73,153 |  |  |   | 4,723  | 
|Total debt                      |  |                |       |      |  |      |        |      |  |      | 27      |  |  |   |       |  |  |   |       | 
|Total stockholders equity      |  |                | 56,656 |      |  |      | 119,835 |      |  |      | 124,191 |  |  |   | 76,049 |  |  |   | 6,952  | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | In August 2000, we completed our acquisition of
    Apptitude in a transaction accounted for as a purchase. The
    Statement of Operations for fiscal year ended September 30,
    2000 include the operating results of Apptitude from the date of
    acquisition.                                                                                                                                                                                                                                                                                                                          
|   
|(2) | On March 31, 1999, we issued 1,600,000
    shares of common stock at a price of $33 per share in an
    equity offering, which raised approximately $49.2 million,
    net of offering expenses. On April 19, 1999 our
    underwriters exercised their option to purchase an additional
    300,000 shares of our common stock, which yielded an
    additional $9.3 million in proceeds to us.                                                                                                                                                                                               
|   
|(3) | We operated as a division of Stac until
    September 30, 1996 and as a subsidiary of Stac until
    December 16, 1998. Accordingly, our selected financial data
    as of and for the fiscal year ended September 30, 1998 has
    been derived from audited financial statements not included
    herein. The financial information may not reflect our future
    performance or our future financial position or results of
    operations, nor does it provide or reflect data as if we had
    actually operated as a separate, stand-alone entity during all
    of the periods covered.

15



---



##### Table of Contents








|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

The following discussion should be read in
conjunction with the Consolidated Financial Statements and Notes
included elsewhere in this Annual Report on Form 10-K. The
results shown in this report are not necessarily indicative of
the results to be expected in any future periods. This
discussion contains forward-looking statements based on current
expectations which involve risks and uncertainties. Actual
results and the timing of certain events may differ
significantly from those projected in such forward-looking
statements due to the factors set forth in the section entitled
Trends, Risks and Uncertainties and appearing
elsewhere in this report.

Overview

hi/fn, inc., together with its subsidiaries
(referred to as Hifn, we, us
or our), is a flow classification and network
security specialist company supplying most major network
equipment vendors with patented technology to improve network
packet processing. We design, develop and market
high-performance, multi-protocol packet processors 
semiconductor devices and software  designed to
enable secure, high-bandwidth network connectivity,
comprehensive differentiation of business-critical application
network traffic from other general purpose network traffic and
efficient compression, encryption/ compression and public key
cryptography, providing our customers with high-performance,
interoperable implementations of a wide variety of
industry-standard networking and storage protocols. Our products
are used in networking and storage equipment such as routers,
remote access concentrators, switches, broadband access
equipment, network interface cards, firewalls and back-up
storage devices.

Hifns encryption/compression and public key
processors allow network equipment vendors to add bandwidth
enhancement and security capabilities to their products. Our
encryption/compression and public key processors provide key
algorithms used in 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 trading partners and others 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 mid-to high-end 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 classes of service (CoS), which enables
businesses to enhance the effectiveness of using the public
Internet network. Using QoS- or CoS-enabled network equipment,
businesses can maintain more consistent and reliable
interactions with their customers and business partners.

Revenues from one customer, through its
manufacturing subcontractor, represented 35%, 36% and 36% of our
net revenues for fiscal years ended September 30, 2002,
2001 and 2000, respectively. Revenues from a second customer
represented 11% of our net revenues for fiscal year ended
September 30, 2002 and revenues from a third customer,
through its manufacturing subcontractors, represented 17% and
35% of our net revenues for fiscal years ended
September 30, 2001 and 2000, respectively.

In September 2002, Hifn acquired certain assets
and intellectual property 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 costs of approximately
$1.1 million, which were expensed at the time of the
acquisition.

In August 2000, Hifn completed its acquisition of
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, $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

16



---



##### Table of Contents



and core technology, workforce and patents.
Additionally, we acquired in-process research and development
costs which were expensed at the time of the acquisition.


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, 2002 was
approximately $1.0 million. We will adopt Statement of
Financial Accounting Standards No. 142
(SFAS 142), Goodwill and Other Intangible
Assets, during the first quarter of fiscal 2003, which
will effectively replace SFAS 121. In accordance with
SFAS 142, the remaining carrying value of goodwill will not
be amortized, but will be 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 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 requires 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 original equipment manufacturers (OEMs)
and, to a lesser extent, distributors. Revenue from the sale of
processors is recognized upon shipment when persuasive evidence
of an arrangement exists, the price is fixed or determined and
collection of the resulting receivables is reasonably

17



---



##### Table of Contents



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.


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 estimated based on historical experience
and are deferred until the return rights expire. We base the
levels of returns on historical experience. 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 revenue balance as of September 30,
2002 was $2.8 million and included approximately $251,000
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 of September 30, 2002, inventories
of $3.5 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 goodwill, other intangible assets and other long-lived assets
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 2002, we concluded that impairment
indicators existed and that goodwill was impaired and as a
result, we recorded an impairment charge of $27.4 million.
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, Goodwill and
Other Intangible Assets, goodwill and intangible assets
deemed to have indefinite lives will no longer be amortized but
instead will be subject to annual impairment tests. We will
adopt SFAS No. 142 during the first quarter of fiscal 2003.
Other intangible assets will continue to be amortized over their
useful lives. Certain existing recognized intangibles will be
reclassified as goodwill. Goodwill amortization expense
aggregated $8.6 million during fiscal 2002. After the
impairment described above, the net book value of goodwill was
approximately $1.0 million at September 30, 2002. Asset

18



---



##### Table of Contents



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


Accounting for income taxes.As part of the process of preparing
our consolidated financial statements we are required to
estimate our income taxes, which involves 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
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. We
recorded a full valuation allowance against deferred tax assets
as of September 30, 2002. 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.

As of September 30, 2002, in relation to the
class action suit against us, the court preliminarily approved a
settlement of all claims and we recognized approximately
$2.7 million in accrued litigation settlement charges,
which represent the uninsured portion of the settlement amount.
In accordance with the settlement, we will issue at least
270,000 shares of our common stock, supplementing the allotment
with cash or additional shares of common stock to compensate for
any shortfall in fair value below $2.7 million. To the
extent that the trading price of the common stock exceeds $10.00
at the time of distribution, we would recognize an additional
litigation settlement charge equal to the aggregate fair market
value of the 270,000 shares of common stock less the
$2.7 million already recognized. Such an adjustment may
materially affect our results of operations, financial condition
and future cash flows.

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,          
|                                          |                                             |                                   
|                                          |                                             | 2002                               |      | 2001 |     | 2000
|                                          |                                             |                                    |      |      |     |     
|Net revenues                              |                                             |                                    | 100  | %    |     |      | 100 | %  |     |  | 100 | % 
|                                          |                                             |                                    |      |      |     |      |     |    |     |  |     |   
|Costs and operating expenses:             |                                             |                                    |      |      |     |      |     |    |     |  |     |   
|                                          | Cost of revenues                            |                                    |      | 29   |     |      |     | 32 |     |  |     | 22 |   
|                                          | Research and development                    |                                    |      | 84   |     |      |     | 43 |     |  |     | 33 |   
|                                          | Sales and marketing                         |                                    |      | 39   |     |      |     | 22 |     |  |     | 18 |   
|                                          | General and administrative                  |                                    |      | 56   |     |      |     | 18 |     |  |     | 11 |   
|                                          | Amortization of intangibles and goodwill    |                                    |      | 48   |     |      |     | 26 |     |  |     | 4  |   
|                                          | Impairment of intangibles and goodwill      |                                    |      | 126  |     |      |     |   |     |  |     |   |   
|                                          | Purchased in-process research & development |                                    |      | 5    |     |      |     |   |     |  |     | 9  |   
|                                          |                                             |                                    |      |      |     |      |     |    |     |  |     |   
|                                          |                                             | Total costs and operating expenses |      |      | 387 |      |     |    | 141 |  |     |    | 97 | 
|                                          |                                             |                                    |      |      |     |      |     |    |     |  |     |   
|Income (loss) from operations             |                                             |                                    | (287 | )    |     |      | (41 | )  |     |  | 3   |   
|Interest and other income (expense), net  |                                             |                                    | 4    |      |     |      | 6   |    |     |  | 9   |   
|                                          |                                             |                                    |      |      |     |      |     |    |     |  |     |   
|Income (loss) before income taxes         |                                             |                                    | (283 | )    |     |      | (35 | )  |     |  | 12  |   
|Provision for (benefit from) income taxes |                                             |                                    | 27   |      |     |      | (4  | )  |     |  | 10  |   
|                                          |                                             |                                    |      |      |     |      |     |    |     |  |     |   
|Net income (loss)                         |                                             |                                    | (310 | )%   |     |      | (31 | )% |     |  | 2   | % 
|                                          |                                             |                                    |      |      |     |      |     |    |     |  |     |   

19



---



##### Table of Contents



Years Ended September 30, 2002, 2001 and
2000

Net Revenues.Net
revenues from sales of semiconductor processors and licenses of
software libraries decreased 49% in fiscal 2002 to
$21.8 million compared to $43.0 million in fiscal
2001. The decrease in net revenues in fiscal 2002 from fiscal
2001 was due to a decrease in sales of our data compression and
encryption processors to network equipment manufacturers of
$19.4 million as well as a decrease in license and software
revenues of $1.8 million. Net revenues from sales of
semiconductor processors and licenses of software libraries
decreased 4% in fiscal 2001 to $43.0 million compared to
$44.8 million in fiscal 2000 due to a decrease in sales of
our data compression and encryption processors to network
equipment manufacturers of $3.7 million partially offset by
an increase of $1.9 million in license and software
revenues. Semiconductor sales to Quantum, an original equipment
manufacturer of high-performance tape storage devices, through
its manufacturing subcontractor, comprised 35%, 36% and 36% of
revenue in each of fiscal 2002, 2001 and 2000, respectively.
Semiconductor sales to Benchmark, an original equipment
manufacturer of tape storage devices, comprised 11% of revenue
in fiscal 2002. Semiconductor sales to Lucent, an original
equipment manufacturer of networking equipment, through its
manufacturing subcontractors, comprised 17% and 35% of revenue
in fiscal 2001 and 2000, respectively.

Cost of Revenues.Cost of revenues consists primarily of
semiconductor processors which were manufactured to our
specifications by third parties for resale by us. Cost of
revenues as a percentage of net revenues was 29% in fiscal 2002
as compared to 32% in fiscal 2001. Cost of revenues in fiscal
2001 included a $3.4 million charge for excess inventory
that resulted from a decrease in semiconductor processor demand
below our previous expectations. Exclusive of the inventory
charge, cost of revenues in fiscal 2001 was 24% of net revenues.
During fiscal 2002, we recovered $710,000 of prior excess
inventory charges as a result of the sale of previously
identified excess inventories. Cost of revenues, as a percentage
of net revenues, increased to 29% in fiscal 2002, including the
benefit from the recovery of excess inventory charge, from 24%
in fiscal 2001, excluding the excess inventory charge, as a
result of a shift in the revenue mix with higher processor
revenues and lower software and license revenues. Cost of
revenues as a percentage of net revenues increased to 32% for
fiscal 2001 from 22% for fiscal 2000. Exclusive of the excess
inventory charge, cost of revenues as a percentage of net
revenues remained relatively the same at 24% for fiscal 2001 as
compared to 22% in fiscal 2000.

Research and Development.Research and development expenses were
$18.2 million, or 84% of net revenues, in fiscal 2002,
$18.6 million, or 43% of net revenues, in fiscal 2001 and
$14.6 million, or 33% of net revenues, in fiscal 2000.
Research and development expenses decreased slightly in fiscal
2002 from fiscal 2001 and reflects the net effect of an increase
in nonrecurring engineering charges of $614,000 and purchase of
engineering development tools for new product development of
$331,000 offset by a reduction in outside service costs for
contractors previously used to develop new products of $855,000
and a reduction in compensation and benefits of $579,000
generally as a result of the suspension of bonus and profit
sharing programs in fiscal 2002.

Research and development expenses increased 27%
in fiscal 2001 as compared to fiscal 2000. The increase in
research and development costs was due to increases in salaries
and benefits of $1.6 million, building expenses of $841,000
and depreciation costs of $340,000 mainly due to the addition of
16 research and development personnel related to the acquisition
of Apptitude in August 2000 as well as an increase in
nonrecurring engineering charges of $650,000, offset by a
reduction in outside services costs of $1.1 million for
contractors previously used to develop new products.

Research and development expense also includes
amortization of deferred stock compensation related to the
acquisition of Apptitude of $2.0 million in fiscal 2002,
which includes $1.3 million in deferred compensation
amortization related to the voluntary stock option exchange, and
$1.8 million and $265,000 in fiscal 2001 and 2000,
respectively. We expect our investments in research and
development to continue to increase in coming periods on an
absolute basis, excluding the effect of deferred compensation
amortization charges, as we continue to develop products
targeted at meeting market needs. We currently have seven
products in development with anticipated production dates
ranging from December 2002 through early 2004. However, we
cannot assure that product development programs invested in by
us will be successful or that products resulting from such
programs will achieve market acceptance.

20



---



##### Table of Contents



Sales and Marketing.Sales and marketing expenses were
$8.4 million, or 39% of net revenues, in fiscal 2002,
$9.5 million, or 22% of net revenues, in fiscal 2001 and
$8.2 million, or 18% of net revenues, in fiscal 2000. The
decrease in sales and marketing expenses in fiscal 2002 from
fiscal 2001 reflects the net effect of a decrease in outside
services and advertising costs of $769,000, a decrease in
tradeshow and conference expenses of $184,000 and a decrease in
rep commissions of $460,000 due to lower revenue levels. This
was offset by an increase in salaries and wages expense of
$402,000 as a result of an average increase in headcount of two
employees and a net increase in deferred compensation expense of
$90,000, inclusive of $329,000 in deferred compensation
amortization related to the voluntary stock option exchange. The
increase in sales and marketing expenses in fiscal 2001 from
fiscal 2000 was primarily due to an increase is salaries and
benefits of $522,000 due to an average increase in headcount of
four employees, increased deferred compensation expense of
$303,000 and increased outside services to support sales and
marketing efforts of $289,000.

General and Administrative.General and administrative expenses
were $12.3 million, or 56% of net revenues, in fiscal 2002,
$7.7 million, or 18% of net revenues, in fiscal 2001 and
$5.1 million, or 11% of net revenues, in fiscal 2000. The
increase in general and administrative expenses in fiscal 2002
as compared to fiscal 2001 primarily reflects a net charge
related to vacant facility lease obligations of
$3.7 million, an accrued shareholder litigation settlement
charge of $2.7 million, as well as increased legal expenses
of $328,000 offset by a decrease in the amortization of deferred
compensation expense of $1.3 million.

The increase in general and administrative
expenses in fiscal 2001 from fiscal 2000 is mainly due to higher
salaries and benefits as a result of increased office
administration and depreciation costs of $466,000 coupled with
an increase in amortization for deferred compensation expense of
$1.8 million offset by a reduction in salaries and wages
expense of $384,000 and in outside consulting fees of $250,000.

Amortization of deferred stock compensation
related to the acquisition of Apptitude were $420,000 for fiscal
2002, inclusive of $70,000 in amortization related to the
voluntary stock option exchange, $1.8 million and $503,000
for fiscal 2001 and 2000, respectively. Legal costs for the
fiscal years ended 2002, 2001 and 2000 were $689,000, $342,000
and $476,000, respectively.

Amortization of Intangibles and Goodwill.Amortization of intangibles and
goodwill of $10.5 million, or 48% of net revenues, in
fiscal 2002, $11.1 million, or 26% of net revenues, in
fiscal 2001 and $1.6 million, or 4% of revenues, in fiscal
2000 related to the acquisition of Apptitude in August 2000 as
well as acquisition of other intellectual property. Goodwill
amortization expense related to the Apptitude acquisition
aggregated $8.6 million, $9.4 million and
$1.3 million in fiscal years 2002, 2001 and 2000,
respectively. However, as a result of scheduled adoption of
SFAS 142 (see Note 2 of Notes to Consolidated
Financial Statements), we will cease amortization of goodwill
beginning October 1, 2002.

Impairment of Intangible and Other Assets.During the fourth quarter of fiscal
2002, we determined that customer preferences with respect to
the Apptitude technology had shifted, resulting in a significant
reduction in expected revenues. As a result of our evaluation of
the carrying value of long-lived assets, we recorded an
impairment charge of $27.4 million as a write-down of
goodwill and developed technology. The remaining carrying value
of goodwill at September 30, 2002 was approximately
$1.0 million, which balance will not be amortized but will
be subject to impairment testing in accordance with
SFAS 142 (see Note 2 of Notes to Consolidated
Financial Statements).

Purchased In-Process Research and Development.Purchased in-process research and
development (IPR&D) in fiscal 2002 related to
the purchase of intellectual property for processing of IPsec
packets using a combination of hardware, firmware and software
was $1.1 million or 5% of net revenues. IPR&D related
to the acquisition of Apptitude in August 2000 was
$4.1 million or 9% of net revenues. Purchased IPR&D
related to the value assigned to products which had not reached
technological feasibility at the time of purchase or acquisition.

Interest and Other Income (Expense),
Net.Interest and other income
(expense), net, for fiscal 2002 were 995,000, or 4% of net
revenues, $2.6 million, or 6% of net revenues, for fiscal
2001 and $4.1 million, or 9% of net revenues, for fiscal
2000. The continuing decrease in net interest income was
primarily a result of a shift in the investment mix from stock
instruments to commercial paper and municipal bonds, lower
average cash

21



---



##### Table of Contents



and short-term investments balance during fiscal
2002 and 2001 as compared to fiscal 2000 as well as an overall
decrease in interest rates.


Income Taxes.The
effective tax rates for fiscal 2002, 2001 and 2000 were (10)%,
11% and 81%, respectively. As a result of our continuing losses
over a longer period than previously expected, we recorded a
valuation allowance of $9.8 million during the third
quarter of fiscal 2002 to reduce the carrying value of our
deferred tax assets. We considered future taxable income and
ongoing prudent and feasible tax planning strategies in
assessing the valuation allowance. We recorded a benefit from
income taxes of $1.7 million in fiscal 2001 and an income
tax provision of $4.4 million in fiscal 2000. The resulting
effective tax rates are primarily the result of the
non-deductibility of certain acquisition-related costs
consisting mainly of the amortization of intangibles and
goodwill. The effective tax rate for fiscal 2001 of 11% is below
the combined statutory tax rate of 40% due primarily to the fact
that there is no tax benefit from the accounting amortization of
intangible assets and stock-based compensation.

Liquidity and Capital Resources

Operating Activities.In fiscal 2002, cash used in operating
activities of approximately $5.9 million was comprised of
net loss as adjusted for non-cash items including provision for
the impairment of intangibles and goodwill of
$27.4 million, amortization of intangibles and goodwill and
of deferred stock compensation of $13.8 million,
depreciation and amortization costs of $1.9 million,
in-process research and development charge of $1.1 million
and a decrease in deferred income taxes of $5.7 million as
well as a decrease in accounts receivable of $1.5 million,
an increase in inventory and prepaids and other current assets
of $1.8 million, a decrease in accounts payable and accrued
expenses and other current liabilities of $8.7 million.
These adjustments were offset by increases in other assets of
$200,000.

In fiscal 2001, we generated cash from operating
activities of approximately $1.3 million comprised of net
loss as adjusted for non-cash items including amortization of
intangibles and deferred stock compensation of
$15.0 million, depreciation and amortization costs of
$1.7 million and an increase in deferred income taxes of
$362,000 as well as a decrease in accounts receivable of
$2.1 million and an increase in accrued expenses and other
current liabilities of $122,000. These adjustments were offset
mainly by increases in prepaid expenses and other current assets
of $2.4 million, other assets of $1.3 million,
inventory of $330,000 and a decrease in accounts payable of
$410,000.

In fiscal 2000, we generated cash from operating
activities of approximately $14.9 million comprised of net
income as adjusted for non-cash items including purchased
in-process research and development of $4.1 million,
amortization of intangibles and deferred stock compensation of
$3.0 million, deferred income taxes of $7.1 million
and depreciation and amortization costs of $1.1 million as
well as a decrease in accounts receivable of $1.3 million.
These adjustments were offset mainly by decreases in income
taxes payable of $1.3 million and in accrued expenses and
other liabilities of $1.7 million.

Investing Activities.Cash provided by investing activities
in fiscal 2002 was $3.4 million, resulting from the net
sales of short-term investments of $8.5 million, the
acquisition of $4.8 million in intellectual property and
$336,000 in property and equipment. Cash used in investing
activities in fiscal 2001 was $7.5 million, resulting from
the purchase of short-term investments of $5.0 million and
the acquisition of $2.5 million in property and equipment.
Cash used in investing activities in fiscal 2000 was
$27.5 million, consisting primarily of the acquisition of
Apptitude and the purchase of intellectual property aggregating
$20.5 million, the purchase of short-term investments of
$5.1 million and the acquisition of $1.8 million in
property and equipment. Our capital expenditures in fiscal 2001
reflect costs incurred in relation to the consolidation of our
northern California facilities as well as the additional
facilities in Los Gatos and Carlsbad. We expect capital
expenditures in the foreseeable future to approximate those
levels as in fiscal 2002.

Financing Activities.Cash provided by financing activities
in fiscal 2002, 2001 and 2000 of $916,000, $1.2 million and
$2.1 million, respectively, reflect proceeds from the
issuance of common stock for stock option exercises and stock
purchase plan purchases slightly offset by payments on debt
obligations.

22



---



##### Table of Contents



We have no long-term liabilities. Our long-term
contractual obligations for operating leases are as follows (in
thousands):

|                                 |                              |   |       |        | 
|-------------------------------- | ---------------------------- | - | ----- | ------ | 
|Fiscal year ending September 30, |                              |   |       |       
|2003                             |                              | $ | 3,170 |       
|2004                             |                              |   | 2,794 |       
|2005                             |                              |   | 2,192 |       
|2006                             |                              |   | 871   |       
|Thereafter                       |                              |   | 1,134 |       
|                                 |                              |   |       |       
|                                 | Total minimum lease payments |   | $     | 10,161 | 
|                                 |                              |   |       |       

We use a number of independent suppliers to
manufacture substantially all of our products. As a result, we
rely on these suppliers to allocate to us a sufficient portion
of foundry capacity to meet our needs and deliver sufficient
quantities of our products on a timely basis. These arrangements
allow us to avoid utilizing our capital resources for
manufacturing facilities and work-in-process inventory and to
focus a substantial proportion of our resources on the design,
development and marketing of our products.

We require funds to finance our working capital,
including accounts receivable and manufactured inventory, and to
finance investments in property and equipment. Our need to raise
capital in the future will depend on many factors including the
rate of sales growth, market acceptance of our 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 anticipate
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
economics. 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 on terms
acceptable to us.

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 Operating Results May Fluctuate
    Significantly.

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



| |   |                                                                                              
| | - | ---------------------------------------------------------------------------------------------
| |  | General business conditions in our markets as
    well as global economic uncertainty;       
|
| |  | Increases or reductions in demand for our
    customers products;                           
|
| |  | The timing and volume of orders we receive from
    our customers;                           
|
| |  | Cancellations or delays of customer product
    orders;                                      
|
| |  | Acquisitions or mergers involving us, our
    competitors or customers;                      
|
| |  | Any new product introductions by us or our
    competitors;                                  
|
| |  | Our suppliers increasing costs or changing the
    delivery of products to us;               
|
| |  | Increased competition or reductions in the prices
    that we are able to charge;            
|
| |  | The variety of the products that we sell as well
    as seasonal demand for our products; and
|
| |  | The availability of manufacturing capacity
    necessary to make our products.               

23



---



##### Table of Contents





| |                                                                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.

During fiscal 2002, we performed an impairment
analysis of goodwill and long-lived assets and determined that
impairment had been realized on goodwill and certain developed
technology, resulting in recognition of an impairment charge of
$27.4 million. 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 assets, asset impairment charges will be
recognized. Approximately $1.0 million of goodwill remains
as of September 30, 2002.

We Depend
Upon A Small Number Of Customers.

Quantum Corporation (Quantum),
through its manufacturing subcontractor, accounted for
approximately 35%, 36% and 36%, respectively, of our net
revenues in fiscal 2002, 2001 and 2000. Benchmark accounted for
approximately 11% of our net revenues in fiscal 2002. Lucent,
through its manufacturing subcontractors, accounted for
approximately 17% and 35% of our net revenues during fiscal 2001
and 2000, respectively. Neither Quantum nor Benchmark are under
any binding obligation to order from us. If our sales to Quantum
or Benchmark decline, our business, financial condition and
results of operations could suffer. We expect 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 an
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 Systems, Inc., Lucent
Technologies Inc., 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 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 And Our Penetration Of The Virtual Private Network
    Market.

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.
This market, which continues to evolve, may not grow and if it
does continue to grow, our products may not successfully serve
this market. Our ability to

24



---



##### Table of Contents



generate significant revenue in the virtual
private network market will depend upon, among other things, the
following:




| |   |                                                                                                                                       
| | - | --------------------------------------------------------------------------------------------------------------------------------------
| |  | Our ability to demonstrate the benefits of our
    technology to distributors, original equipment manufacturers and
    end users; and
|
| |  | The increased use of the Internet by businesses
    as replacements for, or enhancements to, their private networks.                  

If we are unable to penetrate the virtual private
network market, or if that market fails to develop, our
business, financial condition and results of operations could
suffer.



| |                                                                                              
| | ---------------------------------------------------------------------------------------------
| | 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;                                                                           
|
| |  | Enhance our products by adding innovative
    features that differentiate our products from those of
    competitors;
|
| |  | Bring products to market on a timely basis at
    competitive prices; and                                            
|
| |  | Respond effectively to new technological changes
    or new product announcements by others.                         

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

In evaluating new product decisions, we must
anticipate future demand for product features and performance
characteristics, as well as available supporting technologies,
manufacturing capacity, competitive product offerings and
industry standards. We must also continue to make significant
investments in research and development in order to continue to
enhance the performance and functionality of our products to
keep pace with competitive products and customer demands for
improved performance, features and functionality. The technical
innovations required for us to remain competitive are
complicated and require a significant amount of time and money.
We may experience substantial difficulty in introducing new
products 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 Analog
Devices, Inc., SafeNet, Inc., IBM, Broadcom Corporation,
Motorola, Inc. and Royal Philips Electronics. In 1994, Stac
entered into two license agreements with IBM in which Stac
granted IBM the right to use, but not sublicense, our patented

25



---



##### Table of Contents



compression technology in IBM hardware and
software products. Stac also entered into a 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 to bundle
their products with other products. Any of the above would
significantly and negatively impact our ability to compete and
obtain or maintain market share. If we are unable to
successfully compete against our competitors, our business,
results of operations and financial condition will suffer.

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



| |   |                                                                                                
| | - | -----------------------------------------------------------------------------------------------
| |  | Performance;                                                                                   
|
| |  | Price;                                                                                         
|
| |  | The time that is required to develop a new
    product or enhancements to existing products;   
|
| |  | The ability to achieve product acceptance with
    major network and storage equipment vendors;
|
| |  | The support that exists for new network and
    storage standards;                             
|
| |  | Features and functionality;                                                                    
|
| |  | Adaptability of products to specific applications;                                             
|
| |  | Reliability; and                                                                               
|
| |  | Technical service and support as well as
    effective intellectual property protection.       

If we are unable to successfully develop and
market products that compete with those of other suppliers, our
business, financial 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 Business
Depends Upon The Growth Of The Network Equipment And Storage
Equipment 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. In addition, our success depends upon storage equipment
vendors

26



---



##### Table of Contents



incorporating our packet processors into their
systems. The network security equipment market has in the past,
and may in the future, fluctuate significantly based upon
numerous factors, including the lack of industry standards,
adoption of alternative technologies, capital spending levels
and general economic conditions. We are unable to determine the
rate or extent to which these markets will grow, if at all. Any
decrease in the growth of the network or storage equipment
market or a decline in demand for our products could harm our
business, financial condition and results of operations.


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,
maskwork and copyright law to protect our intellectual property.
We own 17 United States patents and seven foreign patents. We
also have two pending patent applications in Japan. Our issued
patents and patent applications primarily cover various aspects
of our compression, bandwidth management and rate shaping
technologies and have expiration dates ranging from 2006 to
2017. In addition to compression, we have six pending patent
applications in the United States, four in Europe and Asia
(Japan) covering our flow classification technology. 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.



| |                                                                                                                               
| | ------------------------------------------------------------------------------------------------------------------------------
| | 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 and OKI Semiconductor. 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.

27



---



##### Table of Contents



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 other 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
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.                                          

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.

Both Toshiba Corporation and OKI Semiconductor
manufacture 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.

Network And
Storage Equipment Prices Typically Decrease.

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



| |   |                                    
| | - | -----------------------------------
| |  | Rapidly changing technologies;     
|
| |  | Price-performance enhancements; and
|
| |  | Product obsolescence.              

28



---



##### Table of Contents



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 Face Order
And Shipment Uncertainties.

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 could harm our profit margins and restrict our
ability to fund our operations. During fiscal 2002, we recorded
an excess inventory reserve 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,
net of an allowance for estimated returns. An unanticipated
level of returns could 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. Several members
of our management team have joined us in the last
24 months. 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.

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

29



---



##### Table of Contents



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.


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 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.

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. While we are not currently negotiating any
acquisitions, we 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, in particular, if we fail to
    successfully integrate the acquisition of Apptitude and the
    recently acquired certain other assets and intellectual
    property, the anticipated benefits of these transaction will not
    occur;
|
| |  | 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.                                                                                                                                                                                                                                                                         

30



---



##### Table of Contents



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.

The
Cyclicality 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.

Our Stock
Price May Be Volatile.

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



| |   |                                                                                 
| | - | --------------------------------------------------------------------------------
| |  | Quarterly variations in operating results;                                      
|
| |  | Announcements of new products by us or our
    competitors;                     
|
| |  | The gain or loss of significant customers;                                      
|
| |  | Changes in analysts estimates;                                                 
|
| |  | Short-selling of our Common Stock; and                                          
|
| |  | Events affecting other companies that investors
    deem to be comparable to us.

We Are
Currently Engaged in Securities Class-Action
Lawsuits.

In October and November 1999, six purported class
action complaints were filed in the United States District Court
for the Northern District of California (the District
Court) against Hifn and certain of its officers and
directors. On March 17, 2000, these complaints were
consolidated into In re Hi/fn, Inc. Securities Litigation
No. 99-04531 SI. The consolidated complaint was filed on
behalf of persons who purchased Hifns stock between
July 26, 1999 and October 7, 1999 (the class
period). The complaint sought unspecified money damages
and alleged that the Hifn and certain of its officers and
directors violated federal securities laws in connection with
various public statements made during the class period. In
August 2000, the District Court dismissed the complaint as to
all defendants, other than Raymond J. Farnham and Hifn. In
February 2001, the District Court certified the purported class.
On May 15, 2002, the parties entered into a Memorandum of
Understanding to settle all claims in the consolidated
securities class action. Under the terms of the settlement, all
claims will be dismissed without any admission of liability or
wrongdoing by any defendant, and the shareholder class will
receive $9.5 million, comprised of $6.8 million in
cash, which was contributed by our insurance carriers, and the
balance in Hifn stock with a minimum of 270,000 shares to
be issued. On June 10, 2002, the District Court entered an
order preliminarily approving the Stipulation of Settlement and
providing for notice and an opportunity to object to the
shareholder class. The District Court approved the settlement
and entered a Final Judgment and Order of Dismissal with
Prejudice on September 4, 2002. In accordance with the
settlement, we will issue at least 270,000 shares of Hifn
common stock, supplementing the allotment with cash or
additional shares of common stock to compensate for shortfall in
fair value below $2.7 million. To the extent that the
trading price of the common stock exceeds $10.00 at the time of
distribution, Hifn would recognize an additional litigation
settlement charge equal to the aggregate fair market value of
the 270,000 shares of common stock less the
$2.7 million already recognized and any such additional
charge may negatively affect our financial condition and results
of operations.

In March 2002, two purported shareholder
derivative actions were filed, one in the United States District
Court for the Northern District of California and one in the
Superior Court of California for the County of Santa Clara (the
federal derivative action and the state
derivative action, respectively). These complaints

31



---



##### Table of Contents



were filed against Hifn and certain of its
current and former officers and directors. The derivative
complaints alleged violations of California Corporations Code
Section 25402, breach of fiduciary duty and waste of
corporate assets, based on the same facts and events alleged in
the class action. On June 7, 2002, the federal court
entered an order granting plaintiffs motion to voluntarily
dismiss the federal derivative action without prejudice. On
June 26, 2002, the state court sustained Hifns
demurrer, with leave to amend, on the ground that plaintiff had
failed to plead facts showing that he was excused from making
demand on Hifns board of directors. The court also ordered
limited discovery relating solely to the issue whether demand is
excused. The court did not rule upon the demurrer to the
derivative complaint filed by the individual director
defendants. Hifn and the individual director defendants believe
the allegations contained in the complaint are without merit and
intend to defend the action vigorously.


Recent
Accounting Pronouncements

In June of 2002, the FASB issued Statement of
Financial Accounting Standards No. 146
(SFAS 146), Accounting for Costs
Associated with Exit or Disposal Activities. SFAS 146
addresses significant issues regarding the recognition,
measurement, and reporting of costs that are associated with
exit and disposal activities, including restructuring activities
that are currently accounted for under EITF No. 94-3,
Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain
Costs Incurred in a Restructuring). The scope of
SFAS 146 also includes costs related to terminating a
contract that is not a capital lease and termination benefits
that employees who are involuntarily terminated receive under
the terms of a one-time benefit arrangement that is not an
ongoing benefit arrangement or an individual
deferred-compensation contract. SFAS 146 will be effective
for exit or disposal activities that are initiated after
December 31, 2002 and early application is encouraged. We
will adopt SFAS 146 during the second fiscal quarter ending
March 31, 2003. The provisions of EITF No. 94-3 shall
continue to apply for an exit activity initiated under an exit
plan that met the criteria of EITF No. 94-3 prior to the
adoption of SFAS 146. The effect on adoption of
SFAS 146 will change on a prospective basis the timing of
when restructuring charges are recorded from a commitment date
approach to when the liability is incurred.

In April of 2002, the FASB issued Statement of
Financial Accounting Standards No. 145
(SFAS 145), Rescission of FASB Statements
No. 4, 44 and 64, Amendment of FASB Statement No. 13,
and Technical Corrections, which is effective for fiscal
years beginning after May 15, 2002. Under SFAS 145,
gains and losses from the extinguishment of debt should be
classified as extraordinary items only if they meet the criteria
of Accounting Principles Board Opinion No. 30.
SFAS 145 also addresses financial accounting and reporting
for capital leases that are modified in such a way as to give
rise to a new agreement classified as an operating lease. We
believe that the adoption of SFAS 145 will not have a
material impact on our financial position or results of
operations.

In August 2001, the FASB issued Statement of
Financial Accounting Standards No. 144
(SFAS 144), Accounting for the Impairment
or Disposal of Long-Lived Assets. SFAS 144 supersedes
SFAS 121, Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed of, and
provides further guidance regarding the accounting and
disclosure of long-lived assets. We do not expect the adoption
of SFAS 144 on October 1, 2002 to have a material
effect on our financial condition and results of operations.

In June 2001, the FASB issued Statement of
Financial Accounting Standards No. 141 (SFAS
141), Business Combinations and Statement of
Financial Accounting Standards No. 142
(SFAS 142), Goodwill and Other Intangible
Assets. SFAS 141 will apply to all business combinations
that we enter into after June 30, 2001, and eliminates the
pooling-of-interests method of accounting. SFAS 142 is
effective for fiscal years beginning after December 15,
2001. Under the new Statements, goodwill and intangible assets
deemed to have indefinite lives will no longer be amortized but
will be subject to annual impairment tests in accordance with
the Statements. Other intangible assets will continue to be
amortized over their useful lives. In addition, the Statements
include provisions upon adoption for the reclassification of
certain existing recognized intangibles as goodwill,
reassessment of the useful lives of existing recognized
intangibles, reclassification of certain intangibles out of
previously reported goodwill and the testing for impairment of
existing goodwill and other intangibles. We are required to
adopt these Statements for accounting for goodwill

32



---



##### Table of Contents



and other intangible assets beginning
October 1, 2002 at which time we will cease amortization of
goodwill. Net of the impairment charge of $27.4 million
recognized during the fourth quarter of fiscal 2002, the net
book value of goodwill at September 30, 2002 was
approximately $1.0 million. Goodwill amortization expense
aggregated $8.6 and $9.4 million in fiscal 2002 and 2001,
respectively.


If amortization expenses related to goodwill that
will no longer be amortized when FAS 142 is adopted had been
excluded from operating expenses for each of fiscal years ended
September 30, 2002, 2001 and 2000, earnings per share would
have been as follows:

|                                 |                                     |                          |   |         |   |      |   |         |   |  |   |       | 
|-------------------------------- | ----------------------------------- | ------------------------ | - | ------- | - | ---- | - | ------- | - |  | - | ----- | 
|                                 |                                     |                         
|                                 |                                     | Year Ended September 30,
|                                 |                                     |                         
|                                 |                                     | 2002                     |   | 2001    |   | 2000
|                                 |                                     |                          |   |         |   |     
|Net income (loss):               |                                     |                          |   |         |   |      |   |         |   |  |   |      
|                                 | Reported net income (loss)          |                          | $ | (67,599 | ) |      | $ | (13,357 | ) |  | $ | 998   | 
|                                 | Goodwill and workforce amortization |                          |   | 8,897   |   |      |   | 9,724   |   |  |   | 1,333 | 
|                                 |                                     |                          |   |         |   |      |   |         |   |  |   |      
|                                 | Adjusted net income (loss)          |                          | $ | (58,702 | ) |      | $ | (3,633  | ) |  | $ | 2,331 | 
|                                 |                                     |                          |   |         |   |      |   |         |   |  |   |      
|Basic income (loss) per share:   |                                     |                          |   |         |   |      |   |         |   |  |   |      
|                                 | Reported net income (loss)          |                          | $ | (6.49   | ) |      | $ | (1.32   | ) |  | $ | 0.11  | 
|                                 | Goodwill and workforce amortization |                          |   | .85     |   |      |   | .96     |   |  |   | .15   | 
|                                 |                                     |                          |   |         |   |      |   |         |   |  |   |      
|                                 | Adjusted net income (loss)          |                          | $ | (5.64   | ) |      | $ | (0.36   | ) |  | $ | 0.26  | 
|                                 |                                     |                          |   |         |   |      |   |         |   |  |   |      
|Diluted income (loss) per share: |                                     |                          |   |         |   |      |   |         |   |  |   |      
|                                 | Reported net income (loss)          |                          | $ | (6.49   | ) |      | $ | (1.32   | ) |  | $ | 0.10  | 
|                                 | Goodwill and workforce amortization |                          |   | .85     |   |      |   | .96     |   |  |   | .13   | 
|                                 |                                     |                          |   |         |   |      |   |         |   |  |   |      
|                                 | Adjusted net income (loss)          |                          | $ | (5.64   | ) |      | $ | (0.36   | ) |  | $ | 0.23  | 
|                                 |                                     |                          |   |         |   |      |   |         |   |  |   |      




Item 7A.     Quantitative
and Qualitative Disclosures About Market Risk



| |                   
| | ------------------
| | Interest Rate Risk

We do not use derivative financial instruments in
our investment portfolio. 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, 2002 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 and most of our
revenues are generated in the United States of America.
Accordingly, our results of operations are not subject to
foreign exchange rate fluctuations. Gains and losses from such
fluctuations have not been incurred by us to date.

33



---



##### Table of Contents






Item 8.     Financial
Statements and Supplementary Data

INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

|                              |                                                                                                                          |      |  |       | 
|----------------------------- | ------------------------------------------------------------------------------------------------------------------------ | ---- |  | ----- | 
|                              |                                                                                                                          | Page
|                              |                                                                                                                          |     
|Financial Statements:         |                                                                                                                          |      |  |      
|                              | Report of Independent Accountants                                                                                        |      |  | 35    | 
|                              | Consolidated Balance Sheets as of
    September 30, 2002 and 2001                                                        |      |  | 36    | 
|                              | Consolidated Statements of Operations for the
    years ended September 30, 2002, 2001 and 2000                          |      |  | 37    | 
|                              | Consolidated Statements of Stockholders
    Equity for the years ended September 30, 2002, 2001 and 2000                |      |  | 38    | 
|                              | Consolidated Statements of Cash Flows for the
    years ended September 30, 2002, 2001 and 2000                          |      |  | 39    | 
|                              | Notes to Consolidated Financial Statements                                                                               |      |  | 40-54 | 
|                             
|Financial Statement Schedule: |                                                                                                                          |      |  |      
|                              | Schedule II Valuation and Qualifying
    Accounts and Reserves for the years ended September 30,
    2002, 2001 and 2000 |      |  | 61    | 

34



---



##### Table of Contents






REPORT OF INDEPENDENT ACCOUNTANTS

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

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, 2002 and 2001, and the
results of their operations and their cash flows for each of the
three years in the period ended September 30, 2002 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 the financial statement schedule are the responsibility of
the Companys management; our responsibility is to express
an opinion on these financial statements and the financial
statement schedule based on our audits. We conducted our audits
of these statements in accordance with auditing standards
generally accepted in the United States of America, which
require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of
material misstatement. An audit 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.



| |                           
| | --------------------------
| | PricewaterhouseCoopers LLP

San Jose, California

October 21, 2002


35



---



##### Table of Contents



HIFN, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)


|                                                        |                                                                                                                                |                            |        |         |        |   |         |         |         | 
|------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------ | -------------------------- | ------ | ------- | ------ | - | ------- | ------- | ------- | 
|                                                        |                                                                                                                                |                           
|                                                        |                                                                                                                                | September 30,             
|                                                        |                                                                                                                                |                           
|                                                        |                                                                                                                                | 2002                       |        | 2001   
|                                                        |                                                                                                                                |                            |        |        
|ASSETS                                                 
|CURRENT ASSETS:                                         |                                                                                                                                |                            |        |         |        |   |         |        
|                                                        | Cash and cash equivalents                                                                                                      |                            | $      | 53,060  |        |   | $       | 54,600  |        
|                                                        | Short-term investments                                                                                                         |                            |        | 1,606   |        |   |         | 10,151  |        
|                                                        | Accounts receivable, net of allowance for
    doubtful accounts
    of $164 and $171, respectively                             |                            |        | 2,263   |        |   |         | 3,814   |        
|                                                        | Inventories                                                                                                                    |                            |        | 704     |        |   |         | 1,685   |        
|                                                        | Deferred income taxes                                                                                                          |                            |        |        |        |   |         | 3,424   |        
|                                                        | Prepaid expenses and other current assets                                                                                      |                            |        | 2,788   |        |   |         | 3,598   |        
|                                                        |                                                                                                                                |                            |        |         |        |   |         |        
|                                                        |                                                                                                                                | Total current assets       |        |         | 60,421 |   |         |         | 77,272  | 
|Property and equipment, net                             |                                                                                                                                |                            | 2,580  |         |        |   | 4,111   |        
|Deferred income taxes                                   |                                                                                                                                |                            |       |         |        |   | 3,836   |        
|Intangible assets, net                                  |                                                                                                                                |                            | 7,567  |         |        |   | 40,049  |        
|Other assets                                            |                                                                                                                                |                            | 1,711  |         |        |   | 1,542   |        
|                                                        |                                                                                                                                |                            |        |         |        |   |         |        
|                                                        |                                                                                                                                | $                          | 72,279 |         |        | $ | 126,810 |        
|                                                        |                                                                                                                                |                            |        |         |        |   |         |        
|LIABILITIES AND STOCKHOLDERS
    EQUITY               
|CURRENT LIABILITIES:                                    |                                                                                                                                |                            |        |         |        |   |         |        
|                                                        | Accounts payable                                                                                                               |                            | $      | 3,686   |        |   | $       | 2,404   |        
|                                                        | Accrued expenses and other current liabilities                                                                                 |                            |        | 11,937  |        |   |         | 4,571   |        
|                                                        |                                                                                                                                |                            |        |         |        |   |         |        
|                                                        |                                                                                                                                | Total current liabilities  |        |         | 15,623 |   |         |         | 6,975   | 
|                                                        |                                                                                                                                |                            |        |         |        |   |         |        
|Commitments and contingencies (Note 11 and Note
    12) |                                                                                                                                |                            |        |         |        |   |         |        
|                                                       
|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;
    10,492,000 and 10,184,000 shares issued and outstanding |                            |        | 10      |        |   |         | 10      |        
|                                                        | Additional paid-in capital                                                                                                     |                            |        | 123,265 |        |   |         | 121,670 |        
|                                                        | Deferred stock compensation                                                                                                    |                            |        | (593    | )      |   |         | (3,418  | )      
|                                                        | Retained earnings (accumulated deficit)                                                                                        |                            |        | (66,026 | )      |   |         | 1,573   |        
|                                                        |                                                                                                                                |                            |        |         |        |   |         |        
|                                                        |                                                                                                                                | Total stockholders equity |        |         | 56,656 |   |         |         | 119,835 | 
|                                                        |                                                                                                                                |                            |        |         |        |   |         |        
|                                                        |                                                                                                                                | $                          | 72,279 |         |        | $ | 126,810 |        
|                                                        |                                                                                                                                |                            |        |         |        |   |         |        

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

36



---



##### Table of Contents



HIFN, INC.

CONSOLIDATED STATEMENTS OF
OPERATIONS

(in thousands, except per share data)


|                                                          |                                                    |                                    |         |        |        |      |         |        |        |   |       |        |        | 
|--------------------------------------------------------- | -------------------------------------------------- | ---------------------------------- | ------- | ------ | ------ | ---- | ------- | ------ | ------ | - | ----- | ------ | ------ | 
|                                                          |                                                    |                                   
|                                                          |                                                    | Year Ended September 30,          
|                                                          |                                                    |                                   
|                                                          |                                                    | 2002                               |         | 2001   |        | 2000
|                                                          |                                                    |                                    |         |        |        |     
|Net revenues:                                             |                                                    |                                    |         |        |        |      |         |        |        |   |       |       
|                                                          | Processors                                         |                                    | $       | 17,087 |        |      | $       | 36,492 |        |   | $     | 40,235 |       
|                                                          | Software licenses and other                        |                                    |         | 4,704  |        |      |         | 6,512  |        |   |       | 4,603  |       
|                                                          |                                                    |                                    |         |        |        |      |         |        |        |   |       |       
|                                                          |                                                    | Total net revenues                 |         |        | 21,791 |      |         |        | 43,004 |   |       |        | 44,838 | 
|                                                          |                                                    |                                    |         |        |        |      |         |        |        |   |       |       
|Costs and operating expenses:                             |                                                    |                                    |         |        |        |      |         |        |        |   |       |       
|                                                          | Cost of revenues  processors                      |                                    |         | 6,230  |        |      |         | 13,681 |        |   |       | 9,622  |       
|                                                          | Cost of revenues  software licenses
    and other |                                    |         | 183    |        |      |         | 147    |        |   |       | 382    |       
|                                                          | Research and development                           |                                    |         | 18,221 |        |      |         | 18,569 |        |   |       | 14,577 |       
|                                                          | Sales and marketing                                |                                    |         | 8,445  |        |      |         | 9,462  |        |   |       | 8,172  |       
|                                                          | General and administrative                         |                                    |         | 12,309 |        |      |         | 7,705  |        |   |       | 5,147  |       
|                                                          | Amortization of intangibles and goodwill           |                                    |         | 10,480 |        |      |         | 11,093 |        |   |       | 1,619  |       
|                                                          | Impairment of intangibles and goodwill             |                                    |         | 27,366 |        |      |         |       |        |   |       |       |       
|                                                          | Purchased in-process research & development        |                                    |         | 1,137  |        |      |         |       |        |   |       | 4,085  |       
|                                                          |                                                    |                                    |         |        |        |      |         |        |        |   |       |       
|                                                          |                                                    | Total costs and operating expenses |         |        | 84,371 |      |         |        | 60,657 |   |       |        | 43,604 | 
|                                                          |                                                    |                                    |         |        |        |      |         |        |        |   |       |       
|Income (loss) from operations                             |                                                    |                                    | (62,580 | )      |        |      | (17,653 | )      |        |   | 1,234 |       
|Interest income                                           |                                                    |                                    | 1,075   |        |        |      | 2,715   |        |        |   | 4,216 |       
|Interest expense                                          |                                                    |                                    | (8      | )      |        |      | (15     | )      |        |   | (5    | )     
|Other expense, net                                        |                                                    |                                    | (72     | )      |        |      | (64     | )      |        |   | (66   | )     
|                                                          |                                                    |                                    |         |        |        |      |         |        |        |   |       |       
|Income (loss) before income taxes                         |                                                    |                                    | (61,585 | )      |        |      | (15,017 | )      |        |   | 5,379 |       
|Provision for (benefit from) income taxes                 |                                                    |                                    | 6,014   |        |        |      | (1,660  | )      |        |   | 4,381 |       
|                                                          |                                                    |                                    |         |        |        |      |         |        |        |   |       |       
|Net income (loss)                                         |                                                    | $                                  | (67,599 | )      |        | $    | (13,357 | )      |        | $ | 998   |       
|                                                          |                                                    |                                    |         |        |        |      |         |        |        |   |       |       
|Net income (loss) per share:                              |                                                    |                                    |         |        |        |      |         |        |        |   |       |       
|                                                          | Basic                                              |                                    | $       | (6.49  | )      |      | $       | (1.32  | )      |   | $     | 0.11   |       
|                                                          |                                                    |                                    |         |        |        |      |         |        |        |   |       |       
|                                                          | Diluted                                            |                                    | $       | (6.49  | )      |      | $       | (1.32  | )      |   | $     | 0.10   |       
|                                                          |                                                    |                                    |         |        |        |      |         |        |        |   |       |       
|Shares used in computing net income
    (loss) per share: |                                                    |                                    |         |        |        |      |         |        |        |   |       |       
|                                                          | Basic                                              |                                    |         | 10,417 |        |      |         | 10,141 |        |   |       | 9,017  |       
|                                                          |                                                    |                                    |         |        |        |      |         |        |        |   |       |       
|                                                          | Diluted                                            |                                    |         | 10,417 |        |      |         | 10,141 |        |   |       | 10,055 |       
|                                                          |                                                    |                                    |         |        |        |      |         |        |        |   |       |       

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

37



---



##### Table of Contents



HIFN, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS
EQUITY

(in thousands)


|                              |                                                                                     |              |        |          |  |              |    |              |  |               |        |        |   |   |         |        |   |   |         |         |   |   |         |         |  
|----------------------------- | ----------------------------------------------------------------------------------- | ------------ | ------ | -------- |  | ------------ | -- | ------------ |  | ------------- | ------ | ------ | - | - | ------- | ------ | - | - | ------- | ------- | - | - | ------- | ------- | -
|                              |                                                                                     |              |        |          |  |              |    | Retained     |  |              
|                              |                                                                                     | Common Stock |        | Deferred |  | Additional   |    | Earnings     |  | Total        
|                              |                                                                                     |              |        | Stock    |  | Paid-In      |    | (Accumulated |  | Stockholders
|                              |                                                                                     | Shares       |        | Amount   |  | Compensation |    | Capital      |  | Deficit)      |        | Equity
|                              |                                                                                     |              |        |          |  |              |    |              |  |               |        |       
|Balance at September 30, 1999 |                                                                                     |              | 8,699  |          |  | $            | 9  |              |  | $             | (208   | )      |   | $ | 62,316  |        |   | $ | 13,932  |         |   | $ | 76,049  |        
|                              | Issuance of common stock upon exercise of options                                   |              |        | 315      |  |              |    |             |  |               |        |       |   |   |         | 1,611  |   |   |         |        |   |   |         | 1,611   |  
|                              | Purchase of Apptitude, Inc.                                                         |              |        | 972      |  |              |    | 1            |  |               |        |       |   |   |         | 38,328 |   |   |         |        |   |   |         | 38,329  |  
|                              | Deferred stock compensation                                                         |              |        |         |  |              |    |             |  |               |        | (8,620 | ) |   |         | 8,620  |   |   |         |        |   |   |         |        |  
|                              | Amortization of deferred stock compensation                                         |              |        |         |  |              |    |             |  |               |        | 1,368  |   |   |         |       |   |   |         |        |   |   |         | 1,368   |  
|                              | Issuance of common stock under employee stock
    purchase plan                     |              |        | 21       |  |              |    |             |  |               |        |       |   |   |         | 625    |   |   |         |        |   |   |         | 625     |  
|                              | Tax benefit from employee stock plans                                               |              |        |         |  |              |    |             |  |               |        |       |   |   |         | 5,211  |   |   |         |        |   |   |         | 5,211   |  
|                              | Net income                                                                          |              |        |         |  |              |    |             |  |               |        |       |   |   |         |       |   |   |         | 998     |   |   |         | 998     |  
|                              |                                                                                     |              |        |          |  |              |    |              |  |               |        |        |   |   |         |        |   |   |         |         |   |   |         |        
|Balance at September 30, 2000 |                                                                                     |              | 10,007 |          |  |              | 10 |              |  |               | (7,460 | )      |   |   | 116,711 |        |   |   | 14,930  |         |   |   | 124,191 |        
|                              | Issuance of common stock upon exercise of options                                   |              |        | 134      |  |              |    |             |  |               |        |       |   |   |         | 421    |   |   |         |        |   |   |         | 421     |  
|                              | Amortization of deferred stock compensation                                         |              |        |         |  |              |    |             |  |               |        | 3,865  |   |   |         |       |   |   |         |        |   |   |         | 3,865   |  
|                              | Reduction in deferred stock compensation due to
    terminations                    |              |        |         |  |              |    |             |  |               |        | 177    |   |   |         | (177   | ) |   |         |        |   |   |         |        |  
|                              | Issuance of common stock under employee stock
    purchase plan                     |              |        | 43       |  |              |    |             |  |               |        |       |   |   |         | 845    |   |   |         |        |   |   |         | 845     |  
|                              | Tax benefit from employee stock plans                                               |              |        |         |  |              |    |             |  |               |        |       |   |   |         | 3,870  |   |   |         |        |   |   |         | 3,870   |  
|                              | Net loss                                                                            |              |        |         |  |              |    |             |  |               |        |       |   |   |         |       |   |   |         | (13,357 | ) |   |         | (13,357 | )
|                              |                                                                                     |              |        |          |  |              |    |              |  |               |        |        |   |   |         |        |   |   |         |         |   |   |         |        
|Balance at September 30, 2001 |                                                                                     |              | 10,184 |          |  |              | 10 |              |  |               | (3,418 | )      |   |   | 121,670 |        |   |   | 1,573   |         |   |   | 119,835 |        
|                              | Issuance of common stock upon exercise of options                                   |              |        | 88       |  |              |    |             |  |               |        |       |   |   |         | 237    |   |   |         |        |   |   |         | 237     |  
|                              | Amortization of deferred stock compensation                                         |              |        |         |  |              |    |             |  |               |        | 1,079  |   |   |         |       |   |   |         |        |   |   |         | 1,079   |  
|                              | Reduction in deferred stock compensation due to
    voluntary stock option exchange |              |        |         |  |              |    |             |  |               |        | 1,746  |   |   |         |       |   |   |         |        |   |   |         | 1,746   |  
|                              | Issuance of common stock for purchase of
    intellectual property                  |              |        | 150      |  |              |    |             |  |               |        |       |   |   |         | 2,202  |   |   |         |        |   |   |         | 2,202   |  
|                              | Issuance of common stock under employee stock
    purchase plan                     |              |        | 70       |  |              |    |             |  |               |        |       |   |   |         | 705    |   |   |         |        |   |   |         | 705     |  
|                              | Reversal of tax benefit from employee stock
    plans, net of recognized benefit    |              |        |         |  |              |    |             |  |               |        |       |   |   |         | (1,549 | ) |   |         |        |   |   |         | (1,549  | )
|                              | Net loss                                                                            |              |        |         |  |              |    |             |  |               |        |       |   |   |         |       |   |   |         | (67,599 | ) |   |         | (67,599 | )
|                              |                                                                                     |              |        |          |  |              |    |              |  |               |        |        |   |   |         |        |   |   |         |         |   |   |         |        
|Balance at September 30, 2002 |                                                                                     |              | 10,492 |          |  | $            | 10 |              |  | $             | (593   | )      |   | $ | 123,265 |        |   | $ | (66,026 | )       |   | $ | 56,656  |        
|                              |                                                                                     |              |        |          |  |              |    |              |  |               |        |        |   |   |         |        |   |   |         |         |   |   |         |        

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

38



---



##### Table of Contents



HIFN, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

(in thousands)


|                                                 |                                                                                                        |                                                                                     |                                                            |         |        |        |        |         |        |        |         |         |        |         |  
|------------------------------------------------ | ------------------------------------------------------------------------------------------------------ | ----------------------------------------------------------------------------------- | ---------------------------------------------------------- | ------- | ------ | ------ | ------ | ------- | ------ | ------ | ------- | ------- | ------ | ------- | -
|                                                 |                                                                                                        |                                                                                    
|                                                 |                                                                                                        | Year Ended September 30,                                                           
|                                                 |                                                                                                        |                                                                                    
|                                                 |                                                                                                        | 2002                                                                                |                                                            | 2001    |        | 2000  
|                                                 |                                                                                                        |                                                                                     |                                                            |         |        |       
|Cash flows from operating activities:            |                                                                                                        |                                                                                     |                                                            |         |        |        |        |         |        |        |         |        
|                                                 | Net income (loss)                                                                                      |                                                                                     | $                                                          | (67,599 | )      |        | $      | (13,357 | )      |        | $       | 998     |       
|                                                 | Adjustments to reconcile net income (loss) to net
    cash provided by (used in) operating activities: |                                                                                     |                                                            |         |        |        |        |         |        |        |         |         |       
|                                                 |                                                                                                        | Depreciation and amortization of property and
    equipment                         |                                                            |         | 1,867  |        |        |         | 1,674  |        |         |         | 1,116  |        
|                                                 |                                                                                                        | Amortization of intangibles and goodwill                                            |                                                            |         | 10,977 |        |        |         | 11,093 |        |         |         | 1,619  |        
|                                                 |                                                                                                        | Impairment of intangibles and goodwill                                              |                                                            |         | 27,366 |        |        |         |       |        |         |         |       |        
|                                                 |                                                                                                        | Amortization of deferred stock compensation                                         |                                                            |         | 1,079  |        |        |         | 3,865  |        |         |         | 1,368  |        
|                                                 |                                                                                                        | Reduction in deferred stock compensation due to
    voluntary stock option exchange |                                                            |         | 1,746  |        |        |         |       |        |         |         |       |        
|                                                 |                                                                                                        | Change in allowance for doubtful accounts                                           |                                                            |         | 10     |        |        |         | (198   | )      |         |         | 118    |        
|                                                 |                                                                                                        | Purchased in-process research and development                                       |                                                            |         | 1,137  |        |        |         |       |        |         |         | 4,085  |        
|                                                 |                                                                                                        | Deferred income taxes                                                               |                                                            |         | 5,672  |        |        |         | 362    |        |         |         | 7,141  |        
|                                                 | Changes in assets and liabilities:                                                                     |                                                                                     |                                                            |         |        |        |        |         |        |        |         |         |       
|                                                 |                                                                                                        | Accounts receivable                                                                 |                                                            |         | 1,541  |        |        |         | 2,132  |        |         |         | 1,301  |        
|                                                 |                                                                                                        | Inventories                                                                         |                                                            |         | 981    |        |        |         | (330   | )      |         |         | 288    |        
|                                                 |                                                                                                        | Prepaid expenses and other current assets                                           |                                                            |         | 848    |        |        |         | (2,377 | )      |         |         | (476   | )      
|                                                 |                                                                                                        | Intangibles and other assets                                                        |                                                            |         | (198   | )      |        |         | (1,324 | )      |         |         | (18    | )      
|                                                 |                                                                                                        | Accounts payable                                                                    |                                                            |         | 1,282  |        |        |         | (410   | )      |         |         | 352    |        
|                                                 |                                                                                                        | Income taxes payable                                                                |                                                            |         |       |        |        |         |       |        |         |         | (1,300 | )      
|                                                 |                                                                                                        | Accrued expenses and other current liabilities                                      |                                                            |         | 7,393  |        |        |         | 122    |        |         |         | (1,666 | )      
|                                                 |                                                                                                        |                                                                                     |                                                            |         |        |        |        |         |        |        |         |        
|                                                 |                                                                                                        |                                                                                     | Net cash provided by (used in) by operating
    activities |         |        | (5,898 | )      |         |        | 1,252  |         |         |        | 14,926  |  
|                                                 |                                                                                                        |                                                                                     |                                                            |         |        |        |        |         |        |        |         |        
|Cash flows from investing activities:            |                                                                                                        |                                                                                     |                                                            |         |        |        |        |         |        |        |         |        
|                                                 | Sales (purchases) of short-term investments, net                                                       |                                                                                     |                                                            | 8,545   |        |        |        | (5,024  | )      |        |         | (5,127  | )     
|                                                 | Acquisition of Apptitude, net of cash and cash
    equivalents                                         |                                                                                     |                                                            |        |        |        |        |        |        |        |         | (19,484 | )     
|                                                 | Purchase of intellectual property                                                                      |                                                                                     |                                                            | (4,767  | )      |        |        |        |        |        |         | (1,049  | )     
|                                                 | Purchases of property and equipment                                                                    |                                                                                     |                                                            | (336    | )      |        |        | (2,517  | )      |        |         | (1,790  | )     
|                                                 |                                                                                                        |                                                                                     |                                                            |         |        |        |        |         |        |        |         |        
|                                                 |                                                                                                        |                                                                                     | Net cash provided by (used in) investing
    activities    |         |        | 3,442  |        |         |        | (7,541 | )       |         |        | (27,450 | )
|                                                 |                                                                                                        |                                                                                     |                                                            |         |        |        |        |         |        |        |         |        
|Cash flows from financing activities:            |                                                                                                        |                                                                                     |                                                            |         |        |        |        |         |        |        |         |        
|                                                 | Proceeds from issuance of common stock, net                                                            |                                                                                     |                                                            | 942     |        |        |        | 1,266   |        |        |         | 2,236   |       
|                                                 | Payment on line of credit and capital lease
    obligations                                            |                                                                                     |                                                            | (26     | )      |        |        | (65     | )      |        |         | (110    | )     
|                                                 |                                                                                                        |                                                                                     |                                                            |         |        |        |        |         |        |        |         |        
|                                                 |                                                                                                        |                                                                                     | Net cash provided by financing activities                  |         |        | 916    |        |         |        | 1,201  |         |         |        | 2,126   |  
|                                                 |                                                                                                        |                                                                                     |                                                            |         |        |        |        |         |        |        |         |        
|Net decrease in cash and cash equivalents        |                                                                                                        |                                                                                     | (1,540                                                     | )       |        |        | (5,088 | )       |        |        | (10,398 | )      
|Cash and cash equivalents at beginning of period |                                                                                                        |                                                                                     | 54,600                                                     |         |        |        | 59,688 |         |        |        | 70,086  |        
|                                                 |                                                                                                        |                                                                                     |                                                            |         |        |        |        |         |        |        |         |        
|Cash and cash equivalents at end of period       |                                                                                                        | $                                                                                   | 53,060                                                     |         |        | $      | 54,600 |         |        | $      | 59,688  |        
|                                                 |                                                                                                        |                                                                                     |                                                            |         |        |        |        |         |        |        |         |        



---

Supplemental cash flow information (Note 6)

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

39



---



##### Table of Contents



Note 1  The
Company

hi/fn, inc. (the Company or
Hifn) is a flow classification and network security
specialist company supplying most major network equipment
vendors with patented technology to improve network packet
processing. The Company designs, develops and markets
high-performance, multi-protocol packet processors 
semiconductor devices and software. The Companys products
are used in networking and storage equipment such as routers,
remote access concentrators, switches, broadband access
equipment, network interface cards, firewalls and back-up
storage devices. Operations and revenues to date have been
generated primarily from sales in the United States.

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 the Companys
Common Stock on April 19, 1999.

The Company anticipates 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, Apptitude
Acquisition Corporation, Hifn Limited and Hifn Netherlands B.V.
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.



| |                  
| | -----------------
| | 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 purchased with an original maturity of three months
or less to be cash equivalents. These investments consist of
money-market funds, commercial paper and municipal bonds 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 municipal bonds. The carrying amount of
these investments approximated fair value due to the short
maturities or variable interest rates for investments with long
term maturities. At September 30, 2002, all short-term
investments were classified as available-for-sale and carried at
fair value. Unrealized gains or losses at September 30,
2002 were not material.

40



---



##### Table of Contents





| |                             
| | ----------------------------
| | Concentration of Credit Risk

Financial instruments, which potentially subject
the Company to credit risk, consist principally of cash and cash
equivalents and trade accounts receivable. The Company places
its temporary cash investments in money market funds and
commercial paper with high credit quality financial institutions.

Substantially all of the Companys customers
are original equipment manufacturers (OEMs) or the
manufacturing subcontractors of OEMs, which results in
concentrated credit risk with respect to the Companys
trade receivables. At September 30, 2002, three customers
accounted for 21%, 18% and 17%, respectively, of total accounts
receivable. At September 30, 2001 one customer accounted
for 75% of the total accounts receivable balance. Management
believes that its credit policies substantially mitigate such
concentrated credit risk. Bad debt expenses were not significant
in fiscal 2002, 2001 and 2000.



| |                                        
| | ---------------------------------------
| | Fair Value of Financial
    Instruments

The Companys financial instruments,
including cash, cash equivalents, short-term investments,
accounts receivable, accounts payable and capital lease
obligations 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. The
Company provides for obsolete, slow moving or excess inventories
in the period when obsolescence or inventories in excess of
expected demand is first identified. Such inventory reserves
permanently reduce the cost basis of the underlying inventory.
Inventories are comprised solely of finished goods, which are
manufactured by third party foundries for resale by the Company.



| |                  
| | -----------------
| | Long-Lived Assets

The Company reviews long-lived assets for
impairment whenever events or changes in circumstances indicate
that the carrying amounts of long-lived assets may not be
recoverable. The Company assesses the impairment of its
long-lived assets 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 fair
value of such assets.



| |                       
| | ----------------------
| | Property and Equipment

Property and equipment are stated at cost.
Depreciation is computed using the straight-line method with 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.
Repair and maintenance costs are expensed as incurred.



| |                                             
| | --------------------------------------------
| | Goodwill and Purchased Intangible
    Assets

Goodwill and purchased intangible assets are
carried at cost less accumulated amortization. Amortization is
computed using the straight-line method over the economic lives
of the respective assets, generally two to five years. During
the year ended September 30, 2002, the Company recorded an
impairment charge of $27.4 million (see Note 3).



| |                    
| | -------------------
| | Revenue Recognition

The Company derives revenue from the sale of
processors and software license fees. Customers comprise
primarily of OEMs and, to a lesser extent, distributors.

41



---



##### Table of Contents



Revenue from the sale of processors is recognized
upon shipment when persuasive evidence of an arrangement exists,
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.

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 estimated based on 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. Development costs incurred in 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, 2002 or 2001.



| |                         
| | ------------------------
| | Stock-Based Compensation

The Company accounts for its employee and stock
option plans and employee stock purchase plans in accordance
with provisions of the Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to
Employees (APB 25) 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, are presented in Note 7.



| |             
| | ------------
| | 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 8). Valuation
allowances are established when necessary to reduce deferred tax
assets when management estimates, based on available objective
evidence, that it is more likely than not that the benefit will
not be realizable as a deferred tax asset. During the year ended
September 30, 2002, the Company recognized a valuation
allowance of $15.4 million.



| |                     
| | --------------------
| | Comprehensive Income

Effective October 1, 1998, the Company
adopted the provision of Statement of Financial Accounting
Standards No. 130 (SFAS 130),
Reporting Comprehensive Income. SFAS 130
establishes standards for

42



---



##### Table of Contents



reporting comprehensive income and its components
in financial statements. Comprehensive income, as defined,
includes all changes in equity during a period from non-owner
sources. To date, the Company has not had any components of
other comprehensive income.




| |                                     
| | ------------------------------------
| | Recent Accounting
    Pronouncements

In June of 2002, the FASB issued Statement of
Financial Accounting Standards No. 146
(SFAS 146), Accounting for Costs
Associated with Exit or Disposal Activities. SFAS 146
addresses significant issues regarding the recognition,
measurement, and reporting of costs that are associated with
exit and disposal activities, including restructuring activities
that are currently accounted for under EITF No. 94-3
(EITF No. 94-3), Liability Recognition
for Certain Employee Termination Benefits and Other Costs to
Exit an Activity (including Certain Costs Incurred in a
Restructuring). The scope of SFAS 146 also includes
costs related to terminating a contract that is not a capital
lease and termination benefits that employees who are
involuntarily terminated receive under the terms of a one-time
benefit arrangement that is not an ongoing benefit arrangement
or an individual deferred-compensation contract. SFAS 146
will be effective for exit or disposal activities that are
initiated after December 31, 2002 and early application is
encouraged. We will adopt SFAS 146 during the fiscal
quarter ending March 31, 2003. The provisions of EITF
No. 94-3 shall continue to apply for an exit activity
initiated under an exit plan that met the criteria of EITF
No. 94-3 prior to the adoption of SFAS 146. The effect
on adoption of SFAS 146 will change on a prospective basis
the timing of when restructuring charges are recorded from a
commitment date approach to when the liability is incurred.

In April of 2002, the FASB issued Statement of
Financial Accounting Standards No. 145
(SFAS 145), Rescission of FASB Statements
No. 4, 44 and 64, Amendment of FASB Statement No. 13,
and Technical Corrections, which is effective for fiscal
years beginning after May 15, 2002. Under SFAS 145,
gains and losses from the extinguishment of debt should be
classified as extraordinary items only if they meet the criteria
of Accounting Principles Board Opinion No. 30.
SFAS 145 also addresses financial accounting and reporting
for capital leases that are modified in such a way as to give
rise to a new agreement classified as an operating lease. The
Company believes that the adoption of SFAS 145 will not
have a material impact on the financial position or results of
operations of the Company.

In August 2001, the FASB issued Statement of
Financial Accounting Standards No. 144
(SFAS 144), Accounting for the Impairment
or Disposal of Long-Lived Assets. SFAS 144 supersedes
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, and provides further guidance regarding the accounting
and disclosure of long-lived assets. The Company does not expect
the adoption of SFAS 144 on October 1, 2002 to have a
material effect on the Companys financial condition or
results of operation.

In June 2001, the FASB issued Statement of
Financial Accounting Standards No. 141
(SFAS 141), Business Combinations
and Statement of Financial Accounting Standards No. 142
(SFAS 142), Goodwill and Other Intangible
Assets. SFAS 141 will apply to all business
combinations that the Company enters into after June 30,
2001, and eliminates the pooling-of-interests method of
accounting. SFAS 142 is effective for fiscal years
beginning after December 15, 2001. Under the new
Statements, goodwill and intangible assets deemed to have
indefinite lives will no longer be amortized but will be subject
to annual impairment tests in accordance with the Statements.
Other intangible assets will continue to be amortized over their
useful lives. In addition, the Statements include provisions
upon adoption for the reclassification of certain existing
recognized intangibles as goodwill, reassessment of the useful
lives of existing recognized intangibles, reclassification of
certain intangibles out of previously reported goodwill and the
testing for impairment of existing goodwill and other
intangibles. The Company is required to adopt these Statements
for accounting for goodwill and other intangible assets
beginning October 1, 2002 at which time the Company will
cease amortization of goodwill. Net of the impairment charge of
$27.4 million recognized during the fourth quarter of
fiscal 2002, the net book value of goodwill at
September 30, 2002 was approximately $1.0 million.

43



---



##### Table of Contents



If amortization expenses related to goodwill that
will no longer be amortized when SFAS 142 is adopted had
been excluded from operating expenses for each of fiscal years
ended September 30, 2002, 2001 and 2000, earnings per share
would have been as follows:

|                                 |                                     |                          |   |         |   |      |   |         |   |  |   |       | 
|-------------------------------- | ----------------------------------- | ------------------------ | - | ------- | - | ---- | - | ------- | - |  | - | ----- | 
|                                 |                                     |                         
|                                 |                                     | Year Ended September 30,
|                                 |                                     |                         
|                                 |                                     | 2002                     |   | 2001    |   | 2000
|                                 |                                     |                          |   |         |   |     
|Net income (loss):               |                                     |                          |   |         |   |      |   |         |   |  |   |      
|                                 | Reported net income (loss)          |                          | $ | (67,599 | ) |      | $ | (13,357 | ) |  | $ | 998   | 
|                                 | Goodwill and workforce amortization |                          |   | 8,897   |   |      |   | 9,724   |   |  |   | 1,333 | 
|                                 |                                     |                          |   |         |   |      |   |         |   |  |   |      
|                                 | Adjusted net income (loss)          |                          | $ | (58,702 | ) |      | $ | (3,633  | ) |  | $ | 2,331 | 
|                                 |                                     |                          |   |         |   |      |   |         |   |  |   |      
|Basic income (loss) per share:   |                                     |                          |   |         |   |      |   |         |   |  |   |      
|                                 | Reported net income (loss)          |                          | $ | (6.49   | ) |      | $ | (1.32   | ) |  | $ | 0.11  | 
|                                 | Goodwill and workforce amortization |                          |   | .85     |   |      |   | .96     |   |  |   | .15   | 
|                                 |                                     |                          |   |         |   |      |   |         |   |  |   |      
|                                 | Adjusted net income (loss)          |                          | $ | (5.64   | ) |      | $ | (0.36   | ) |  | $ | 0.26  | 
|                                 |                                     |                          |   |         |   |      |   |         |   |  |   |      
|Diluted income (loss) per share: |                                     |                          |   |         |   |      |   |         |   |  |   |      
|                                 | Reported net income (loss)          |                          | $ | (6.49   | ) |      | $ | (1.32   | ) |  | $ | 0.10  | 
|                                 | Goodwill and workforce amortization |                          |   | .85     |   |      |   | .96     |   |  |   | .13   | 
|                                 |                                     |                          |   |         |   |      |   |         |   |  |   |      
|                                 | Adjusted net income (loss)          |                          | $ | (5.64   | ) |      | $ | (0.36   | ) |  | $ | 0.23  | 
|                                 |                                     |                          |   |         |   |      |   |         |   |  |   |      

Note 3  Acquisitions



| |                     
| | --------------------
| | Business Acquisition

In August 2000, the Company acquired all the
outstanding stock of Apptitude, Inc. (Apptitude), a
software development company, for $20 million in cash and
1.2 million shares of the Companys Common Stock in a
transaction accounted for under the purchase method. All
outstanding options of Apptitude were also assumed by the
Company. The results of operations of Apptitude have been
included in the consolidated statement of operations of the
Company from the date of acquisition. The purchase price of the
acquisition of $58.5 million, which included $127,000 in
estimated acquisition related costs. The purchase price was
allocated to assets acquired and liabilities assumed based on
their estimated fair value and an independent appraisal for all
other identifiable assets. The excess of the purchase price over
the net tangible and intangible assets acquired and liabilities
assumed was allocated to goodwill. The allocation of the
purchase price was as follows (in thousands):

|                                                                  |  |   |        |  
|----------------------------------------------------------------- |  | - | ------ | -
|Property and equipment                                            |  | $ | 205    |  
|Current and other assets                                          |  |   | 1,081  |  
|Deferred tax asset                                                |  |   | 3,905  |  
|Liabilities assumed                                               |  |   | (2,404 | )
|Goodwill                                                          |  |   | 47,121 |  
|Purchased in-process research and development                     |  |   | 4,085  |  
|Acquired developed and core technology, workforce
    and patents |  |   | 4,462  |  
|                                                                  |  |   |        |  
|                                                                  |  | $ | 58,455 |  
|                                                                  |  |   |        |  

The goodwill, acquired developed and core
technology, workforce and patents were recorded on the balance
sheet as intangibles and other assets and amortized on a
straight-line basis over periods ranging from two to five years.

The Company also provided for the issuance of
456,612 additional shares of its Common Stock relating to stock
options granted to Apptitude employees for retention purposes.
Deferred stock compensation of

44



---



##### Table of Contents



$8.3 million related to options assumed by
the Company was recognized during the fourth quarter of fiscal
2000 and is amortizable over a period of six months to four
years.


The following table represents unaudited proforma
information assuming that the acquisition took place at the
beginning of the periods presented (in thousands, except per
share data):

|                                 |  |                     |        |  
|-------------------------------- |  | ------------------- | ------ | -
|                                 |  | Twelve Months Ended
|                                 |  | September 30, 2000 
|                                 |  |                    
|                                 |  | (unaudited)        
|Net sales                        |  | $                   | 46,836 |  
|Net loss                         |  |                     | (8,579 | )
|Basic and diluted loss per share |  | $                   | (0.95  | )



| |                 
| | ----------------
| | Asset Impairment

During the fourth quarter of fiscal 2002, the
Company 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, was less than the
carrying amount of the assets associated with Apptitude and an
impairment charge was triggered under SFAS 121.
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 remaining carrying
value of goodwill at September 30, 2002 was approximately
$1.0 million. The Company will adopt SFAS 142 during the
first quarter of fiscal 2003, which will effectively replace
SFAS 121. In accordance with SFAS 142, the remaining carrying
value of goodwill will no longer be amortized, but will be
subject to annual impairment testing.



| |                  
| | -----------------
| | Asset Acquisition

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 based upon an independent
third party valuation conducted as of the date of acquisition.
The amount allocated to core technology and workforce of
$639,000 and $255,000, respectively, were recorded on the
balance sheet as intangible assets and are amortized on a
straight-line basis over a 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 was expensed at the time of
purchase as a one-time charge because technological feasibility
had not been established. Fixed asset amounted to $122,000.

Note 4  Balance Sheet
Details

|                                           |                      |                |       |      |  |   |       |       | 
|------------------------------------------ | -------------------- | -------------- | ----- | ---- |  | - | ----- | ----- | 
|                                           |                      |               
|                                           |                      | September 30, 
|                                           |                      |               
|                                           |                      | 2002           |       | 2001
|                                           |                      |                |       |     
|                                           |                      |               
|                                           |                      | (in thousands)
|Prepaid expenses and other current assets: |                      |                |       |      |  |   |       |      
|                                           | Prepaid income taxes |                | $     | 948  |  |   | $     | 2,420 | 
|                                           | Prepaid licenses     |                |       | 727  |  |   |       | 40    | 
|                                           | Prepaid maintenance  |                |       | 323  |  |   |       | 145   | 
|                                           | Prepaid rent         |                |       | 259  |  |   |       | 260   | 
|                                           | Other                |                |       | 531  |  |   |       | 733   | 
|                                           |                      |                |       |      |  |   |       |      
|                                           |                      | $              | 2,788 |      |  | $ | 3,598 |      
|                                           |                      |                |       |      |  |   |       |      

45



---



##### Table of Contents



|                                                |                                    |                |        |        |   |   |        |         |  
|----------------------------------------------- | ---------------------------------- | -------------- | ------ | ------ | - | - | ------ | ------- | -
|                                                |                                    |               
|                                                |                                    | September 30, 
|                                                |                                    |               
|                                                |                                    | 2002           |        | 2001  
|                                                |                                    |                |        |       
|                                                |                                    |               
|                                                |                                    | (in thousands)
|Property and equipment:                         |                                    |                |        |        |   |   |        |        
|                                                | Computer equipment                 |                | $      | 5,084  |   |   | $      | 4,833   |  
|                                                | Furniture and fixtures             |                |        | 1,191  |   |   |        | 1,158   |  
|                                                | Leasehold improvements             |                |        | 1,205  |   |   |        | 1,188   |  
|                                                | Office equipment                   |                |        | 615    |   |   |        | 580     |  
|                                                |                                    |                |        |        |   |   |        |        
|                                                |                                    |                | 8,095  |        |   |   | 7,759  |        
|                                                | Less: accumulated depreciation     |                |        | (5,515 | ) |   |        | (3,648  | )
|                                                |                                    |                |        |        |   |   |        |        
|                                                |                                    | $              | 2,580  |        |   | $ | 4,111  |        
|                                                |                                    |                |        |        |   |   |        |        
|Intangible assets:                              |                                    |                |        |        |   |   |        |        
|                                                | Developed and core technology      |                | $      | 8,871  |   |   | $      | 3,263   |  
|                                                | Workforce                          |                |        | 255    |   |   |        | 599     |  
|                                                | Patents                            |                |        | 600    |   |   |        | 600     |  
|                                                | Goodwill                           |                |        | 1,029  |   |   |        | 47,121  |  
|                                                | Purchased intellectual property    |                |        |       |   |   |        | 1,049   |  
|                                                |                                    |                |        |        |   |   |        |        
|                                                |                                    |                | 10,755 |        |   |   | 52,632 |        
|                                                | Less: accumulated amortization     |                |        | (3,188 | ) |   |        | (12,583 | )
|                                                |                                    |                |        |        |   |   |        |        
|                                                |                                    | $              | 7,567  |        |   | $ | 40,049 |        
|                                                |                                    |                |        |        |   |   |        |        
|Accrued expenses and other current liabilities: |                                    |                |        |        |   |   |        |        
|                                                | Deferred revenue                   |                | $      | 2,788  |   |   | $      | 2,433   |  
|                                                | Compensation and employee benefits |                |        | 1,367  |   |   |        | 1,005   |  
|                                                | Accrued vacant facility lease cost |                |        | 4,329  |   |   |        | 361     |  
|                                                | Accrued litigation settlement      |                |        | 2,700  |   |   |        |        |  
|                                                | Other                              |                |        | 753    |   |   |        | 772     |  
|                                                |                                    |                |        |        |   |   |        |        
|                                                |                                    | $              | 11,937 |        |   | $ | 4,571  |        
|                                                |                                    |                |        |        |   |   |        |        

Note 5  Net Income (Loss) Per
Share

Basic earnings per share is computed by dividing
net income (loss) available to common stockholders by the
weighted average number of common shares outstanding during the
period. Weighted average shares exclude shares subject to
repurchase by the Company. Diluted earnings per share gives
effect to all dilutive potential common shares outstanding
during the period including stock options, using the treasury
method, and convertible preferred stock, using the if-converted
method. In computing diluted earnings per share, the average
stock price for the period is used in determining the number of
shares assumed to be purchased from the exercise of stock
options.

46



---



##### Table of Contents



Following is a reconciliation of the calculation
of basic and diluted earnings per share for the periods
presented below (in thousands, except for per share amounts):

|                                                          |                                  |                          |         |        |   |      |         |        |   |   |     |        | 
|--------------------------------------------------------- | -------------------------------- | ------------------------ | ------- | ------ | - | ---- | ------- | ------ | - | - | --- | ------ | 
|                                                          |                                  |                         
|                                                          |                                  | Year Ended September 30,
|                                                          |                                  |                         
|                                                          |                                  | 2002                     |         | 2001   |   | 2000
|                                                          |                                  |                          |         |        |   |     
|Net income (loss)                                         |                                  | $                        | (67,599 | )      |   | $    | (13,357 | )      |   | $ | 998 |       
|                                                          |                                  |                          |         |        |   |      |         |        |   |   |     |       
|Shares used in computing net income
    (loss) per share: |                                  |                          |         |        |   |      |         |        |   |   |     |       
|                                                          | Basic                            |                          |         | 10,417 |   |      |         | 10,141 |   |   |     | 9,017  | 
|                                                          | Dilutive effect of stock options |                          |         |       |   |      |         |       |   |   |     | 1,038  | 
|                                                          |                                  |                          |         |        |   |      |         |        |   |   |     |       
|                                                          | Diluted                          |                          |         | 10,417 |   |      |         | 10,141 |   |   |     | 10,055 | 
|                                                          |                                  |                          |         |        |   |      |         |        |   |   |     |       
|Net income (loss) per share:                              |                                  |                          |         |        |   |      |         |        |   |   |     |       
|                                                          | Basic                            |                          | $       | (6.49  | ) |      | $       | (1.32  | ) |   | $   | 0.11   | 
|                                                          | Diluted                          |                          | $       | (6.49  | ) |      | $       | (1.32  | ) |   | $   | 0.10   | 

Options to purchase 3,439,366 and 3,521,688 and
787,249 shares of Common Stock at weighted average exercise
prices of $12.91, $26.77 and $54.32 per share were outstanding
at September 30, 2002, 2001 and 2000, respectively, but
were not included in the computation of diluted net loss per
share because their impact would be anti-dilutive.

Note 6  Supplemental Cash Flow
Information

|                                                              |                                                                |                          |   |       |  |  |   |       |  |  |   |        | 
|------------------------------------------------------------- | -------------------------------------------------------------- | ------------------------ | - | ----- |  |  | - | ----- |  |  | - | ------ | 
|                                                              |                                                                | 2002                     |   |       |  | 
|                                                              |                                                                |                          |   |       |  | 
|                                                              |                                                                |                          |   | 2001  |  | 
|                                                              |                                                                |                          |   |       |  | 
|                                                              |                                                                |                         
|                                                              |                                                                | Year Ended September 30,
|                                                              |                                                                |                         
|                                                              |                                                                |                          |   | 2000 
|                                                              |                                                                |                          |   |      
|                                                              |                                                                | )                       
|                                                              |                                                                | (in thousands           
|Supplemental cash flow information:                           |                                                                |                          |   |       |  |  |   |       |  |  |   |       
|                                                              | Cash paid during the year for interest                         |                          | $ | 8     |  |  | $ | 15    |  |  | $ | 5      | 
|                                                              | Cash paid during the year for income taxes                     |                          |   | 888   |  |  |   | 1,424 |  |  |   |       | 
|                                                              | Cash received during the year from refund of
    income taxes  |                          |   | 863   |  |  |   | 1,375 |  |  |   |       | 
|Supplemental non-cash investing and financing
    activities: |                                                                |                          |   |       |  |  |   |       |  |  |   |       
|                                                              | Common stock issued upon purchase of intellectual
    property |                          |   | 2,202 |  |  |   |      |  |  |   |       | 
|                                                              | Common stock issued upon acquisition of Apptitude              |                          |   |      |  |  |   |      |  |  |   | 38,456 | 

Note 7  Stock Options and
Employee Benefits



| |                           
| | --------------------------
| | Employee Stock Option Plan

The 1996 Equity Incentive Plan (the 1996
Plan) had 4,449,900 shares of the Companys
Common Stock reserved for issuance pursuant to nonqualified and
incentive stock options and restricted stock awards. The 1996
Plan is administered by the Board of Directors of the Company or
its designees and provides generally that nonqualified stock
options and restricted stock 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,
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.

47



---



##### Table of Contents



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, the Board of
Directors authorized an additional 500,000 shares 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.



| |                                    
| | -----------------------------------
| | Voluntary Stock Option
    Exchange

On November 15, 2001, the Company extended a
voluntary stock option exchange offer (the Exchange
Program) to its eligible employees whereby employees had
the opportunity to cancel options granted from January 29,
1999 through January 8, 2001, with exercise prices ranging
from $5.74 to $142.50, in exchange for new options to be issued
on June 18, 2002. On December 17, 2001, a total of
1,278,406 shares were tendered for exchange. The Company was
required to accelerate the amortization of previously recorded
deferred compensation related to options cancelled and,
accordingly, recognized approximately $1.7 million in
deferred compensation expense during the period ended
December 31, 2001. The number of shares granted in exchange
for the old options was subject to the applicable exchange
ratio: (i) for every old option to buy three shares of
Common Stock that was granted between January 29, 1999 and
January 14, 2000, a new option was granted to buy two
shares of Common Stock and (ii) for every old option to buy
four shares of Common Stock that was granted between
January 15, 2000 and January 8, 2001, a new option was
granted to buy three shares of Common Stock. Additionally,
participating employees who were required to cancel all stock
options granted during the six month period prior to the
Exchange Program offer were entitled to receive an equal number
of shares subject to the new options. On June 18, 2002, the
Company granted new options to purchase 910,278 shares of
the Companys Common Stock in exchange for the options
surrendered under the Exchange Program at an exercise price of
$6.66, the fair market value of the Companys common stock
on the new grant date. The new options have the same vesting
schedule as if the old options continued to vest through the new
grant date. The voluntary stock option exchange was accounted
for as a modification of stock option awards for purposes of the
fair value disclosures in this footnote.

48



---



##### Table of Contents



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

|                              |                              |                   |           |             |   |                     |           |            |   |   |       |       | 
|----------------------------- | ---------------------------- | ----------------- | --------- | ----------- | - | ------------------- | --------- | ---------- | - | - | ----- | ----- | 
|                              |                              |                   |           |             |   | Weighted Average   
|                              |                              |                   |           |             |   | Exercise Price (per
|                              |                              | Options Available |           | Options     |   | share) of Options  
|                              |                              | for Grant         |           | Outstanding |   | Outstanding        
|                              |                              |                   |           |             |   |                    
|Balance at September 30, 1999 |                              |                   | 679,262   |             |   |                     | 1,658,394 |            |   | $ | 18.57 |      
|                              | Additional shares authorized |                   |           | 425,000     |   |                     |           |            |   |   |       |       | 
|                              | Additional shares reserved   |                   |           | 687,142     |   |                     |           |            |   |   |       | 25.22 | 
|                              | Options granted              |                   |           | (2,017,142  | ) |                     |           | 2,017,142  |   |   |       | 36.96 | 
|                              | Options exercised            |                   |           |            |   |                     |           | (314,248   | ) |   |       | 5.12  | 
|                              | Options cancelled            |                   |           | 603,681     |   |                     |           | (609,536   | ) |   |       | 32.28 | 
|                              |                              |                   |           |             |   |                     |           |            |   |   |       |      
|Balance at September 30, 2000 |                              |                   | 377,943   |             |   |                     | 2,751,752 |            |   |   | 30.55 |      
|                              | Additional shares authorized |                   |           | 1,975,000   |   |                     |           |            |   |   |       |       | 
|                              | Options granted              |                   |           | (1,583,423  | ) |                     |           | 1,583,423  |   |   |       | 19.90 | 
|                              | Options exercised            |                   |           |            |   |                     |           | (134,322   | ) |   |       | 3.14  | 
|                              | Options cancelled            |                   |           | 664,394     |   |                     |           | (679,165   | ) |   |       | 30.74 | 
|                              |                              |                   |           |             |   |                     |           |            |   |   |       |      
|Balance at September 30, 2001 |                              |                   | 1,433,914 |             |   |                     | 3,521,688 |            |   |   | 26.77 |      
|                              | Additional shares authorized |                   |           | 1,000,000   |   |                     |           |            |   |   |       |       | 
|                              | Options granted              |                   |           | (1,542,913  | ) |                     |           | 1,542,913  |   |   |       | 8.88  | 
|                              | Options exercised            |                   |           |            |   |                     |           | (88,637    | ) |   |       | 2.68  | 
|                              | Options cancelled            |                   |           | 1,169,611   |   |                     |           | (1,536,598 | ) |   |       | 41.17 | 
|                              |                              |                   |           |             |   |                     |           |            |   |   |       |      
|Balance at September 30, 2002 |                              |                   | 2,060,612 |             |   |                     | 3,439,366 |            |   |   | 12.91 |      
|                              |                              |                   |           |             |   |                     |           |            |   |   |       |      

The following table summarizes options
outstanding at September 30, 2002 and related weighted
average exercise prices and lives as follows:

|                |  |                                     |           |                 |  |                |      |          |  |                |        |  |  |  |           |  |  |   |        | 
|--------------- |  | ----------------------------------- | --------- | --------------- |  | -------------- | ---- | -------- |  | -------------- | ------ |  |  |  | --------- |  |  | - | ------ | 
|                |  |                                     |           |                 |  |                |      |         
|                |  |                                     |           | Options Vested 
|                |  | Options Outstanding and Exercisable |           | and Exercisable
|                |  |                                     |           |                
|                |  |                                     |           | Weighted        |  |                |      |         
|                |  |                                     |           | Average         |  | Weighted       |      |          |  | Weighted      
|Range of        |  |                                     |           | Remaining Life  |  | Average        |      |          |  | Average       
|Exercise Prices |  | Quantity                            |           | (in years)      |  | Exercise Price |      | Quantity |  | Exercise Price
|                |  |                                     |           |                 |  |                |      |          |  |               
|$  0.60-$  5.00 |  |                                     | 466,968   |                 |  |                | 5.78 |          |  | $              | 3.29   |  |  |  | 445,565   |  |  | $ | 3.24   | 
|5.09-   6.00    |  |                                     | 132,629   |                 |  |                | 9.27 |          |  |                | 5.73   |  |  |  | 22,361    |  |  |   | 5.74   | 
|6.09-   6.66    |  |                                     | 929,405   |                 |  |                | 7.74 |          |  |                | 6.64   |  |  |  | 522,094   |  |  |   | 6.66   | 
|7.87-  13.11    |  |                                     | 357,876   |                 |  |                | 8.91 |          |  |                | 11.55  |  |  |  | 69,210    |  |  |   | 10.28  | 
|13.93-  13.94   |  |                                     | 59,000    |                 |  |                | 8.77 |          |  |                | 13.93  |  |  |  | 17,540    |  |  |   | 13.93  | 
|14.69           |  |                                     | 536,301   |                 |  |                | 8.42 |          |  |                | 14.69  |  |  |  | 208,165   |  |  |   | 14.69  | 
|14.72-  16.00   |  |                                     | 518,020   |                 |  |                | 8.92 |          |  |                | 15.76  |  |  |  | 81,378    |  |  |   | 15.87  | 
|16.19-  42.00   |  |                                     | 357,825   |                 |  |                | 7.90 |          |  |                | 27.53  |  |  |  | 190,354   |  |  |   | 29.19  | 
|42.56-  71.38   |  |                                     | 66,342    |                 |  |                | 7.40 |          |  |                | 48.30  |  |  |  | 57,802    |  |  |   | 48.87  | 
|125.50          |  |                                     | 15,000    |                 |  |                | 6.97 |          |  |                | 125.50 |  |  |  | 11,249    |  |  |   | 125.50 | 
|                |  |                                     |           |                 |  |                |      |          |  |                |        |  |  |  |           |  |  |   |        | 
|0.60- 125.50    |  |                                     | 3,439,366 |                 |  |                | 7.96 |          |  |                | 12.91  |  |  |  | 1,625,718 |  |  |   | 12.39  | 
|                |  |                                     |           |                 |  |                |      |          |  |                |        |  |  |  |           |  |  |   |        | 

The weighted average fair value of options
granted during 2002, 2001 and 2000 were $8.88, $17.79 and
$41.17, respectively. The fair value of each stock award is
estimated on the date of grant using the Black-Scholes model
with the following assumptions used for grants during 2002, 2001
and 2000: annual dividend yield of 0.0% for all periods;
risk-free annual interest rates of 3.77%, 4.66% and 6.27%,
respectively; a weighted

49



---



##### Table of Contents



average expected stock award term of
4.0 years for all periods; and an expected volatility
factor of 80%, 70% and 80%, respectively.




| |                             
| | ----------------------------
| | 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 400,000. The price of shares purchased under the
ESPP is the lower of 85% of the fair market value of the shares
on the first day of each semi-annual offering period, or 85% of
the fair market value of the shares on the last day of the
semi-annual offering period. Pursuant to the ESPP, 69,746 and
43,175 shares were issued during fiscal 2002 and 2001,
respectively, at weighted average prices of $10.10 and $19.58
per share, respectively.

The fair value of shares issued during fiscal
2002, 2001 and 2000 were $11.89, $29.58 and $16.03,
respectively. The fair value of each stock award is estimated on
the date of grant using the Black-Scholes model with the
following assumptions used for grants during fiscal 2002, 2001
and 2000: annual dividend yield of 0.0% for all periods;
risk-free annual interest rates of 1.92%, 4.66% and 5.99%;
weighted average expected stock award term of 0.50 years
for each of the fiscal years; and an expected volatility factor
of 80%, 70% and 80%.

For the fiscal years ended September 30,
2002 and 2001, the Company received $281,000 and
$3.9 million, respectively, in tax benefit from the
exercise of non-qualified options, on the disposition of stock
acquired with incentive stock options and through the employee
stock purchase plan.



| |                            
| | ---------------------------
| | Deferred Stock Compensation

In connection with certain employee stock option
grants made during the fiscal years ended September 30,
2000 and 1999, the Company recognized deferred stock
compensation of $303,000 and $239,000 (excluding the acquisition
of Apptitude), respectively. Additionally, during fiscal 2000,
the Company recognized deferred stock compensation of
$8.3 million in connection with the acquisition of
Apptitude as disclosed in Note 3. Deferred stock compensation is
being amortized on the straight-line basis over the vesting
period of the related options, ranging from six months to four
years. Amortization of deferred stock compensation of
$1.1 million and $3.9 million was recorded during the
fiscal years ended September 30, 2002 and 2001,
respectively. In connection with the voluntary option exchange
program, the Company recognized an additional $1.7 million
in deferred compensation amortization related to options
cancelled under such option exchange program. Future
compensation charges are subject to reduction for any employee
who terminates prior to expiration of such employees
option vesting period.

50



---



##### Table of Contents





| |                       
| | ----------------------
| | Fair Value Disclosures

Had compensation expense for the Companys
stock-based compensation plans been determined based on the
method prescribed by SFAS 123, the Companys net income
(loss) and net income (loss) per share would have been as
follows (in thousands, except per share information):

|                             |             |                          |   |         |       |      |   |         |       |   |   |        |       |  
|---------------------------- | ----------- | ------------------------ | - | ------- | ----- | ---- | - | ------- | ----- | - | - | ------ | ----- | -
|                             |             |                         
|                             |             | Year Ended September 30,
|                             |             |                         
|                             |             | 2002                     |   | 2001    |       | 2000
|                             |             |                          |   |         |       |     
|Net income (loss):           |             |                          |   |         |       |      |   |         |       |   |   |       
|                             | As reported |                          | $ | (67,599 | )     |      | $ | (13,357 | )     |   | $ | 998    |      
|                             | Pro forma   |                          |   | (77,098 | )     |      |   | (23,613 | )     |   |   | (5,915 | )    
|Net income (loss) per share: |             |                          |   |         |       |      |   |         |       |   |   |       
|                             | As reported |                          |   |         |       |      |   |         |       |   |   |        |      
|                             |             | Basic                    |   | $       | (6.49 | )    |   | $       | (1.32 | ) |   | $      | 0.11  |  
|                             |             | Diluted                  |   |         | (6.49 | )    |   |         | (1.32 | ) |   |        | 0.10  |  
|                             | Pro forma   |                          |   |         |       |      |   |         |       |   |   |        |      
|                             |             | Basic                    |   |         | (7.40 | )    |   |         | (2.33 | ) |   |        | (0.66 | )
|                             |             | Diluted                  |   |         | (7.40 | )    |   |         | (2.33 | ) |   |        | (0.66 | )



| |                     
| | --------------------
| | 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 of up to 25% of the eligible annual
salary, subject to the maximum limitation allowed by the
Internal Revenue Code.

Note 8  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 components of the provision for (benefit
from) income taxes were as follows (in thousands):

|                                          |         |                          |       |       |  |      |        |        |   |   |       |       | 
|----------------------------------------- | ------- | ------------------------ | ----- | ----- |  | ---- | ------ | ------ | - | - | ----- | ----- | 
|                                          |         |                         
|                                          |         | Year Ended September 30,
|                                          |         |                         
|                                          |         | 2002                     |       | 2001  |  | 2000
|                                          |         |                          |       |       |  |     
|Current:                                  |         |                          |       |       |  |      |        |        |   |   |       |      
|                                          | Federal |                          | $     |      |  |      | $      | 1,475  |   |   | $     | 2,130 | 
|                                          | State   |                          |       |      |  |      |        | 310    |   |   |       | 168   | 
|                                          | Foreign |                          |       | 55    |  |      |        | 63     |   |   |       | 108   | 
|                                          |         |                          |       |       |  |      |        |        |   |   |       |      
|                                          |         |                          | 55    |       |  |      | 1,848  |        |   |   | 2,406 |      
|                                          |         |                          |       |       |  |      |        |        |   |   |       |      
|Deferred:                                 |         |                          |       |       |  |      |        |        |   |   |       |      
|                                          | Federal |                          |       | 5,959 |  |      |        | (2,393 | ) |   |       | 1,641 | 
|                                          | State   |                          |       |      |  |      |        | (1,115 | ) |   |       | 334   | 
|                                          |         |                          |       |       |  |      |        |        |   |   |       |      
|                                          |         |                          | 5,959 |       |  |      | (3,508 | )      |   |   | 1,975 |      
|                                          |         |                          |       |       |  |      |        |        |   |   |       |      
|Provision for (benefit from) income taxes |         | $                        | 6,014 |       |  | $    | (1,660 | )      |   | $ | 4,381 |      
|                                          |         |                          |       |       |  |      |        |        |   |   |       |      

51



---



##### Table of Contents



The components of deferred taxes are as follows
(in thousands):

|                                         |  |               |         |      |  |   |       |  
|---------------------------------------- |  | ------------- | ------- | ---- |  | - | ----- | -
|                                         |  |              
|                                         |  | September 30,
|                                         |  |              
|                                         |  | 2002          |         | 2001
|                                         |  |               |         |     
|Net operating loss                       |  | $             | 8,100   |      |  | $ | 2,727 |  
|Property and equipment                   |  |               | 448     |      |  |   | 352   |  
|Inventory valuation accounts             |  |               | 1,407   |      |  |   | 1,690 |  
|Accruals and reserves                    |  |               | 3,570   |      |  |   | 1,734 |  
|Research and development credit          |  |               | 1,907   |      |  |   | 1,334 |  
|Amortization of intangibles and goodwill |  |               | 21      |      |  |   | (577  | )
|                                         |  |               |         |      |  |   |       |  
|                                         |  |               | 15,453  |      |  |   | 7,260 |  
|Valuation allowance                      |  |               | (15,453 | )    |  |   |      |  
|                                         |  |               |         |      |  |   |       |  
|                                         |  | $             |        |      |  | $ | 7,260 |  
|                                         |  |               |         |      |  |   |       |  

As of September 30, 2002, the Company had
approximately $13.7 million of federal and
$7.2 million of state net operating loss carryforwards
available to offset future taxable income. The Company also had
approximately $780,000 of federal and $1.7 million of state
research and development tax credit carryforwards. These tax
attributes expire in varying amounts between 2004 and 2021.
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
$7.0 million of the valuation allowance relates to income
tax benefits arising from the exercise of stock options which
will be credited directly to stockholders equity if the
associated deferred tax assets are realized.

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

|                                                        |  |                          |         |      |  |      |        |   |  |   |       |  
|------------------------------------------------------- |  | ------------------------ | ------- | ---- |  | ---- | ------ | - |  | - | ----- | -
|                                                        |  |                         
|                                                        |  | Year Ended September 30,
|                                                        |  |                         
|                                                        |  | 2002                     |         | 2001 |  | 2000
|                                                        |  |                          |         |      |  |     
|Tax at federal statutory rate                           |  | $                        | (20,939 | )    |  | $    | (5,084 | ) |  | $ | 1,829 |  
|State taxes, net of federal tax benefit                 |  |                          |        |      |  |      | (805   | ) |  |   | 539   |  
|Nondeductible intangible amortization and
    write-off |  |                          | 12,295  |      |  |      | 3,204  |   |  |   | 1,905 |  
|Stock compensation                                      |  |                          | 960     |      |  |      | 1,310  |   |  |   | 465   |  
|Change in valuation allowance                           |  |                          | 13,629  |      |  |      |       |   |  |   |      |  
|Other                                                   |  |                          | 69      |      |  |      | (285   | ) |  |   | (357  | )
|                                                        |  |                          |         |      |  |      |        |   |  |   |       |  
|                                                        |  | $                        | 6,014   |      |  | $    | (1,660 | ) |  | $ | 4,381 |  
|                                                        |  |                          |         |      |  |      |        |   |  |   |       |  

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 9  Segment Reporting

Effective October 1, 1998, the Company
adopted the provisions of Statement of Financial Accounting
Standards No. 131 (SFAS 131),
Disclosures about Segments of an Enterprise and Related
Information. SFAS 131 supersedes SFAS No. 14,
Financial Reporting for Segments of a Business
Enterprise, replacing the Industry Segment
approach with the Management approach. The
management approach designates the internal organization that is
used by management for making operating decisions and assessing
performance as the source of the Companys reportable
segments. SFAS 131 also requires disclosures about products
and services, geographic areas, and major customers. The Company
operates in one industry segment

52



---



##### Table of Contents



comprising the design, development and marketing
of high-performance, multi-protocol packet
processors  semiconductor devices. The Company
operates in one geographic area, being the U.S.




| |                
| | ---------------
| | Major Customers

Revenues from one customer, through its
manufacturing subcontractor, represented 35%, 36% and 36% of the
Companys net revenues for the fiscal years ended
September 30, 2002, 2001 and 2000, respectively. Revenues
from another customer represented 11% of net revenues for the
fiscal year ended September 30, 2002. Revenues from another
customer, through its manufacturing subcontractor, represented
17% and 35% of the Companys net revenues for fiscal years
ended September 30, 2001 and 2000, respectively.

Note 10  Severance Costs

In September 2002, the Company announced a plan
to align its costs and expenses through a reduction in
workforce. The plan involved the elimination of
27 positions consisting of one operations employee,
17 research and development employees, seven sales and
marketing employees and two general and administrative
employees. The Company recorded an accrual for severance and
employment related costs of $423,000 which is included in
accrued liabilities as of September 30, 2002.

Note 11  Commitments



| |       
| | ------
| | Leases

The Company occupies its facilities under several
non-cancelable operating leases that expire at various dates
through December 2007, and which contain renewal options. Future
minimum lease payments for operating leases are as follows (in
thousands):

|                                 |                              |   |       |        | 
|-------------------------------- | ---------------------------- | - | ----- | ------ | 
|Fiscal year ending September 30, |                              |   |       |       
|2003                             |                              | $ | 3,170 |       
|2004                             |                              |   | 2,794 |       
|2005                             |                              |   | 2,192 |       
|2006                             |                              |   | 871   |       
|Thereafter                       |                              |   | 1,134 |       
|                                 |                              |   |       |       
|                                 | Total minimum lease payments |   | $     | 10,161 | 
|                                 |                              |   |       |       

Total rental expense under operating leases was
$3.1 million, $2.9 million and $1.5 million for
fiscal years ended September 30, 2002, 2001 and 2000,
respectively. The Company recorded sub-lease income of $274,000
and $439,000 during fiscal years ended September 30, 2001
and 2000, respectively. The Company accrued vacant facility
lease costs of $4.3 million for lease commitments of
$824,000, $855,000, $850,000 and $2.0 million for 2003,
2004, 2005, 2006 and thereafter, respectively.

Note 12  Litigation

In October and November 1999, six purported class
action complaints were filed in the United States District Court
for the Northern District of California (the District
Court) against the Company and certain of its officers and
directors. On March 17, 2000, these complaints were
consolidated into In re Hi/fn, Inc. Securities Litigation
No. 99-04531 SI. The consolidated complaint was filed on
behalf of persons who purchased the Companys stock between
July 26, 1999 and October 7, 1999 (the class
period). The complaint sought unspecified money damages
and alleged that the Company and certain of its officers and
directors violated federal securities laws in connection with
various public statements made during the class period. In
August 2000, the District Court dismissed the complaint as to
all defendants, other than Raymond J. Farnham and the
Company. In February 2001, the District Court certified the
purported class. On May 15, 2002, the parties entered into
a Memorandum of Understanding to settle all claims in the
consolidated securities class action. Under the terms of the
settlement, all claims will be dismissed without any admission
of liability or wrongdoing by any defendant, and the shareholder
class will receive $9.5 million,

53



---



##### Table of Contents



comprised of $6.8 million in cash, which was
contributed by the Companys insurance carriers, and the
balance in the Companys Common Stock with a minimum of
270,000 shares to be issued. On June 10, 2002, the District
Court entered an order preliminarily approving the Stipulation
of Settlement and providing for notice and an opportunity to
object to the shareholder class. The District Court approved the
settlement and entered a Final Judgment and Order of Dismissal
with Prejudice on September 4, 2002. In accordance with the
settlement, the Company will issue at least 270,000 shares
of its Common Stock, supplementing the allotment with cash or
additional shares of Common Stock to compensate for shortfall in
fair value below $2.7 million. To the extent that the
trading price of the Common Stock exceeds $10.00 at the time of
distribution, the Company would recognize an additional
litigation settlement charge equal to the aggregate fair market
value of the 270,000 shares of Common Stock less the
$2.7 million already recognized.


In March 2002, two purported shareholder
derivative actions were filed, one in the United States District
Court for the Northern District of California and one in the
Superior Court of California for the County of Santa Clara (the
federal derivative action and the state
derivative action, respectively). These complaints were
filed against the Company and certain of its current and former
officers and directors. The derivative complaints alleged
violations of California Corporations Code Section 25402,
breach of fiduciary duty and waste of corporate assets, based on
the same facts and events alleged in the class action. On
June 7, 2002, the federal court entered an order granting
plaintiffs motion to voluntarily dismiss the federal
derivative action without prejudice. On June 26, 2002, the
state court sustained the Companys demurrer, with leave to
amend, on the ground that plaintiff had failed to plead facts
showing that he was excused from making demand on the
Companys board of directors. The court also ordered
limited discovery relating solely to the issue whether demand is
excused. The court did not rule upon the demurrer to the
derivative complaint filed by the individual director
defendants. The Company and the individual director defendants
believe the allegations contained in the complaint are without
merit and intend to defend the action vigorously.

Note 13  Supplementary
Quarterly Financial Data



| |                                      
| | -------------------------------------
| | Quarterly Information
    (unaudited)

|                                      |  |                                          |         |         |  |          |         |             |  |   |        |   |  |   |        |  
|------------------------------------- |  | ---------------------------------------- | ------- | ------- |  | -------- | ------- | ----------- |  | - | ------ | - |  | - | ------ | -
|                                      |  |                                         
|                                      |  | Three Months Ended                      
|                                      |  |                                         
|                                      |  | September 30                             |         | June 30 |  | March 31 |         | December 31
|                                      |  |                                          |         |         |  |          |         |            
|                                      |  |                                         
|                                      |  | (In thousands, except per share amounts)
|Fiscal 2002:                          |  |                                          |         |         |  |          |         |             |  |   |        |   |  |   |        |  
|Net revenues                          |  | $                                        | 4,176   |         |  | $        | 5,485   |             |  | $ | 5,726  |   |  | $ | 6,404  |  
|Total costs and operating expenses    |  |                                          | 42,127  |         |  |          | 14,534  |             |  |   | 14,398 |   |  |   | 13,312 |  
|Net loss                              |  |                                          | (37,780 | )       |  |          | (18,666 | )           |  |   | (6,140 | ) |  |   | (5,013 | )
|Net loss per share, basic and diluted |  |                                          | (3.63   | )       |  |          | (1.78   | )           |  |   | (0.59  | ) |  |   | (0.49  | )
|Fiscal 2001:                          |  |                                          |         |         |  |          |         |             |  |   |        |   |  |   |        |  
|Net revenues                          |  | $                                        | 6,492   |         |  | $        | 6,575   |             |  | $ | 13,828 |   |  | $ | 16,109 |  
|Total costs and operating expenses    |  |                                          | 12,461  |         |  |          | 16,830  |             |  |   | 15,678 |   |  |   | 15,688 |  
|Net loss                              |  |                                          | (4,395  | )       |  |          | (6,884  | )           |  |   | (1,722 | ) |  |   | (356   | )
|Net loss per share, basic and diluted |  |                                          | (0.43   | )       |  |          | (0.68   | )           |  |   | (0.17  | ) |  |   | (0.04  | )

54



---



##### Table of Contents








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

Not applicable.




PART III






|         |                                                       
|-------- | ------------------------------------------------------
|Item 10. | Directors and Executive Officers of the
    Registrant

The information required by Item 10
regarding our directors is incorporated by reference from
Hifns Proxy Statement for the fiscal year ended
September 30, 2002 which we will file with the Securities
and Exchange Commission within 120 days after the end of
the fiscal year covered by this report. 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, 2002.






|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management

The information required by this item is
incorporated by reference from Hifns Proxy Statement for
the fiscal year ended September 30, 2002.






|         |                                                   
|-------- | --------------------------------------------------
|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, 2002.






|         |                        
|-------- | -----------------------
|Item 14. | Controls and Procedures

(a) Evaluation of disclosure controls and
procedures. Based on their evaluation as of a date within
90 days of the filing date of this Annual Report on
Form 10-K, the Companys principal executive officer
and principal financial officer have concluded that the
Companys disclosure controls and procedures (as defined in
Rules 13a-14(c) and 15d-14(c) under the Securities Exchange
Act of 1934 (the Exchange Act) are effective to
ensure that information required to be disclosed by the Company
in reports that it files or submits under the Exchange Act is
recorded, processed, summarized and reported within the time
periods specified in Securities and Exchange Commission rules
and forms.

(b) Changes in internal controls.
There were no significant changes in the Companys internal
controls or in other factors that could significantly affect
these controls subsequent to the date of their evaluation. There
were no significant deficiencies or material weaknesses, and
therefore there were no corrective actions taken.




PART IV






|         |                                                                    
|-------- | -------------------------------------------------------------------
|Item 15. | Exhibits, Financial Statement Schedules and
    Reports on Form 8-K

(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 61.                                                                      
|
| | 3. | Exhibits
    The exhibits listed in the accompanying Index to
    Exhibits are filed as part of this Annual Report on
    Form 10-K.

55



---



##### Table of Contents



|        |          |         |  |                                                                                                                                                           
|------- | -------- | ------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|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.                                                                                                        
|        | 23.1     |         |  | Consent of PricewaterhouseCoopers LLP,
    independent accountants.                                                                                       
|        | 24.1     |         |  | Power of Attorney (see page 58).                                                                                                                          
|        | 99.1     |         |  | 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.
|        | 99.2     |         |  | 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.

56



---



##### Table of Contents





|    |                                                                                                                                                                                                                                 
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   | 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.



| |     |                     
| | --- | --------------------
| | (b) | Reports on Form 8-K:

None.



| |     |                                                                                   
| | --- | ----------------------------------------------------------------------------------
| | (c) | Exhibits: See Item 14(a) above.                                                   
|
| | (d) | Financial Statement Schedules 
     Schedule II  Valuation Qualifying Accounts 61

57



---



##### Table of Contents






SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, 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.                                                                                                                                              
|
| | /s/ CHRISTOPHER G. KENBER 
     _______________________________________ 
     Christopher G. Kenber 
     Chairman, President and Chief Executive Officer

Dated: December 13, 2002

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, this Report has been signed below by the
following persons in the capacities and on December 13,
2002.

|                                                 |  |                                                                                                                    
|------------------------------------------------ |  | -------------------------------------------------------------------------------------------------------------------
|Signature                                        |  | Title                                                                                                              
|                                                 |  |                                                                                                                    
|/s/ CHRISTOPHER G. KENBER(Christopher G. Kenber) |  | Chairman, President and
    Chief Executive Officer
    (Principal Executive Officer)                              
|                                                
|/s/ WILLIAM R. WALKER(William R. Walker)         |  | Vice President, Finance, Chief
    Financial Officer and Secretary
    (Principal Financial and Accounting Officer)
|                                                
|/s/ DOUGLAS L. WHITING(Douglas L. Whiting)       |  | Chief Scientist and Director                                                                                       
|                                                
|/s/ DAVID A. NORMAN(David A. Norman)             |  | Vice Chairman of the Board of Directors                                                                            
|                                                
|/s/ DENNIS DECOSTE(Dennis DeCoste)               |  | Director                                                                                                           
|                                                
|/s/ TAHER ELGAMAL(Taher Elgamal)                 |  | Director                                                                                                           
|                                                
|/s/ ROBERT W. JOHNSON(Robert W. Johnson)         |  | Director                                                                                                           
|                                                
|/s/ ALBERT E. SISTO(Albert E. Sisto)             |  | Director                                                                                                           

58



---



##### Table of Contents



CERTIFICATION PURSUANT TO

SECTION 302


THE SARBANES-OXLEY ACT OF 2002


I, Christopher G. Kenber, certify that:



| |    |                                                                                                                                                                                                                                                                                                                                             
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. | I have reviewed this annual report on
    Form 10-K of Hifn, Inc.;                                                                                                                                                                                                                                                                          
|
| | 2. | Based on my knowledge, this annual report does
    not contain any untrue statement of a material fact or omit to
    state a material fact necessary to make the statements made, in
    light of the circumstances under which such statements were
    made, not misleading with respect to the period covered by this
    annual report;
|
| | 3. | Based on my knowledge, the financial statements,
    and other financial information included in this annual report,
    fairly present in all material respects the financial condition,
    results of operations and cash flows of the registrant as of,
    and for, the periods presented in this annual report;                       
|
| | 4. | The registrants other certifying officers
    and I are responsible for establishing and maintaining
    disclosure controls and procedures (as defined in Exchange Act
    Rules 13a-14 and 15d-14) for the registrant and we have:                                                                                                       



| |    |                                                                                                                                                                                                                                                                                                             
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | designed such disclosure controls and procedures
    to ensure that material information relating to the registrant,
    including its consolidated subsidiaries, is made known to us by
    others within those entities, particularly during the period in
    which this annual report is being prepared;
|
| | b) | evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) | presented in this annual report our conclusions
    about the effectiveness of the disclosure controls and
    procedures based on our evaluation as of the Evaluation Date;                                                                                                                                



| |    |                                                                                                                                                                                                                                                                
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 5. | The registrants other certifying officers
    and I have disclosed, based on our most recent evaluation, to
    the registrants auditors and the audit committee of
    registrants board of directors (or persons performing the
    equivalent functions):



| |    |                                                                                                                                                                                                                                                                                                                   
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | all significant deficiencies in the design or
    operation of internal controls which could adversely affect the
    registrants ability to record, process, summarize and
    report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) | any fraud, whether or not material, that involves
    management or other employees who have a significant role in the
    registrants internal controls; and                                                                                                                                                    



| |    |                                                                                                                                                                                                                                                                                                                                                                                                               
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 6. | The registrants other certifying officers
    and I have indicated in this annual report whether or not there
    were significant changes in internal controls or in other
    factors that could significantly affect internal controls
    subsequent to the date of our most recent evaluation, including
    any corrective actions with regard to significant deficiencies
    and material weaknesses.

|                        |  |                                                                                                                                         
|----------------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------
|Date: December 13, 2002 |  | /s/ CHRISTOPHER G. KENBER
    ------------------------------------------------
    Christopher G. Kenber
    Chairman, President and CEO

59



---



##### Table of Contents



CERTIFICATION PURSUANT TO

SECTION 302


THE SARBANES-OXLEY ACT OF 2002


I, William R. Walker, certify that:



| |    |                                                                                                                                                                                                                                                                                                                                             
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. | I have reviewed this annual report on
    Form 10-K of Hifn, Inc.;                                                                                                                                                                                                                                                                          
|
| | 2. | Based on my knowledge, this annual report does
    not contain any untrue statement of a material fact or omit to
    state a material fact necessary to make the statements made, in
    light of the circumstances under which such statements were
    made, not misleading with respect to the period covered by this
    annual report;
|
| | 3. | Based on my knowledge, the financial statements,
    and other financial information included in this annual report,
    fairly present in all material respects the financial condition,
    results of operations and cash flows of the registrant as of,
    and for, the periods presented in this annual report;                       
|
| | 4. | The registrants other certifying officers
    and I are responsible for establishing and maintaining
    disclosure controls and procedures (as defined in Exchange Act
    Rules 13a-14 and 15d-14) for the registrant and we have:                                                                                                       



| |    |                                                                                                                                                                                                                                                                                                             
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | designed such disclosure controls and procedures
    to ensure that material information relating to the registrant,
    including its consolidated subsidiaries, is made known to us by
    others within those entities, particularly during the period in
    which this annual report is being prepared;
|
| | b) | evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) | presented in this annual report our conclusions
    about the effectiveness of the disclosure controls and
    procedures based on our evaluation as of the Evaluation Date;                                                                                                                                



| |    |                                                                                                                                                                                                                                                                
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 5. | The registrants other certifying officers
    and I have disclosed, based on our most recent evaluation, to
    the registrants auditors and the audit committee of
    registrants board of directors (or persons performing the
    equivalent functions):



| |    |                                                                                                                                                                                                                                                                                                                   
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | all significant deficiencies in the design or
    operation of internal controls which could adversely affect the
    registrants ability to record, process, summarize and
    report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) | any fraud, whether or not material, that involves
    management or other employees who have a significant role in the
    registrants internal controls; and                                                                                                                                                    



| |    |                                                                                                                                                                                                                                                                                                                                                                                                               
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 6. | The registrants other certifying officers
    and I have indicated in this annual report whether or not there
    were significant changes in internal controls or in other
    factors that could significantly affect internal controls
    subsequent to the date of our most recent evaluation, including
    any corrective actions with regard to significant deficiencies
    and material weaknesses.

|                        |  |                                                                                                                             
|----------------------- |  | ----------------------------------------------------------------------------------------------------------------------------
|Date: December 13, 2002 |  | /s/ WILLIAM R. WALKER
    ------------------------------------------------
    William R. Walker
    Chief Financial Officer

60



---



##### Table of Contents



HIFN, INC.

SCHEDULE II

VALUATION AND QUALIFYING ACCOUNTS AND
RESERVES


|                                  |                               |                |   |            |  |            |   |            |  |            |   |     |  |  |   |      |   |  |   |     | 
|--------------------------------- | ----------------------------- | -------------- | - | ---------- |  | ---------- | - | ---------- |  | ---------- | - | --- |  |  | - | ---- | - |  | - | --- | 
|                                  |                               |                |   | Additions  |  | Additions  |   |            |  |           
|                                  |                               | Balance at     |   | Charged to |  | Charged to |   |            |  | Balance at
|                                  |                               | Beginning      |   | Costs and  |  | Other      |   |            |  | End of    
|                                  |                               | of Period      |   | Expenses   |  | Accounts   |   | Deductions |  | Period    
|                                  |                               |                |   |            |  |            |   |            |  |           
|                                  |                               |               
|                                  |                               | (in thousands)
|Deducted from accounts receivable |                               |                |   |            |  |            |   |            |  |            |   |     |  |  |   |      |   |  |   |    
|Allowance for doubtful accounts:  |                               |                |   |            |  |            |   |            |  |            |   |     |  |  |   |      |   |  |   |    
|                                  | Year ended September 30, 2000 |                | $ | 251        |  |            | $ | 37         |  |            | $ | 105 |  |  | $ | (24  | ) |  | $ | 369 | 
|                                  | Year ended September 30, 2001 |                |   | 369        |  |            |   | 309        |  |            |   |    |  |  |   | (507 | ) |  |   | 171 | 
|                                  | Year ended September 30, 2002 |                |   | 171        |  |            |   | 75         |  |            |   |    |  |  |   | (82  | ) |  |   | 164 | 

61



---



##### Table of Contents






INDEX TO EXHIBITS

|         |  |                                                                                                                                                           
|-------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit  |  |                                                                                                                                                           
|Number   |  | Exhibit                                                                                                                                                   
|         |  |                                                                                                                                                           
|3.1*     |  | Form of Third Amended and Restated Certificate of
    Incorporation of hi/fn, inc.                                                                        
|3.2*     |  | Amended and Restated Bylaws of hi/fn, inc.                                                                                                                
|10.1*    |  | Amended and Restated 1996 Equity Incentive Plan
    of hi/fn, inc.                                                                                        
|10.2*    |  | Assignment, Assumption and License Agreement
    dated as of November 21, 1996 between Stac, Inc. and hi/fn,
    inc.                                     
|10.3*    |  | Cross License Agreement dated as of
    November 21, 1996 between Stac, Inc. and hi/fn, inc.                                                              
|10.4*    |  | Form of Distribution Agreement.                                                                                                                           
|10.5*    |  | Form of Employee Benefits and Other Matters
    Allocation Agreement.                                                                                     
|10.6*    |  | Form of Tax Allocation and Indemnity Agreement.                                                                                                           
|10.7*    |  | Form of Transitional Services Agreement.                                                                                                                  
|10.8*    |  | Form of Indemnification Agreement.                                                                                                                        
|10.9*    |  | Agreement dated as of April 1, 1994 between
    International Business Machines Corporation and Stac, Inc.
    (Program Patent License Agreement).        
|10.10*   |  | Agreement dated as of April 1, 1994 between
    International Business Machines Corporation and Stac, Inc.
    (Cross License Agreement).                 
|10.11*   |  | License Agreement dated as of June 20, 1994
    between Microsoft Corporation and Stac, Inc.                                                              
|10.12*   |  | License Agreement dated as of February 16,
    1996 between Microsoft Corporation and Stac, Inc.                                                          
|10.13*   |  | License Agreement dated as of December 15,
    1995 between Motorola, Inc. and Stac, Inc.                                                                 
|10.14*   |  | Agreement dated as of November 13, 1997
    between 750 University, LLC and hi/fn, inc.                                                                   
|10.15*   |  | 1998 Employee Stock Purchase Plan of hi/fn, inc.                                                                                                          
|10.16*   |  | Form of Director Change of Control Agreement.                                                                                                             
|10.17*   |  | Form of Employee Change of Control Agreement.                                                                                                             
|10.18*   |  | Promissory Note dated as of September 28,
    1998 made by hi/fn, inc. in favor of Stac, Inc.                                                             
|10.19*   |  | Security Agreement dated as of September 28,
    1998 between Stac, Inc. and hi/fn, inc.                                                                  
|10.20**  |  | Agreement and Plan of Reorganization, dated
    May 12, 2000 between hi/fn, inc. and Apptitude, Inc. and
    amendments thereto.                          
|10.21*** |  | Apptitude, Inc. 1995 Stock Option Plan.                                                                                                                   
|10.22   |  | Agreement dated as of October 23, 2000
    between Spieker Properties, L.P. and hi/fn, inc.                                                               
|10.23   |  | Agreement dated as of October 24, 2000
    between Sally Spencer and hi/fn, inc.                                                                          
|10.24  |  | Agreement dated as of April 6, 2001 between
    Sally Spencer and hi/fn, inc.                                                                             
|10.25 |  | 2001 Nonstatutory Stock Option Plan of hi/fn, inc.                                                                                                        
|23.1     |  | Consent of PricewaterhouseCoopers LLP,
    independent accountants.                                                                                       
|24.1     |  | Power of Attorney (see page 53).                                                                                                                          
|99.1     |  | 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.
|99.2     |  | 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.

62



---



##### Table of Contents





|   |                                                                                                                                                 
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------
|** | 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.

63