##### 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,
    2003
|                                                
|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

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

The aggregate market value of the voting and
non-voting common equity held by non-affiliates of the
Registrant as of March 31, 2003 was $32,168,480 (based upon
the closing price reported on the NASDAQ National Market System
as of the last business day of the Registrants most
recently completed second fiscal quarter). For purposes of this
disclosure, shares of Common Stock held by persons who hold more
than 5% of the outstanding shares of Common Stock and shares
held by officers and directors of the Registrant have been
excluded in that such persons may be deemed to be affiliates.
This determination of affiliate status is not necessarily
conclusive.

The number of shares outstanding of the
Registrants Common Stock as of December 8, 2003, was
11,440,905.

DOCUMENTS INCORPORATED BY REFERENCE

Parts of the Proxy Statement for
Registrants 2004 Annual Meeting of Shareholders to be held
February 23, 2004 (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 8. Financial Statements and Supplementary Data                                                    
|REPORT OF INDEPENDENT AUDITORS
|PART III                      
|                               | Item 10. Directors and Executive Officers of the Registrant                                            
|                               | Item 11. Executive Compensation                                                                        
|                               | Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
|                               | Item 13. Certain Relationships and Related Transactions                                                
|                               | Item 14. Principal Accounting Fees and Services                                                        
|PART IV                       
|                               | Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K                               
|SIGNATURES                    
|INDEX TO EXHIBITS             
|EXHIBIT 21.1                  
|EXHIBIT 23.1                  
|EXHIBIT 31.1                  
|EXHIBIT 31.2                  
|EXHIBIT 32.1                  
|EXHIBIT 32.2                  



---



##### Table of Contents



TABLE OF CONTENTS

|           |  |                                                                                                    |    |      |    | 
|---------- |  | -------------------------------------------------------------------------------------------------- | -- | ---- | -- | 
|           |  |                                                                                                    |    | Page
|           |  |                                                                                                    |    |     
|PART I    
|Item 1.    |  | Business                                                                                           |    |      | 1  | 
|Item 2.    |  | Properties                                                                                         |    |      | 11 | 
|Item 3.    |  | Legal Proceedings                                                                                  |    |      | 11 | 
|Item 4.    |  | Submission of Matters to a Vote of Security
    Holders                                            |    |      | 12 | 
|PART II   
|Item 5.    |  | Market for Registrants Common Equity and
    Related Stockholder Matters                          |    |      | 14 | 
|Item 6.    |  | Selected Financial Data                                                                            |    |      | 15 | 
|Item 7.    |  | Managements Discussion and Analysis of
    Financial Condition and Results of Operations          |    |      | 16 | 
|Item 7A.   |  | Quantitative and Qualitative Disclosure About
    Market Risk                                      |    |      | 33 | 
|Item 8.    |  | Financial Statements and Supplementary Data                                                        |    |      | 34 | 
|Item 9.    |  | Changes in and Disagreements with Accountants on
    Accounting and Financial Disclosure           |    |      | 54 | 
|Item 9A.   |  | Controls and Procedures                                                                            |    |      | 54 | 
|PART III  
|Item 10.   |  | Directors and Executive Officers of the Registrant                                                 |    |      | 55 | 
|Item 11.   |  | Executive Compensation                                                                             |    |      | 55 | 
|Item 12.   |  | Security Ownership of Certain Beneficial Owners
    and Management and Related Stockholder Matters |    |      | 55 | 
|Item 13.   |  | Certain Relationships and Related Transactions                                                     |    |      | 55 | 
|Item 14.   |  | Principal Accounting Fees and Services                                                             |    |      | 55 | 
|PART IV   
|Item 15.   |  | Exhibits, Financial Statements Schedules, and
    Reports on Form 8-K                              |    |      | 55 | 
|SIGNATURES |  |                                                                                                    | 57 |     



---



##### Table of Contents



CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING
STATEMENTS

With the exception of historical facts, the
statements contained in this Annual Report on Form 10-K are
forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as
amended (the Exchange Act), and are subject to the
safe harbor provisions created by such statutes. Certain
statements contained herein, including, without limitation,
statements containing the words believes,
anticipates, estimates,
expects, and words of similar import, relating to
matters including, but not limited to: (i) the relationship
between the Companys technology and competitive advantage;
(ii) the effect of our ongoing product and technology
development on product integration and performance;
(iii) the increase of competition from existing and new
competitors, including major domestic and international
semiconductor suppliers; (iv) the impact of U.S. export
regulations on our European competitors; (v) the
competitive factors in our markets; (vi) the impact of our
distribution agreement on global demand for network security
products; (vii) the importance of our comprehensive product
service and support on our market position and design
efficiency; (viii) the sufficiency of our alternate
suppliers; (ix) the impact of the transition of our
products to smaller semiconductor dimensions; (x) the
retention of future earnings and dividend policies;
(xi) our investment in Research and Development;
(xii) our level of capital expenditures; (xiii) the
sufficiency of our existing cash resources for the next twelve
months; (xiv) future operating results; (xv) the
composition of our customer base; (xvi) the anticipated
average selling prices of our products; and (xvii) future
performance of our investment portfolio constitute
forward-looking statements that involve risks and uncertainties.
Such statements are based on current expectations and are
subject to risk, uncertainties and changes in condition,
significance, value and effect, including those discussed under
the heading Trends, Risks and Uncertainties within the section
of this report entitled Item 7. Managements
Discussion and Analysis of Financial Condition and Results of
Operations and reports filed by hi/fn, inc. with the
Securities and Exchange Commission, specifically Forms 8-K,
10-Q and S-8. Such risks, uncertainties and changes in
condition, significance, value and effect could cause our actual
results to differ materially from those anticipated events.
Although we believe that the assumptions underlying the
forward-looking statements are reasonable, any of the
assumptions could prove inaccurate, including, but not limited
to, statements as to our future operating results and business
plans. We disclaim any intention or obligation to update or
revise any forward-looking statements, whether as a result of
new information, future events or otherwise.




PART I






Item 1.     Business


Overview

hi/fn, inc., together with its subsidiaries, Hifn
Limited and Hifn Netherlands B.V., (collectively 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

1



---



##### Table of Contents



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

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

Industry Background

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

The network computing market has undergone 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

2



---



##### Table of Contents



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
semiconductors 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 virtual private network
(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), Secure Session Layer (SSL) and
Transport Layer Security (TLS) protocols. This
integration allows network equipment vendors to add
highly-integrated, high-performance VPN capabilities to their
routers, remote access concentrators, switches, broadband access
equipment and firewalls.

3



---



##### Table of Contents



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) 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.

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, 2003, we had a backlog of
semiconductor orders representing $5.2 million of products
deliverable to customers over the 6 months following the
placement of these orders. At September 30, 2002, we had a
backlog of $3.5 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

4



---



##### Table of Contents



security for network equipment such as routers,
remote access concentrators, switches and firewalls. For
high-performance security requirements, Hifns 7814, 7815,
7851, 7854 and 7855 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 security processor. This device provides 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.
Hifns 7955 and 7956 devices are next-generation high-speed
security co-processors designed for ROBO/ SME networking
applications like VPN Broadband Routers, Wireless LAN Access
Points and Switches, VPN Edge Routers/ Gateways, Firewall/ VPN
Appliances, and other Network and Customer Premise Equipment
(CPE). With the exception of 7851, all these devices
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 FlowThrough Security
Products.Hifn has announced its HIPP
III line of intelligent FlowThrough security processors targeted
both for the traditional VPN networking market as well as the
emerging storage area network (SAN) security market
using the iSCSI and FCIP protocols. The Hifn 4300, 4350,
8300 and 8350 are capable of performing the entire IPsec
protocol on-chip at multi-Gigabit speeds, as well as the
Internet Key Exchange (IKE) handshake all in one
device. Interfacing these devices to a system is straightforward
as they sit at the Ethernet I/ O between the Physical layer
transceiver and the Ethernet MAC function.

Network 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. 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 9620
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 forty in under four
years. Through the use of various architectural

5



---



##### Table of Contents



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 one patent issued and an
additional five 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.

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

Intellectual Property

Our future success and ability to compete are
dependent, in part, upon our proprietary technology. We rely in
part on patent, trade secret, trademark, maskwork and copyright
laws to protect our intellectual property. We own eighteen
(18) 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, flow classification, bandwidth management
and rate shaping technologies and have expiration dates ranging
from 2006 to 2020. We also have five 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

6



---



##### Table of Contents



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. 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., IBM, Broadcom Corporation, Motorola, Inc.
and Cavium Networks. 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

7



---



##### Table of Contents



market. However, we expect significant future
competition from major domestic and international semiconductor
suppliers. Several established electronics and semiconductor
suppliers have recently entered or indicated an intent to enter
the network equipment market. We may also face competition from
suppliers of products based on new or emerging technologies.
Furthermore, many of our existing and potential customers
internally develop application specific integrated circuits,
general-purpose microprocessors and other devices that attempt
to perform all or a portion of the functions performed by our
products.


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, Inc., 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) and the Storage Network Industry Association
(SNIA).

As of September 30, 2003, our research and
development staff consisted of 77 employees. Our research
and development expenditures were $20.3 million in the
fiscal year ended September 30, 2003, $18.2 million in
the fiscal year ended September 30, 2002 and
$18.6 million in the fiscal year ended September 30,
2001, representing 99%, 84% and 43% of net revenues for such
periods, respectively. Research and development expenses
primarily consist of salaries and related costs of employees
engaged in ongoing research, design and development activities,
costs of fabricating chip mask sets and subcontracting costs. We
perform our research and product development activities at our
facilities in Los Gatos and Carlsbad, California, as well as in
Framingham, Massachusetts and Morrisville, North Carolina.

8



---



##### Table of Contents



The acquisition of certain assets of NetOctave in
September 2002 and of Apptitude in August 2000 further
strengthened our development efforts, adding to our pool of
hardware and software expertise and intellectual properties.
Furthermore, we were able to expand our product base to include
storage area network, high-performance IPSec, acceleration for
firewall applications, bandwidth management, load balancing, QoS
and CoS.

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 Corporation, through its
manufacturing subcontractor, represented 34%, 46% and 36% of our
net revenues for fiscal years ended September 30, 2003,
2002 and 2001, respectively. Revenues from Cisco, through its
manufacturing subcontractors, represented 23% of our net
revenues for fiscal year ended September 30, 2003 and
revenues from Lucent, through its manufacturing subcontractors,
represented 17% of our net revenues for fiscal year ended
September 30, 2001. Our customers are not subject to any
binding obligation to order from us. If our sales to Quantum or
Cisco 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

9



---



##### Table of Contents



and Results of Operations  Trends,
Risks and Uncertainties  We Depend Upon A Small
Number Of Customers.


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.

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

Manufacturing

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

We subcontract our semiconductor manufacturing to
Atmel Corporation, Toshiba Corporation and Philips
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, .18 and .13 micron Complementary Metal Oxide
Semiconductor (CMOS) processes. Products under
development are being designed with the .13-micron CMOS process.
We believe that transitioning our products to increasingly
smaller semiconductor dimensions will be important for us to
remain competitive. We cannot assure that future process
migration will be achieved without difficulty.

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.

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

10



---



##### Table of Contents



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, 2003, Hifn employed a
total of 117 full-time employees. Of the total number of
employees, 77 were employed in research and development, 19 in
sales and marketing, five in operations and 16 in finance and
administration. 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.

Available Information

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




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
16,500 square feet of space for our design and operations
center in Carlsbad, California, under leases that expire at
various dates through December 2004; 4,200 square feet and
3,600 square feet of design center space in Framingham,
Massachusetts and Morrisville, North Carolina, respectively; 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.




Item 3.     Legal
Proceedings

During fiscal 2003, Hifn completed the settlement
terms of the class action complaint and had certain shareholder
derivative actions dismissed. As of September 30, 2003,
there were no outstanding claims against Hifn and Hifn did not
have any outstanding obligations. Details relating to the class
action complaint and the shareholder derivative actions are as
follows:

In 1999, a class action complaint was filed
against Hifn and certain of its officers and directors alleging
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 May 2002, a
settlement agreement was reached and in September 2002, a final
judgment and order of dismissal with prejudice was issued by the
court. Under the terms of the settlement, all claims were
dismissed without any admission of liability or wrongdoing by
any defendant, and the shareholder class received
$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 aggregating 285,412 shares,

11



---



##### Table of Contents



valued at $2.7 million, based on the agreed
price of $9.46 per share. The cash and Common Stock settlements
were distributed in September 2003. Hifn is not obligated to
perform any additional action and considers the class action
litigation to be resolved.


In March 2002, two purported shareholder
derivative actions were filed against Hifn and certain of its
current and former officers and directors, alleging 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. In May 2003, the
court entered an order dismissing the action against Hifn and
all of the individual defendants with prejudice.




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, 2003:

|                          |  |     |    |          |  |                                                                     
|------------------------- |  | --- | -- | -------- |  | --------------------------------------------------------------------
|Name                      |  | Age |    | Position
|                          |  |     |    |         
|Christopher G. Kenber     |  |     | 59 |          |  | Chairman, President and Chief Executive Officer                     
|William R. Walker         |  |     | 62 |          |  | Vice President of Finance, Chief Financial
    Officer and Secretary
|Russell S. Dietz          |  |     | 40 |          |  | Vice President and Chief Technical Officer                          
|Kamran Malik              |  |     | 51 |          |  | Vice President of Hardware Engineering                              
|John E. Metzger           |  |     | 45 |          |  | Vice President of Software Engineering                              
|Thomas A. Moore           |  |     | 46 |          |  | Vice President of Sales and Marketing                               
|Douglas L. Whiting, Ph.D. |  |     | 47 |          |  | 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.

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.

12



---



##### Table of Contents



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

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 and of Sales and Marketing since September 2003,
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 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.

13



---



##### Table of Contents






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,
    2003: |                |      |   |       |  |  |   |      
|                                          | Fourth Quarter |      | $ | 9.54  |  |  | $ | 6.00  | 
|                                          | Third Quarter  |      |   | 9.00  |  |  |   | 4.66  | 
|                                          | Second Quarter |      |   | 5.84  |  |  |   | 4.35  | 
|                                          | First Quarter  |      |   | 7.32  |  |  |   | 3.50  | 
|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  | 

On December 8, 2003, the reported last sale
price of Common Stock on the Nasdaq National Market was $10.30
per share and there were approximately 764 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.

Sales of Unregistered Securities

In September 2003, the Company issued 285,412
shares of unregistered common stock, valued at
$2.7 million, as partial consideration for a settlement
agreement in connection with a class action complaint filed
against Hifn and certain of its officers and directors. The
shares of unregistered common stock were issued in reliance upon
the exemption from registration contained in
Section 3(a)(10) of the Securities Act of 1933, as amended.

Equity Compensation Plans

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

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,                
|                                             |                                                 |                                         
|                                             |                                                 | 2003                                     |         | 2002   |  | 2001 |         | 2000(1) |  | 1999(2)
|                                             |                                                 |                                          |         |        |  |      |         |         |  |        
|                                             |                                                 |                                         
|                                             |                                                 | (in thousands, except per share amounts)
|Statement of Operations Data:                |                                                 |                                          |         |        |  |      |         |         |  |         |         |        |  |   |        |        |  |   |        |       
|Net revenues                                 |                                                 | $                                        | 20,480  |        |  | $    | 21,791  |         |  | $       | 43,004  |        |  | $ | 44,838 |        |  | $ | 42,351 |       
|Costs and operating expenses:                |                                                 |                                          |         |        |  |      |         |         |  |         |         |        |  |   |        |        |  |   |        |       
|                                             | Cost of revenues                                |                                          |         | 6,567  |  |      |         | 6,413   |  |         |         | 13,828 |  |   |        | 10,004 |  |   |        | 10,498 | 
|                                             | Research and development                        |                                          |         | 20,329 |  |      |         | 18,221  |  |         |         | 18,569 |  |   |        | 14,577 |  |   |        | 8,022  | 
|                                             | Sales and marketing                             |                                          |         | 7,211  |  |      |         | 8,445   |  |         |         | 9,462  |  |   |        | 8,172  |  |   |        | 5,963  | 
|                                             | General and administrative                      |                                          |         | 3,862  |  |      |         | 12,309  |  |         |         | 7,705  |  |   |        | 5,147  |  |   |        | 2,993  | 
|                                             | Amortization of intangibles and goodwill        |                                          |         | 1,319  |  |      |         | 10,480  |  |         |         | 11,093 |  |   |        | 1,619  |  |   |        | 113    | 
|                                             | Impairment of intangibles and goodwill          |                                          |         | 3,919  |  |      |         | 27,366  |  |         |         |       |  |   |        |       |  |   |        |       | 
|                                             | Purchased in-process research &
    development |                                          |         |       |  |      |         | 1,137   |  |         |         |       |  |   |        | 4,085  |  |   |        |       | 
|                                             |                                                 |                                          |         |        |  |      |         |         |  |         |         |        |  |   |        |        |  |   |        |       
|Income (loss) from operations                |                                                 |                                          | (22,727 | )      |  |      | (62,580 | )       |  |         | (17,653 | )      |  |   | 1,234  |        |  |   | 14,762 |       
|Interest income (expense), net               |                                                 |                                          | 566     |        |  |      | 1,067   |         |  |         | 2,700   |        |  |   | 4,211  |        |  |   | 1,720  |       
|Other income (expense), net                  |                                                 |                                          | (22     | )      |  |      | (72     | )       |  |         | (64     | )      |  |   | (66    | )      |  |   | (14    | )     
|Provision for (benefit from) income taxes    |                                                 |                                          | (1,842  | )      |  |      | 6,014   |         |  |         | (1,660  | )      |  |   | 4,381  |        |  |   | 6,587  |       
|                                             |                                                 |                                          |         |        |  |      |         |         |  |         |         |        |  |   |        |        |  |   |        |       
|Net income (loss)                            |                                                 | $                                        | (20,341 | )      |  | $    | (67,599 | )       |  | $       | (13,357 | )      |  | $ | 998    |        |  | $ | 9,881  |       
|                                             |                                                 |                                          |         |        |  |      |         |         |  |         |         |        |  |   |        |        |  |   |        |       
|Net income (loss) per share, basic           |                                                 | $                                        | (1.89   | )      |  | $    | (6.49   | )       |  | $       | (1.32   | )      |  | $ | 0.11   |        |  | $ | 1.22   |       
|Net income (loss) per share, diluted         |                                                 | $                                        | (1.89   | )      |  | $    | (6.49   | )       |  | $       | (1.32   | )      |  | $ | 0.10   |        |  | $ | 1.06   |       
|Weighted average shares outstanding, basic   |                                                 |                                          | 10,741  |        |  |      | 10,417  |         |  |         | 10,141  |        |  |   | 9,017  |        |  |   | 8,115  |       
|Weighted average shares outstanding, diluted |                                                 |                                          | 10,741  |        |  |      | 10,417  |         |  |         | 10,141  |        |  |   | 10,055 |        |  |   | 9,295  |       

|                                |  |                |        |      |  |      |        |      |  |      |         |  |  |   |         |  |  |   |        | 
|------------------------------- |  | -------------- | ------ | ---- |  | ---- | ------ | ---- |  | ---- | ------- |  |  | - | ------- |  |  | - | ------ | 
|                                |  |               
|                                |  | September 30, 
|                                |  |               
|                                |  | 2003           |        | 2002 |  | 2001 |        | 2000 |  | 1999
|                                |  |                |        |      |  |      |        |      |  |     
|                                |  |               
|                                |  | (in thousands)
|Balance Sheet Data:             |  |                |        |      |  |      |        |      |  |      |         |  |  |   |         |  |  |   |        | 
|Cash and short-term investments |  | $              | 43,074 |      |  | $    | 54,666 |      |  | $    | 64,751  |  |  | $ | 64,815  |  |  | $ | 70,086 | 
|Total assets                    |  |                | 52,821 |      |  |      | 72,279 |      |  |      | 126,810 |  |  |   | 131,479 |  |  |   | 83,530 | 
|Working capital                 |  |                | 35,465 |      |  |      | 44,071 |      |  |      | 70,297  |  |  |   | 66,498  |  |  |   | 73,153 | 
|Total debt                      |  |                |       |      |  |      |       |      |  |      |        |  |  |   | 27      |  |  |   |       | 
|Total stockholders equity      |  |                | 41,117 |      |  |      | 56,656 |      |  |      | 119,835 |  |  |   | 124,191 |  |  |   | 76,049 | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                 
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(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 includes 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.

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 34%, 46% and 36% of our
net revenues for fiscal years ended September 30, 2003,
2002 and 2001, respectively. Revenues from a second customer,
through its manufacturing subcontractors, represented 23% of our
net revenues for fiscal year ended September 30, 2003.

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

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

16



---



##### Table of Contents



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

Hifns quarterly and annual operating
results are affected by a wide variety of factors that could
materially and adversely affect net sales, gross margins and
operating income. These factors include the volume and timing of
orders received, changes in the mix of proprietary and second
source products sold, market acceptance of our and our
customers products, competitive pricing pressures, our
ability to introduce new products on a timely basis, the timing
and extent of research and development expenses, fluctuations in
manufacturing yields, cyclical semiconductor industry
conditions, our access to advanced process technologies and the
timing and extent of process development costs. Historically in
the semiconductor industry, average selling prices of products
have decreased over time. If we are unable to introduce new
products with higher margins, maintain our product mix between
proprietary and second source products, or reduce manufacturing
cost to offset decreases in the prices of our existing products,
then our operating results will be adversely affected. Our
business is characterized by short-term orders and shipment
schedules, and customer orders typically can be canceled or
rescheduled without penalty to the customer. Since most of our
backlog is cancelable without penalty, we typically plan our
production and 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,
2003 was $2.0 million and included approximately $195,000
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, 2003, inventories
of $2.7 million that were previously written down were
still on hand. Subsequent increases in projected demand will not
result in a reversal of these reserves until the sale of the
related inventory.

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

Valuation of long-lived and intangible assets
and goodwill.We evaluate the recovery
of finite lived intangible assets and other finite long-lived
assets whenever events or changes in circumstances indicate that
their carrying value may not be recoverable through the
estimated undiscounted future cash flows resulting from the use
of the assets. If we determine that the carrying value of
goodwill, other intangible assets and other long-lived assets
may not be recoverable, we measure impairment by using the
projected discounted cash flow method. Our judgments regarding
the existence of impairment indicators are based on market
conditions and operational performance of our business. During
the fourth quarter of fiscal 2003, the Companys product
plans changed as a result of a shift in customer feature
requirements and demand. Consequently, long-lived and
intangibles assets associated with terminated projects were
impaired and a charge of $3.9 million was recorded. During
the fourth quarter of fiscal 2002, prior to the implementation
of SFAS 142, we recorded a $27.4 million charge for
impairment of goodwill and other intangible assets. The
impairment charges were 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 are no longer be amortized but
instead are subject to annual impairment tests or interim
impairment tests whenever events or circumstances indicate that
their carrying value may not be recoverable. We adopted SFAS
No. 142 during the first quarter of fiscal 2003. Other
intangible assets will continue to be amortized over their
useful lives. Goodwill amortization expense aggregated
$8.6 million and

18



---



##### Table of Contents



$9.4 million during fiscal 2002 and 2001,
respectively. After the impairment described above, the carrying
value of goodwill was approximately $1.0 million at
September 30, 2003. Asset 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
2003, we recognized a tax benefit of $1.8 million related
to carry back of net operating losses to prior years. During
fiscal 2002, we recorded a net tax expense of $6.0 million
to establish a valuation allowance against deferred tax assets.
Continuing losses in recent reporting periods increase the
uncertainties regarding realizability of deferred tax assets.
While we have considered future taxable income and ongoing
prudent and feasible tax planning strategies in assessing the
need for the valuation allowance, in the event we were to
determine that we would be able to realize our deferred tax
assets in the future in excess of its net recorded amount, an
adjustment to the deferred tax asset would increase income in
the period such determination is made.

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

During fiscal 2002, in relation to the
$9.5 million court-approved settlement of the class action
suit against us, we recognized $2.7 million in litigation
settlement charges, representing the uninsured portion of the
total settlement amount. Subsequently, in September 2003, we
settled our obligation through the issuance of
285,412 shares of our common stock to the class.

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,          
|                                          |                                             |                                   
|                                          |                                             | 2003                               |      | 2002 |     | 2001
|                                          |                                             |                                    |      |      |     |     
|Net revenues                              |                                             |                                    | 100  | %    |     |      | 100  | %   |     |  | 100 | % 
|                                          |                                             |                                    |      |      |     |      |      |     |     |  |     |   
|Costs and operating expenses:             |                                             |                                    |      |      |     |      |      |     |     |  |     |   
|                                          | Cost of revenues                            |                                    |      | 32   |     |      |      | 29  |     |  |     | 32 |    
|                                          | Research and development                    |                                    |      | 99   |     |      |      | 84  |     |  |     | 43 |    
|                                          | Sales and marketing                         |                                    |      | 35   |     |      |      | 39  |     |  |     | 22 |    
|                                          | General and administrative                  |                                    |      | 19   |     |      |      | 56  |     |  |     | 18 |    
|                                          | Amortization of intangibles and goodwill    |                                    |      | 6    |     |      |      | 48  |     |  |     | 26 |    
|                                          | Impairment of intangibles and goodwill      |                                    |      | 19   |     |      |      | 126 |     |  |     |   |    
|                                          | Purchased in-process research & development |                                    |      |     |     |      |      | 5   |     |  |     |   |    
|                                          |                                             |                                    |      |      |     |      |      |     |     |  |     |   
|                                          |                                             | Total costs and operating expenses |      |      | 211 |      |      |     | 387 |  |     |    | 141 | 
|                                          |                                             |                                    |      |      |     |      |      |     |     |  |     |   
|Income (loss) from operations             |                                             |                                    | (111 | )    |     |      | (287 | )   |     |  | (41 | ) 
|Interest and other income (expense), net  |                                             |                                    | 3    |      |     |      | 4    |     |     |  | 6   |   
|                                          |                                             |                                    |      |      |     |      |      |     |     |  |     |   
|Income (loss) before income taxes         |                                             |                                    | (108 | )    |     |      | (283 | )   |     |  | (35 | ) 
|Provision for (benefit from) income taxes |                                             |                                    | (9   | )    |     |      | 27   |     |     |  | (4  | ) 
|                                          |                                             |                                    |      |      |     |      |      |     |     |  |     |   
|Net income (loss)                         |                                             |                                    | (99  | )%   |     |      | (310 | )%  |     |  | (31 | )%
|                                          |                                             |                                    |      |      |     |      |      |     |     |  |     |   

19



---



##### Table of Contents



Years Ended September 30, 2003, 2002 and
2001

Net Revenues.Net
revenues from sales of semiconductor processors and licenses of
software libraries decreased 6% in fiscal 2003 to
$20.5 million compared to $21.8 million in fiscal
2002. The decrease in net revenues in fiscal 2003 from fiscal
2002 was mainly due to a decrease in license and software
revenues of $1.3 million. 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.
Semiconductor sales to Quantum, an original equipment
manufacturer of high-performance tape storage devices, through
its manufacturing subcontractor, comprised 34%, 46% and 36% of
net revenues in each of fiscal 2003, 2002 and 2001,
respectively. Semiconductor sales to Cisco, an original
equipment manufacturer, comprised 23% of net revenues in fiscal
2003. Semiconductor sales to Lucent, an original equipment
manufacturer of networking equipment, through its manufacturing
subcontractors, comprised 17% of net revenues in fiscal 2001.

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, increased to 32% in
fiscal 2003 from 29% in fiscal 2002. Cost of revenues, as a
percentage of revenues, of 32% 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
2003 and 2002, we sold inventories that had previously been
written off and recognized net recoveries of $780,000 and
$710,000, respectively. The fluctuation in cost of revenues is
primarily attributable to shifts in the proportion of processors
revenues to software revenues.

Research and Development.Research and development expenses were
$20.3 million, or 99% of net revenues in fiscal 2003,
$18.2 million, or 84% of net revenues, in fiscal 2002 and
$18.6 million, or 43% of net revenues, in fiscal 2001.
Research and development expenses increased in fiscal 2003 from
fiscal 2002 and reflect an increase in salaries and benefits of
$1.1 million as a result of an increase in headcount, an
increase in nonrecurring engineering charges of
$1.6 million and depreciation of engineering development
tools of $867,000 offset by a reduction in deferred compensation
amortization related to the acquisition of Apptitude of
$1.7 million, which includes $1.3 million in deferred
compensation amortization related to the voluntary stock option
exchange in fiscal 2002.

Research and development expenses decreased
slightly in fiscal 2002 from fiscal 2001 and reflect an increase
in nonrecurring engineering charges of $614,000 and the purchase
of engineering development tools for new product development of
$331,000 offset by a reduction in outside service costs for
contractors 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 expense also includes
amortization of deferred stock compensation related to the
acquisition of Apptitude of $309,000 in fiscal 2003,
$2.0 million in fiscal 2002 and $1.8 million in fiscal
2001. 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 six products in development with
anticipated production dates ranging from December 2003 through
early 2005. 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.

Sales and Marketing.Sales and marketing expenses were
$7.2 million, or 35% of net revenues, in fiscal 2003,
$8.4 million, or 39% of net revenues, in fiscal 2002 and
$9.5 million, or 22% of net revenues, in fiscal 2001. The
decrease in sales and marketing expenses in fiscal 2003 from
fiscal 2002 reflects the net effect of a decrease in salaries
and wages expense of $524,000 as a result of a decrease in
average headcount of eight employees, a decrease in deferred
compensation expense of $383,000 and decreases in travel,
tradeshow and

20



---



##### Table of Contents



conference expenses of $241,000 which were offset
by an increase in sales representative commissions of $195,000
due to higher level of sales made through sales representatives.


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 sales representative 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
increase in average 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.

General and Administrative.General and administrative expenses
were $3.9 million, or 19% of net revenues, in
fiscal 2003, $12.3 million, or 56% of net revenues, in
fiscal 2002 and $7.7 million, or 18% of net revenues,
in fiscal 2001. The decrease in general and administrative
expenses in fiscal 2003 as compared to fiscal 2002
mainly relate to certain charges recorded in fiscal 2002
including $3.7 million related to vacant facility lease
obligations, accrued shareholder litigation settlement charge of
$2.7 million, as well as decreased legal expenses of
$526,000 and in the amortization of deferred compensation
expense of $394,000.

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, 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.

Amortization of deferred stock compensation
related to the acquisition of Apptitude were $51,000 for
fiscal 2003, $420,000 for fiscal 2002, inclusive of
$70,000 in amortization related to the voluntary stock option
exchange, and $1.8 million for fiscal 2001. Legal
costs for the fiscal years ended 2003, 2002 and 2001 were
$143,000, $689,000 and $342,000, respectively.

Amortization of Intangibles and Goodwill.Amortization of intangibles was
$1.3 million, or 6% of net revenues, for fiscal 2003,
$1.8 million, or 8% of net revenues, for fiscal 2002,
and $1.7 million, or 4% of net revenues, for
fiscal 2001. Goodwill amortization expense related to the
acquisition of Apptitude aggregated $8.6 million and
$9.4 million in fiscal years 2002 and 2001, respectively.
As a result of our adoption of SFAS 142 (see Note 2 of
Notes to Consolidated Financial Statements), we ceased
amortization of goodwill beginning October 1, 2002.

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

During the fourth quarter of 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, 2003 was approximately $1.0 million,
which balance is not amortized but is 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 for a
flow classification processor 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 2003 was $544,000, or 3% of net
revenues, $995,000, or 4% of net revenues for fiscal 2002,
and $2.6 million, or 6% of net revenues, for
fiscal 2001. The continuing decrease in net interest income
was primarily a result of a shift in

21



---



##### Table of Contents



the investment mix from stock instruments to
commercial paper and municipal bonds, lower average cash and
short-term investments balance during the past three fiscal
years as well as a decrease in market interest rates.


Income Taxes.The
effective tax rates for fiscal 2002 was a benefit of 10%
and for fiscal 2003 and 2001 charges of 8% and 11%,
respectively. During fiscal 2003, we recognized a tax benefit of
$1.8 million related to carry back of net operating losses
to prior years. As a result of 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. 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 2003, cash used in
operating activities of approximately $12.2 million was
comprised of net loss as adjusted for non-cash items including
provision for the impairment of intangibles of
$3.9 million, amortization of intangibles and of deferred
stock compensation of $2.7 million, depreciation and
amortization costs of $1.5 million and decreases in
prepaids and other current assets of $1.0 million, in
inventories of $349,000 and in other assets of $228,000. These
adjustments were offset by an increase in accounts receivable of
$452,000 and decreases in accounts payable and accrued expenses
and other current liabilities aggregating $1.2 million.

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.
Operating cash flows were also provided by a decrease in
accounts receivable of $1.5 million offset by 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
$1.9 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.

Investing Activities.Cash used in investing activities in
fiscal 2003 was $1.5 million, resulting from the sale
of short-term investments of $388,000 and the acquisition of
$1.1 million in property and equipment. 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. Our capital
expenditures in fiscal 2003 reflect costs incurred for
office and engineering test and development equipment. Our
capital expenditure in fiscal 2001 reflects 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 fiscal 2003 levels.

Financing Activities.Cash provided by financing activities
in fiscal 2003, 2002 and 2001 of $1.7 million,
$916,000 and $1.2 million, respectively, reflect proceeds
from 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, 2004 |                              | $ | 2,874 |      
|2005                                  |                              |   | 2,259 |      
|2006                                  |                              |   | 895   |      
|2007                                  |                              |   | 906   |      
|Thereafter                            |                              |   | 229   |      
|                                      |                              |   |       |      
|                                      | Total minimum lease payments |   | $     | 7,163 | 
|                                      |                              |   |       |      

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

The Company requires substantial working capital
to fund its business, particularly to finance accounts
receivable and inventory, and for investments in property and
equipment. The Companys need to raise capital in the
future will depend on many factors including the rate of sales
growth, market acceptance of the Companys existing and new
products, the amount and timing of research and development
expenditures, the timing and size of acquisitions of businesses
or technologies, the timing of the introduction of new products
and the expansion of sales and marketing efforts. We 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
economies. Accordingly, there can be no assurance that events in
the future will not require us to seek additional capital sooner
or, if so required, that such capital will be available at all
or on terms acceptable to us.

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 2003 and 2002, we performed
impairment analyses of goodwill and long-lived and intangible
assets and determined that impairment had been realized on
certain developed technology and goodwill, resulting in
recognition of impairment charges of $3.9 million and
$27.4 million, respectively. Pursuant to SFAS 142,
Goodwill and Other Intangible Assets, we will
continue to perform an annual impairment test and if, as a
result of this analysis, we determine that there has been an
impairment of our goodwill and other long-lived and intangible
assets, asset impairment charges will be recognized.
Approximately $1.0 million of goodwill remains as of
September 30, 2003.



| |                                                
| | -----------------------------------------------
| | We Depend Upon A Small Number Of
    Customers.

Quantum Corporation (Quantum),
through its manufacturing subcontractor, accounted for
approximately 34%, 46% and 36% of our net revenues in fiscal
2003, 2002 and 2001, respectively. Cisco, an OEM producer of
network equipment, comprised 23% of our net revenues for the
year ended September 30, 2003. Lucent, through its
manufacturing subcontractor, accounted for approximately 17% of
our net revenues in fiscal 2001. Neither Quantum nor Cisco is
under any binding obligation to order from us. If our sales to
Quantum or Cisco 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
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., 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.
Alternatively, if it continues to grow, our products may not
successfully serve this market. Our

24



---



##### Table of Contents



ability to 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;                                                                           
|
| |  | Develop end-to-end, ubiquitous systems solutions;                                                                    
|
| |  | Develop, or partner with providers of, security
    services processors;                                             
|
| |  | Develop both hardware and software security
    services solutions;                                                  
|
| |  | Enhance our products by adding innovative
    features that differentiate our products from those of
    competitors;
|
| |  | Bring products to market on a timely basis at
    competitive prices; and                                            
|
| |  | Respond effectively to new technological changes
    or new product announcements by others.                         

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

In evaluating new product decisions, we must
anticipate future demand for product features and performance
characteristics, as well as available supporting technologies,
manufacturing capacity, competitive product offerings and
industry standards. We must also continue to make significant
investments in research and development in order to continue to
enhance the performance and functionality of our products to
keep pace with competitive products and customer demands for
improved performance, features and functionality. The technical
innovations required for us to remain competitive are
complicated and require a significant amount of time and money.
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

25



---



##### Table of Contents



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 Cavium
Networks. Hifn was a wholly-owned subsidiary of Stac, Inc. until
Hifns spin-off from Stac in 1996 upon which Stac assigned
two license agreements entered into with IBM in 1994 in which
Stac granted IBM the right to use, but not sublicense, our
patented compression technology in IBM hardware and software
products. Stac also assigned its license agreement with
Microsoft Corporation (Microsoft) in 1994 whereby
Stac granted Microsoft the right to use, but not sublicense, our
compression technology in their software products. We expect
significant future competition from major domestic and
international semiconductor suppliers. Several established
electronics and semiconductor suppliers have recently entered,
or expressed an interest to enter, the network equipment market.
We also may face competition from suppliers of products based on
new or emerging technologies. Furthermore, many of our existing
and potential customers internally develop solutions which
attempt to perform all or a portion of the functions performed
by our products.


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

Many of our current and prospective competitors
offer broader product lines and have significantly greater
financial, technical, manufacturing and marketing resources than
us. As a result, they may be able to adapt more quickly to new
or emerging technologies and changes in customer requirements or
to devote greater resources to promote the sale of their
products. In particular, companies such as Intel Corporation,
Lucent Technologies Inc., Motorola, Inc., National Semiconductor
Corporation and Texas Instruments Incorporated have 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

26



---



##### Table of Contents



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 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 eighteen (18) 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, flow classification,
bandwidth management and rate shaping technologies and have
expiration dates ranging from 2006 to 2020. We have five 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.

27



---



##### Table of Contents





| |                                                                            
| | ---------------------------------------------------------------------------
| | 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 Philips 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.

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.

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

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

28



---



##### Table of Contents





| |                                                             
| | ------------------------------------------------------------
| | Network And Storage Equipment Prices
    Typically Decrease.

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



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

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



| |                                                                        
| | -----------------------------------------------------------------------
| | We Face Product Return, Product Liability
    And Product Defect Risks.

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



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

29



---



##### Table of Contents





| |                                                     
| | ----------------------------------------------------
| | Our Products Are Subject To Export
    Restrictions.

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



| |                                                                         
| | ------------------------------------------------------------------------
| | 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 and may make additional acquisitions in the future.
Future acquisitions could be effected without stockholder
approval, and could cause us to dilute shareholder equity, incur
debt and contingent liabilities and amortize acquisition
expenses related

30



---



##### Table of Contents



to intangible assets, any of which could harm our
operating results and/or the price of our Common Stock.
Acquisitions entail numerous risks, including:




| |   |                                                                                  
| | - | ---------------------------------------------------------------------------------
| |  | Difficulties in assimilating acquired operations,
    technologies and products; 
|
| |  | Diversion of managements attention from
    other business concerns;            
|
| |  | Risks of entering markets in which we have little
    or no prior experience; and
|
| |  | Loss of key employees of acquired organizations.                                 

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



| |                                                                             
| | ----------------------------------------------------------------------------
| | The Cyclical Nature Of The Semiconductor
    Industry May Harm Our Business.

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



| |                                     
| | ------------------------------------
| | 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 Have Been Engaged in Securities
    Class-Action Lawsuits.

During fiscal 2003, we completed the settlement
terms of the class action complaint and had shareholder
derivative actions dismissed. As of September 30, 2003,
there were no outstanding claims against us and we did not have
any outstanding obligations. Details relating to the class
action complaint and the shareholder derivative actions are as
follows:

In 1999, a class action complaint was filed
against us and certain of our officers and directors alleging
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 May 2002, a
settlement agreement was reached and in September 2002, a final
judgment and order of dismissal with prejudice was issued by the
court. Under the terms of the settlement, all claims were
dismissed without any admission of liability or wrongdoing by
any defendant, and the shareholder class received
$9.5 million, comprised of $6.8 million in cash, which
was contributed by our insurance carriers, and the balance in
Hifn common stock aggregating 285,412 shares, valued at
$2.7 million, based on the agreed price of $9.46 per share.
The cash and common stock settlements were distributed in
September 2003. We are not obligated to perform any additional
action and consider the class action litigation to be resolved.

In March 2002, two purported shareholder
derivative actions were filed against us and certain of our
current and former officers and directors, alleging violations
of California Corporations Code Section 25402,

31



---



##### Table of Contents



breach of fiduciary duty and waste of corporate
assets, based on the same facts and events alleged in the class
action. In May 2003, the court entered an order dismissing the
action against us and all of the individual defendants with
prejudice.




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

In June 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 is effective for
exit or disposal activities initiated after December 31,
2002. The Company adopted SFAS 146 during the second fiscal
quarter ended March 31, 2003. The effect of adoption of
SFAS 146 changes on a prospective basis the timing of when
restructuring charges are recorded from a commitment date
approach to when the liability is incurred.

In November 2002, the EITF reached a consensus on
Issue 00-21 (EITF 00-21),
Multiple-Deliverable Revenue Arrangements.
EITF 00-21 addresses how to account for arrangements that
may involve the delivery or performance of multiple products,
services, and/or rights to use assets. The consensus mandates
how to identify whether goods or services or both that are to be
delivered separately in a bundled sales arrangement should be
accounted for separately because they are separate units of
accounting. The guidance can affect the timing of revenue
recognition for such arrangements, even though it does not
change rules governing the timing or pattern of revenue
recognition of individual items accounted for separately. The
final consensus will be applicable to agreements entered into in
fiscal periods beginning after June 15, 2003 with early
adoption permitted. Additionally, companies will be permitted to
apply the consensus guidance to all existing arrangements as the
cumulative effect of a change in accounting principle in
accordance with APB Opinion No. 20, Accounting
Changes. The Companys adoption of EITF 00-21
did not have a material impact on its financial position, cash
flows or results of operations.

In January 2003, the FASB issued FASB
Interpretation No. 46
(FIN 46),Consolidation of Variable
Interest Entities, an Interpretation of Accounting Research
Bulletin No. 51. FIN 46 requires certain
variable interest entities to be consolidated by the primary
beneficiary of the entity if the equity investors in the entity
do not have the characteristics of a controlling financial
interest or do not have sufficient equity at risk for the entity
to finance its activities without additional subordinated
financial support from other parties. FIN 46 is effective
immediately for all new variable interest entities created or
acquired after January 31, 2003. For variable interest
entities created or acquired prior to February 1, 2003, the
provisions of FIN 46 must be applied for the first interim
or annual period beginning after June 15, 2003. On
October 9, 2003, the FASB released FASB Staff
Position 46-6, which deferred the effective date for the
consolidation guidance of FIN 46 from July 1, 2003 to
December 31, 2003, for Variable Interest Entities existing
prior to February 1, 2003. The Companys adoption of
FIN 46 during the quarter ended June 30, 2003 did not
have a material impact on its financial position, cash flows or
results of operations.

In April 2003, the FASB issued Statement of
Accounting Standards No. 149 (SFAS 149),
Amendment of Statement 133 on Derivative Instruments
and Hedging Activities. SFAS 149 amends and clarifies
financial accounting and reporting of derivative instruments and
hedging activities under Statement of Accounting Standards
No. 133 (SFAS 133), Accounting for
Derivative Instruments and Hedging Activities.
SFAS 149 amends SFAS 133 for decisions made:
(i) as part of the Derivatives Implementation Group process
that require amendment to SFAS 133, (ii) in connection
with other FASB projects dealing with financial instruments, and
(iii) in connection with the implementation issues raised
related to the application of the definition of a derivative.
SFAS 149 is effective for contracts entered into or
modified after June 30, 2003 and for designated hedging
relationships after June 30, 2003. SFAS 149 will be
applied

32



---



##### Table of Contents



prospectively. The Companys adoption of
SFAS 149 did not have a material impact on its financial
position, cash flows or results of operations.


In May 2003, the FASB issued Statement of
Accounting Standards No. 150 (SFAS 150),
Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity. The
Statement establishes standards for how an issuer classifies and
measures certain financial instruments with characteristics of
both liabilities and equity and further requires that an issuer
classify as a liability (or an asset in some circumstances)
financial instruments that fall within its scope because that
financial instrument embodies an obligation of the issuer. Many
of such instruments were previously classified as equity. The
statement is effective for financial instruments entered into or
modified after May 31, 2003, and otherwise is effective at
the beginning of the first interim period beginning after
June 15, 2003, except for mandatory redeemable financial
instruments of nonpublic entities. The Statement is implemented
by reporting the cumulative effect of a change in accounting
principle for financial instruments created before the issuance
of the date of the Statement and still existing at the beginning
of the interim period of adoption. Restatement is not permitted.
On October 29, 2003, the FASB voted to indefinitely defer
the effective date of SFAS 150 for mandatorily redeemable
instruments as they relate to minority interests in consolidated
finite-lived entities through the issuance of FASB Staff
Position 150-3. The Companys adoption of this
Statement during the quarter ended September 30, 2003, did
not have a material impact on its financial position, cash flows
or results of operations.

In August 2003, the EITF reached a consensus on
Issue No. 03-5 (EITF03-5), Applicability
of AICPA Statement of Position 97-2, Software Revenue
Recognition to Non-Software Deliverables in an Arrangement
Containing More-Than-Incidental Software. EITF 03-5
involves whether non-software deliverables included in an
arrangement that contains software that is more-than-incidental
to the products or services as a whole are included with the
scope of SOP 97-2 Software Revenue Recognition.
The Company is currently evaluating the impact of this new
pronouncement.



|         |                                                               
|-------- | --------------------------------------------------------------
|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, 2003 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. We to date have not incurred
gains and losses from such fluctuations.

33



---



##### Table of Contents








|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

|                              |                                                                                                                          |      |  |       | 
|----------------------------- | ------------------------------------------------------------------------------------------------------------------------ | ---- |  | ----- | 
|                              |                                                                                                                          | Page
|                              |                                                                                                                          |     
|Financial Statements:         |                                                                                                                          |      |  |      
|                              | Report of Independent Auditors                                                                                           |      |  | 35    | 
|                              | Consolidated Balance Sheets as of
    September 30, 2003 and 2002                                                        |      |  | 36    | 
|                              | Consolidated Statements of Operations for the
    years ended September 30, 2003, 2002 and 2001                          |      |  | 37    | 
|                              | Consolidated Statements of Stockholders
    Equity for the years ended September 30, 2003, 2002 and 2001                |      |  | 38    | 
|                              | Consolidated Statements of Cash Flows for the
    years ended September 30, 2003, 2002 and 2001                          |      |  | 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,
    2003, 2002 and 2001 |      |  | 58    | 

34



---



##### Table of Contents








REPORT OF INDEPENDENT AUDITORS


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, 2003 and 2002, and the
results of their operations and their cash flows for each of the
three years in the period ended September 30, 2003 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.

As discussed in Note 2 to the Consolidated
Financial Statements, effective October 1, 2002, the
Company changed its method of accounting for goodwill in
accordance with Statement of Financial Accounting Standards
No. 142, Goodwill and Other Intangible Assets.

/s/ PricewaterhouseCoopers LLP

PricewaterhouseCoopers LLP


San Jose, California

October 20, 2003


35



---



##### Table of Contents



HIFN, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)


|                                                        |                                                                                                                                |                            |        |         |        |   |        |         |        | 
|------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------ | -------------------------- | ------ | ------- | ------ | - | ------ | ------- | ------ | 
|                                                        |                                                                                                                                |                           
|                                                        |                                                                                                                                | September 30,             
|                                                        |                                                                                                                                |                           
|                                                        |                                                                                                                                | 2003                       |        | 2002   
|                                                        |                                                                                                                                |                            |        |        
|ASSETS                                                 
|CURRENT ASSETS:                                         |                                                                                                                                |                            |        |         |        |   |        |        
|                                                        | Cash and cash equivalents                                                                                                      |                            | $      | 41,080  |        |   | $      | 53,060  |       
|                                                        | Short-term investments                                                                                                         |                            |        | 1,994   |        |   |        | 1,606   |       
|                                                        | Accounts receivable, net of allowance for
    doubtful accounts of $205 and $164, respectively                                 |                            |        | 2,715   |        |   |        | 2,263   |       
|                                                        | Inventories                                                                                                                    |                            |        | 355     |        |   |        | 704     |       
|                                                        | Prepaid expenses and other current assets                                                                                      |                            |        | 1,025   |        |   |        | 2,061   |       
|                                                        |                                                                                                                                |                            |        |         |        |   |        |        
|                                                        |                                                                                                                                | Total current assets       |        |         | 47,169 |   |        |         | 59,694 | 
|Property and equipment, net                             |                                                                                                                                |                            | 2,107  |         |        |   | 2,580  |        
|Intangible assets, net                                  |                                                                                                                                |                            | 2,035  |         |        |   | 7,567  |        
|Other assets                                            |                                                                                                                                |                            | 1,510  |         |        |   | 2,438  |        
|                                                        |                                                                                                                                |                            |        |         |        |   |        |        
|                                                        |                                                                                                                                | $                          | 52,821 |         |        | $ | 72,279 |        
|                                                        |                                                                                                                                |                            |        |         |        |   |        |        
|LIABILITIES AND STOCKHOLDERS
    EQUITY               
|CURRENT LIABILITIES:                                    |                                                                                                                                |                            |        |         |        |   |        |        
|                                                        | Accounts payable                                                                                                               |                            | $      | 2,123   |        |   | $      | 2,712   |       
|                                                        | Accrued expenses and other current liabilities                                                                                 |                            |        | 9,581   |        |   |        | 12,911  |       
|                                                        |                                                                                                                                |                            |        |         |        |   |        |        
|                                                        |                                                                                                                                | Total current liabilities  |        |         | 11,704 |   |        |         | 15,623 | 
|                                                        |                                                                                                                                |                            |        |         |        |   |        |        
|Commitments and contingencies (Note 10 and
    Note 11) |                                                                                                                                |                            |        |         |        |   |        |        
|                                                       
|STOCKHOLDERS EQUITY:                                   |                                                                                                                                |                            |        |         |        |   |        |        
|                                                        | Convertible preferred stock, $0.001 par
    value; 10,000,000 shares authorized; none issued and
    outstanding               |                            |        |        |        |   |        |        |       
|                                                        | Common stock, $0.001 par value;
    100,000,000 shares authorized; 11,201,000 and
    10,492,000 shares issued and outstanding |                            |        | 11      |        |   |        | 10      |       
|                                                        | Additional paid-in capital                                                                                                     |                            |        | 127,611 |        |   |        | 123,265 |       
|                                                        | Deferred stock compensation                                                                                                    |                            |        | (138    | )      |   |        | (593    | )     
|                                                        | Accumulated deficit                                                                                                            |                            |        | (86,367 | )      |   |        | (66,026 | )     
|                                                        |                                                                                                                                |                            |        |         |        |   |        |        
|                                                        |                                                                                                                                | Total stockholders equity |        |         | 41,117 |   |        |         | 56,656 | 
|                                                        |                                                                                                                                |                            |        |         |        |   |        |        
|                                                        |                                                                                                                                | $                          | 52,821 |         |        | $ | 72,279 |        
|                                                        |                                                                                                                                |                            |        |         |        |   |        |        

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,          
|                                             |                                                    |                                   
|                                             |                                                    | 2003                               |         | 2002   |        | 2001
|                                             |                                                    |                                    |         |        |        |     
|Net revenues:                                |                                                    |                                    |         |        |        |      |         |        |        |   |         |       
|                                             | Processors                                         |                                    | $       | 17,041 |        |      | $       | 17,087 |        |   | $       | 36,492 |       
|                                             | Software licenses and other                        |                                    |         | 3,439  |        |      |         | 4,704  |        |   |         | 6,512  |       
|                                             |                                                    |                                    |         |        |        |      |         |        |        |   |         |       
|                                             |                                                    | Total net revenues                 |         |        | 20,480 |      |         |        | 21,791 |   |         |        | 43,004 | 
|                                             |                                                    |                                    |         |        |        |      |         |        |        |   |         |       
|Costs and operating expenses:                |                                                    |                                    |         |        |        |      |         |        |        |   |         |       
|                                             | Cost of revenues  processors                      |                                    |         | 6,138  |        |      |         | 6,230  |        |   |         | 13,681 |       
|                                             | Cost of revenues  software licenses
    and other |                                    |         | 429    |        |      |         | 183    |        |   |         | 147    |       
|                                             | Research and development                           |                                    |         | 20,329 |        |      |         | 18,221 |        |   |         | 18,569 |       
|                                             | Sales and marketing                                |                                    |         | 7,211  |        |      |         | 8,445  |        |   |         | 9,462  |       
|                                             | General and administrative                         |                                    |         | 3,862  |        |      |         | 12,309 |        |   |         | 7,705  |       
|                                             | Amortization of intangibles                        |                                    |         | 1,319  |        |      |         | 1,841  |        |   |         | 1,669  |       
|                                             | Amortization of goodwill                           |                                    |         |       |        |      |         | 8,639  |        |   |         | 9,424  |       
|                                             | Impairment of intangibles                          |                                    |         | 3,919  |        |      |         | 629    |        |   |         |       |       
|                                             | Impairment of goodwill                             |                                    |         |       |        |      |         | 26,737 |        |   |         |       |       
|                                             | Purchased in-process research & development        |                                    |         |       |        |      |         | 1,137  |        |   |         |       |       
|                                             |                                                    |                                    |         |        |        |      |         |        |        |   |         |       
|                                             |                                                    | Total costs and operating expenses |         |        | 43,207 |      |         |        | 84,371 |   |         |        | 60,657 | 
|                                             |                                                    |                                    |         |        |        |      |         |        |        |   |         |       
|Loss from operations                         |                                                    |                                    | (22,727 | )      |        |      | (62,580 | )      |        |   | (17,653 | )     
|Interest income                              |                                                    |                                    | 566     |        |        |      | 1,075   |        |        |   | 2,715   |       
|Interest expense                             |                                                    |                                    |        |        |        |      | (8      | )      |        |   | (15     | )     
|Other expense, net                           |                                                    |                                    | (22     | )      |        |      | (72     | )      |        |   | (64     | )     
|                                             |                                                    |                                    |         |        |        |      |         |        |        |   |         |       
|Loss before income taxes                     |                                                    |                                    | (22,183 | )      |        |      | (61,585 | )      |        |   | (15,017 | )     
|Provision for (benefit from) income taxes    |                                                    |                                    | (1,842  | )      |        |      | 6,014   |        |        |   | (1,660  | )     
|                                             |                                                    |                                    |         |        |        |      |         |        |        |   |         |       
|Net loss                                     |                                                    | $                                  | (20,341 | )      |        | $    | (67,599 | )      |        | $ | (13,357 | )     
|                                             |                                                    |                                    |         |        |        |      |         |        |        |   |         |       
|Net loss per share:                          |                                                    |                                    |         |        |        |      |         |        |        |   |         |       
|                                             | Basic and diluted                                  |                                    | $       | (1.89  | )      |      | $       | (6.49  | )      |   | $       | (1.32  | )     
|                                             |                                                    |                                    |         |        |        |      |         |        |        |   |         |       
|Shares used in computing net loss per share: |                                                    |                                    |         |        |        |      |         |        |        |   |         |       
|                                             | Basic and diluted                                  |                                    |         | 10,741 |        |      |         | 10,417 |        |   |         | 10,141 |       
|                                             |                                                    |                                    |         |        |        |      |         |        |        |   |         |       

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, 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  |        
|                              | Issuance of common stock upon exercise of options                                   |              |        | 249      |  |              |    | 1            |  |               |        |       |  |   |         | 965    |   |   |         |        |   |   |         | 966     |  
|                              | Amortization of deferred stock compensation                                         |              |        |         |  |              |    |             |  |               |        | 355    |  |   |         |       |   |   |         |        |   |   |         | 355     |  
|                              | Reduction in deferred stock compensation due to
    terminations                    |              |        |         |  |              |    |             |  |               |        | 100    |  |   |         | (100   | ) |   |         |        |   |   |         |        |  
|                              | Issuance of common stock for class action
    litigation settlement                 |              |        | 285      |  |              |    |             |  |               |        |       |  |   |         | 2,700  |   |   |         |        |   |   |         | 2,700   |  
|                              | Issuance of common stock under employee stock
    purchase plan                     |              |        | 175      |  |              |    |             |  |               |        |       |  |   |         | 781    |   |   |         |        |   |   |         | 781     |  
|                              | Net loss                                                                            |              |        |         |  |              |    |             |  |               |        |       |  |   |         |       |   |   |         | (20,341 | ) |   |         | (20,341 | )
|                              |                                                                                     |              |        |          |  |              |    |              |  |               |        |        |  |   |         |        |   |   |         |         |   |   |         |        
|Balance at September 30, 2003 |                                                                                     |              | 11,201 |          |  | $            | 11 |              |  | $             | (138   | )      |  | $ | 127,611 |        |   | $ | (86,367 | )       |   | $ | 41,117  |        
|                              |                                                                                     |              |        |          |  |              |    |              |  |               |        |        |  |   |         |        |   |   |         |         |   |   |         |        

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,                                                           
|                                                 |                                                                                               |                                                                                    
|                                                 |                                                                                               | 2003                                                                                |                                                         | 2002    |       | 2001   
|                                                 |                                                                                               |                                                                                     |                                                         |         |       |        
|Cash flows from operating activities:            |                                                                                               |                                                                                     |                                                         |         |       |         |        |         |        |        |        |        
|                                                 | Net loss                                                                                      |                                                                                     | $                                                       | (20,341 | )     |         | $      | (67,599 | )      |        | $      | (13,357 | )     
|                                                 | Adjustments to reconcile net loss to net cash
    provided by (used in) operating activities: |                                                                                     |                                                         |         |       |         |        |         |        |        |        |         |       
|                                                 |                                                                                               | Depreciation and amortization of property and
    equipment                         |                                                         |         | 1,533 |         |        |         | 1,867  |        |        |         | 1,674  |       
|                                                 |                                                                                               | Write-down of fixed assets                                                          |                                                         |         | 25    |         |        |         |       |        |        |         |       |       
|                                                 |                                                                                               | Amortization of intangibles                                                         |                                                         |         | 2,313 |         |        |         | 2,338  |        |        |         | 1,669  |       
|                                                 |                                                                                               | Amortization of goodwill                                                            |                                                         |         |      |         |        |         | 8,639  |        |        |         | 9,424  |       
|                                                 |                                                                                               | Impairment of intangibles                                                           |                                                         |         | 3,919 |         |        |         | 629    |        |        |         |       |       
|                                                 |                                                                                               | Impairment of goodwill                                                              |                                                         |         |      |         |        |         | 26,737 |        |        |         |       |       
|                                                 |                                                                                               | Amortization of deferred stock compensation                                         |                                                         |         | 355   |         |        |         | 1,079  |        |        |         | 3,865  |       
|                                                 |                                                                                               | Reduction in deferred stock compensation due to
    voluntary stock option exchange |                                                         |         |      |         |        |         | 1,746  |        |        |         |       |       
|                                                 |                                                                                               | Purchased in-process research and development                                       |                                                         |         |      |         |        |         | 1,137  |        |        |         |       |       
|                                                 |                                                                                               | Deferred income taxes                                                               |                                                         |         |      |         |        |         | 5,672  |        |        |         | 362    |       
|                                                 |                                                                                               | Change in allowance for doubtful accounts                                           |                                                         |         | 41    |         |        |         | 10     |        |        |         | (198   | )     
|                                                 | Changes in assets and liabilities:                                                            |                                                                                     |                                                         |         |       |         |        |         |        |        |        |         |       
|                                                 |                                                                                               | Accounts receivable                                                                 |                                                         |         | (493  | )       |        |         | 1,541  |        |        |         | 2,132  |       
|                                                 |                                                                                               | Inventories                                                                         |                                                         |         | 349   |         |        |         | 981    |        |        |         | (330   | )     
|                                                 |                                                                                               | Prepaid expenses and other current assets                                           |                                                         |         | 1,036 |         |        |         | 848    |        |        |         | (2,377 | )     
|                                                 |                                                                                               | Other assets                                                                        |                                                         |         | 228   |         |        |         | (198   | )      |        |         | (1,324 | )     
|                                                 |                                                                                               | Accounts payable                                                                    |                                                         |         | (589  | )       |        |         | 1,282  |        |        |         | (410   | )     
|                                                 |                                                                                               | Accrued expenses and other current liabilities                                      |                                                         |         | (630  | )       |        |         | 7,393  |        |        |         | 122    |       
|                                                 |                                                                                               |                                                                                     |                                                         |         |       |         |        |         |        |        |        |        
|                                                 |                                                                                               |                                                                                     | Net cash provided by (used in) operating
    activities |         |       | (12,254 | )      |         |        | (5,898 | )      |         |        | 1,252  |  
|                                                 |                                                                                               |                                                                                     |                                                         |         |       |         |        |         |        |        |        |        
|Cash flows from investing activities:            |                                                                                               |                                                                                     |                                                         |         |       |         |        |         |        |        |        |        
|                                                 | Sales (purchases) of short-term investments, net                                              |                                                                                     |                                                         | (388    | )     |         |        | 8,545   |        |        |        | (5,024  | )     
|                                                 | Purchase of intellectual property                                                             |                                                                                     |                                                         |        |       |         |        | (4,767  | )      |        |        |        |       
|                                                 | Purchases of property and equipment                                                           |                                                                                     |                                                         | (1,085  | )     |         |        | (336    | )      |        |        | (2,517  | )     
|                                                 |                                                                                               |                                                                                     |                                                         |         |       |         |        |         |        |        |        |        
|                                                 |                                                                                               |                                                                                     | Net cash provided by (used in) investing
    activities |         |       | (1,473  | )      |         |        | 3,442  |        |         |        | (7,541 | )
|                                                 |                                                                                               |                                                                                     |                                                         |         |       |         |        |         |        |        |        |        
|Cash flows from financing activities:            |                                                                                               |                                                                                     |                                                         |         |       |         |        |         |        |        |        |        
|                                                 | Proceeds from issuance of common stock, net                                                   |                                                                                     |                                                         | 1,747   |       |         |        | 942     |        |        |        | 1,266   |       
|                                                 | Payment on line of credit and capital lease
    obligations                                   |                                                                                     |                                                         |        |       |         |        | (26     | )      |        |        | (65     | )     
|                                                 |                                                                                               |                                                                                     |                                                         |         |       |         |        |         |        |        |        |        
|                                                 |                                                                                               |                                                                                     | Net cash provided by financing activities               |         |       | 1,747   |        |         |        | 916    |        |         |        | 1,201  |  
|                                                 |                                                                                               |                                                                                     |                                                         |         |       |         |        |         |        |        |        |        
|Net decrease in cash and cash equivalents        |                                                                                               |                                                                                     | (11,980                                                 | )       |       |         | (1,540 | )       |        |        | (5,088 | )      
|Cash and cash equivalents at beginning of period |                                                                                               |                                                                                     | 53,060                                                  |         |       |         | 54,600 |         |        |        | 59,688 |        
|                                                 |                                                                                               |                                                                                     |                                                         |         |       |         |        |         |        |        |        |        
|Cash and cash equivalents at end of period       |                                                                                               | $                                                                                   | 41,080                                                  |         |       | $       | 53,060 |         |        | $      | 54,600 |        
|                                                 |                                                                                               |                                                                                     |                                                         |         |       |         |        |         |        |        |        |        



---

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 has an accumulated deficit of
$86.4 million as of September 30, 2003 and incurred losses
of $20.3 million during the year ended September 30,
2003. 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, Hifn Limited, Hifn
Netherlands B.V. and Apptitude Acquisition Corporation
(Apptitude). In January 2003, Apptitude was merged
into Hifn. 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, 2003, all short-term
investments were classified as available-for-sale and carried at
fair value. Unrealized gains or losses for the periods presented
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, 2003, four customers
accounted for 20%, 17%, 16% and 14%, respectively, of total
accounts receivable. At September 30, 2002, three customers
accounted for 21%, 18% and 17%, respectively, of total accounts
receivable. Management believes that its credit policies
substantially mitigate such concentrated credit risk. Bad debt
expenses were not significant in fiscal 2003, 2002 and 2001.



| |                                        
| | ---------------------------------------
| | 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 obsolete or excess inventories are 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 assesses the impairment of its
long-lived assets whenever events or changes in circumstances
indicate that their carrying amounts may not be recoverable. The
assessment of possible impairment is based on estimates of
future cash flows, undiscounted and without interest charges,
expected to result from the use of those assets and their
eventual disposition. If the sum of the future cash flows is
less than the carrying amounts of those assets, the Company
recognizes an impairment loss based on the excess of the
carrying amounts over the 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.
The Company reviews property and equipment for impairment
whenever events or changes in circumstances indicate that the
carrying amounts of property and equipment may not be
recoverable. Repair and maintenance costs are expensed as
incurred.



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

Identifiable finite lived intangible assets
generally comprises of purchased intellectual property, core
technology, workforce and patents and are amortized on a
straight-line basis over the estimated useful lives of the
assets, as determined by underlying contract terms or
appraisals. Such lives range from 24 months to
5 years. The Company evaluates the recovery of finite lived
intangible assets whenever events or changes in circumstances
indicate that their carrying value may not be recoverable
through the estimated undiscounted future cash flows resulting
from the use of the assets. If we determine that the carrying
value may not be recoverable, we measure impairment by using the
projected discounted cash flow method. During the fourth quarter
of fiscal 2003, we concluded that impairment indicators existed
and that certain long-lived and

41



---



##### Table of Contents



intangible assets and goodwill were impaired and
as a result, we recorded impairment charges of
$3.9 million. During the fourth quarter of 2002, prior to
the implementation of SFAS 142, Goodwill and Other
Intangible Assets, we recorded a $27.4 million charge
for impairment of goodwill and other intangible assets.


The excess of the cost of acquired companies over
the net amounts assigned to assets acquired and liabilities
assumed is recorded as goodwill. Goodwill is not amortized but
instead tested for impairment annually on May 31 and
whenever events or circumstances may occur that might require
the need for more frequent tests. The Company currently operates
as one reporting unit. Accordingly, the impairment test is a
comparison of the Companys market capitalization as
measured by the price of its common stock to the Companys
net asset value. The excess of the fair value of the Company
over the amounts allocated to the identifiable assets and
liabilities of the Company is the implied fair value of the
Companys goodwill.



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

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, 2003 or 2002.



| |                         
| | ------------------------
| | 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

42



---



##### Table of Contents



Statement of Financial Accounting Standards
No. 123 (SFAS 123), Accounting for
Stock-Based Compensation and Statement of Financial
Accounting Standards No. 148 (SFAS 148),
Accounting for Stock-Based Compensation 
Transition and Disclosure are as follows:


|                    |                                                                                    |                          |   |         |       |      |   |         |       |   |   |         |       |  
|------------------- | ---------------------------------------------------------------------------------- | ------------------------ | - | ------- | ----- | ---- | - | ------- | ----- | - | - | ------- | ----- | -
|                    |                                                                                    |                         
|                    |                                                                                    | Year Ended September 30,
|                    |                                                                                    |                         
|                    |                                                                                    | 2003                     |   | 2002    |       | 2001
|                    |                                                                                    |                          |   |         |       |     
|Net loss:           |                                                                                    |                          |   |         |       |      |   |         |       |   |   |        
|                    | As reported                                                                        |                          | $ | (20,341 | )     |      | $ | (67,599 | )     |   | $ | (13,357 | )    
|                    | Add: stock-based employee compensation recorded
    in the Statement of Operations |                          |   | 355     |       |      |   | 2,825   |       |   |   | 3,865   |      
|                    | Less: fair value of stock-based employee
    compensation                          |                          |   | (11,151 | )     |      |   | (12,324 | )     |   |   | (14,121 | )    
|                    |                                                                                    |                          |   |         |       |      |   |         |       |   |   |        
|                    | Pro forma                                                                          |                          | $ | (31,137 | )     |      | $ | (77,098 | )     |   | $ | (23,613 | )    
|                    |                                                                                    |                          |   |         |       |      |   |         |       |   |   |        
|Net loss per share: |                                                                                    |                          |   |         |       |      |   |         |       |   |   |        
|                    | Basic and diluted                                                                  |                          |   |         |       |      |   |         |       |   |   |         |      
|                    |                                                                                    | As reported              |   | $       | (1.89 | )    |   | $       | (6.49 | ) |   | $       | (1.32 | )
|                    |                                                                                    | Pro forma                |   |         | (2.90 | )    |   |         | (7.40 | ) |   |         | (2.33 | )

See Note 7 for a discussion of the
assumptions used in computing the fair value of option grants
for purposes of these disclosures.



| |             
| | ------------
| | Income Taxes

Deferred tax assets and liabilities are
recognized for the expected tax consequences of temporary
differences between the income tax bases of assets and
liabilities and the amounts reported for financial reporting
purposes for all periods presented (see Note 8). Valuation
allowances are established to 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
recorded a valuation allowance of $15.4 million.



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

Comprehensive income (loss) is defined as
the change in equity of a business enterprise during a period
from transactions and other events and circumstances from
non-owner sources. Comprehensive income (loss) includes
foreign currency translation adjustments arising from
consolidation of the Companys foreign subsidiary and
unrealized gains and losses on the Companys short-term
investments. Comprehensive income (loss) is disclosures in
the Consolidated Statements of Stockholders Deficit.



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

During the fourth quarter of fiscal 2003, our
product plans changed as a result of a shift in customer feature
requirements and demand, consequently, long-lived and intangible
assets associated with terminated projects were impaired and the
Company recorded a charge of $3.9 million to write down
developed and licensed technologies. During the fourth quarter
of fiscal 2002, the Company also determined that customer
preferences with respect to the architecture upon which the
Apptitude technology would be delivered had shifted. As a
result, management significantly lowered its estimates of
expected future revenues and cash flows from the Apptitude
technology. The expected future cash flows, undiscounted and
without interest charges, 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, 2003 was approximately $1.0 million.

43



---



##### Table of Contents





| |         
| | --------
| | Goodwill

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 applies to business combinations and
eliminates the pooling-of-interests method of accounting.
Goodwill and intangible assets deemed to have indefinite lives
are no longer amortized and are subject to annual impairment
tests, the first of which was conducted as of October 1,
2002, in accordance with the Statements. Other intangible assets
are amortized over their useful lives. Under the new Statements,
certain intangibles such as workforce acquired in a business
combination were reclassified as goodwill and certain
intangibles were reclassified as previously reported goodwill.
In addition, we have ceased amortization of goodwill. As of
September 30, 2003, the Company has goodwill of
$1.0 million.

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

|                                  |                                     |               |   |         |   |  |   |         |  
|--------------------------------- | ----------------------------------- | ------------- | - | ------- | - |  | - | ------- | -
|                                  |                                     |              
|                                  |                                     | Year Ended   
|                                  |                                     | September 30,
|                                  |                                     |              
|                                  |                                     | 2002          |   | 2001   
|                                  |                                     |               |   |        
|Net loss:                         |                                     |               |   |         |   |  |   |        
|                                  | Reported net loss                   |               | $ | (67,599 | ) |  | $ | (13,357 | )
|                                  | Goodwill and workforce amortization |               |   | 8,897   |   |  |   | 9,724   |  
|                                  |                                     |               |   |         |   |  |   |        
|                                  | Adjusted net loss                   |               | $ | (58,702 | ) |  | $ | (3,633  | )
|                                  |                                     |               |   |         |   |  |   |        
|Basic and diluted loss per share: |                                     |               |   |         |   |  |   |        
|                                  | Reported net loss                   |               | $ | (6.49   | ) |  | $ | (1.32   | )
|                                  | Goodwill and workforce amortization |               |   | .85     |   |  |   | .96     |  
|                                  |                                     |               |   |         |   |  |   |        
|                                  | Adjusted net loss                   |               | $ | (5.64   | ) |  | $ | (0.36   | )
|                                  |                                     |               |   |         |   |  |   |        



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

In June 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 is effective for
exit or disposal activities initiated after December 31,
2002. The Company adopted SFAS 146 during the second fiscal
quarter ended March 31, 2003. The effect of adoption of
SFAS 146 changes on a prospective basis the timing of when
restructuring charges are recorded from a commitment date
approach to when the liability is incurred.

In November 2002, the EITF reached a consensus on
Issue 00-21 (EITF 00-21),
Multiple-Deliverable Revenue Arrangements.
EITF 00-21 addresses how to account for arrangements that
may involve the delivery or performance of multiple products,
services, and/or rights to use assets. The consensus mandates
how to identify whether goods or services or both that are to be
delivered separately in a bundled sales arrangement should be
accounted for separately because they are separate units of
accounting. The guidance can affect the timing of revenue
recognition for such arrangements, even though it does not
change rules governing the timing or pattern of revenue
recognition of individual items accounted for separately. The
final consensus will be applicable to agreements entered into in
fiscal periods beginning after June 15, 2003 with early
adoption permitted. Additionally, companies will be permitted to
apply the consensus guidance to all existing arrangements as the
cumulative effect of a change in accounting principle in
accordance with APB Opinion No. 20, Accounting
Changes. The Companys adoption of EITF 00-21
did not have a material impact on its financial position, cash
flows or results of operations.

44



---



##### Table of Contents



In January 2003, the FASB issued FASB
Interpretation No. 46
(FIN 46),Consolidation of Variable
Interest Entities, an Interpretation of Accounting Research
Bulletin No. 51. FIN 46 requires certain variable
interest entities to be consolidated by the primary beneficiary
of the entity if the equity investors in the entity do not have
the characteristics of a controlling financial interest or do
not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support
from other parties. FIN 46 is effective immediately for all
new variable interest entities created or acquired after
January 31, 2003. For variable interest entities created or
acquired prior to February 1, 2003, the provisions of FIN
46 must be applied for the first interim or annual period
beginning after June 15, 2003. On October 9, 2003, the
FASB released FASB Staff Position 46-6, which deferred the
effective date for the consolidation guidance of FIN 46 from
July 1, 2003 to December 31, 2003, for Variable
Interest Entities existing prior to February 1, 2003. The
Companys adoption of FIN 46 during the quarter ended
June 30, 2003 did not have a material impact on its
financial position, cash flows or results of operations.

In April 2003, the FASB issued Statement of
Accounting Standards No. 149 (SFAS 149),
Amendment of Statement 133 on Derivative Instruments and
Hedging Activities. SFAS 149 amends and clarifies
financial accounting and reporting of derivative instruments and
hedging activities under Statement of Accounting Standards
No. 133 (SFAS 133), Accounting for
Derivative Instruments and Hedging Activities. SFAS 149
amends SFAS 133 for decisions made: (i) as part of the
Derivatives Implementation Group process that require amendment
to SFAS 133, (ii) in connection with other FASB
projects dealing with financial instruments, and (iii) in
connection with the implementation issues raised related to the
application of the definition of a derivative. SFAS 149 is
effective for contracts entered into or modified after
June 30, 2003 and for designated hedging relationships
after June 30, 2003. SFAS 149 will be applied
prospectively. The Companys adoption of SFAS 149 did
not have a material impact on its financial position, cash flows
or results of operations.

In May 2003, the FASB issued Statement of
Accounting Standards No. 150 (SFAS 150),
Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity. The
Statement establishes standards for how an issuer classifies and
measures certain financial instruments with characteristics of
both liabilities and equity and further requires that an issuer
classify as a liability (or an asset in some circumstances)
financial instruments that fall within its scope because that
financial instrument embodies an obligation of the issuer. Many
of such instruments were previously classified as equity. The
statement is effective for financial instruments entered into or
modified after May 31, 2003, and otherwise is effective at
the beginning of the first interim period beginning after
June 15, 2003, except for mandatory redeemable financial
instruments of nonpublic entities. The Statement is implemented
by reporting the cumulative effect of a change in accounting
principle for financial instruments created before the issuance
of the date of the Statement and still existing at the beginning
of the interim period of adoption. Restatement is not permitted.
On October 29, 2003, the FASB voted to indefinitely defer
the effective date of SFAS 150 for mandatorily redeemable
instruments as they relate to minority interests in consolidated
finite-lived entities through the issuance of FASB Staff
Position 150-3. The Companys adoption of this Statement
during the quarter ended September 30, 2003, did not have a
material impact on its financial position, cash flows or results
of operations.

Note 3  Acquisitions



| |                  
| | -----------------
| | 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 partly upon third
party valuations conducted as of the date of acquisition. The
amounts allocated to core technology and workforce of $639,000
and $255,000, respectively, were recorded as intangible assets
and are being amortized on a straight-line basis over a period
of two and fours years, respectively. The design team of 15
engineers related to the acquired intellectual property joined
the Company effective October 1, 2002. Purchased in-process
research and development of $1.1 million related to
processing of IPsec packets, representing the portion of the
acquired technology that was not part of the identifiable core,
was expensed at the time of purchase as a one-time charge
because technological feasibility had not been established.
Technological feasibility was subsequently established

45



---



##### Table of Contents



during October 2004 after the Company continued
to develop the acquired technology at a cost consistent with
expectations. Fixed assets amounted to $122,000.


Note 4  Balance Sheet
Details

|                                                |                                         |                |       |        |   |   |        |        |  
|----------------------------------------------- | --------------------------------------- | -------------- | ----- | ------ | - | - | ------ | ------ | -
|                                                |                                         |               
|                                                |                                         | September 30, 
|                                                |                                         |               
|                                                |                                         | 2003           |       | 2002  
|                                                |                                         |                |       |       
|                                                |                                         |               
|                                                |                                         | (in thousands)
|Property and equipment:                         |                                         |                |       |        |   |   |        |       
|                                                | Computer equipment                      |                | $     | 5,557  |   |   | $      | 4,540  |  
|                                                | Furniture and fixtures                  |                |       | 1,161  |   |   |        | 1,161  |  
|                                                | Leasehold improvements                  |                |       | 1,188  |   |   |        | 1,188  |  
|                                                | Office equipment                        |                |       | 636    |   |   |        | 593    |  
|                                                |                                         |                |       |        |   |   |        |       
|                                                |                                         |                | 8,542 |        |   |   | 7,482  |       
|                                                | Less: accumulated depreciation          |                |       | (6,435 | ) |   |        | (4,902 | )
|                                                |                                         |                |       |        |   |   |        |       
|                                                |                                         | $              | 2,107 |        |   | $ | 2,580  |       
|                                                |                                         |                |       |        |   |   |        |       
|Intangible assets:                              |                                         |                |       |        |   |   |        |       
|                                                | Developed and core technology           |                | $     | 3,903  |   |   | $      | 8,871  |  
|                                                | Workforce                               |                |       | 255    |   |   |        | 255    |  
|                                                | Patents                                 |                |       | 600    |   |   |        | 600    |  
|                                                |                                         |                |       |        |   |   |        |       
|                                                |                                         |                | 4,758 |        |   |   | 9,726  |       
|                                                | Less: accumulated amortization          |                |       | (3,752 | ) |   |        | (3,188 | )
|                                                |                                         |                |       |        |   |   |        |       
|                                                |                                         |                | 1,006 |        |   |   | 6,538  |       
|                                                | Goodwill                                |                |       | 1,029  |   |   |        | 1,029  |  
|                                                |                                         |                |       |        |   |   |        |       
|                                                |                                         | $              | 2,035 |        |   | $ | 7,567  |       
|                                                |                                         |                |       |        |   |   |        |       
|Accrued expenses and other current liabilities: |                                         |                |       |        |   |   |        |       
|                                                | Accrued vacant facility lease cost      |                | $     | 3,492  |   |   | $      | 4,329  |  
|                                                | Accrued non-recurring engineering costs |                |       | 2,120  |   |   |        | 974    |  
|                                                | Deferred revenue                        |                |       | 2,013  |   |   |        | 2,788  |  
|                                                | Compensation and employee benefits      |                |       | 1,486  |   |   |        | 1,367  |  
|                                                | Accrued litigation settlement           |                |       |       |   |   |        | 2,700  |  
|                                                | Other                                   |                |       | 470    |   |   |        | 753    |  
|                                                |                                         |                |       |        |   |   |        |       
|                                                |                                         | $              | 9,581 |        |   | $ | 12,911 |       
|                                                |                                         |                |       |        |   |   |        |       

Note 5  Net Loss Per
Share

Basic earnings per share is computed by dividing
net 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.

Options to purchase 3,593,946, 3,439,366 and
3,521,688 shares of Common Stock at weighted average exercise
prices of $11.14, $12.91 and $26.77 per share were outstanding
at September 30, 2003, 2002 and 2001, respectively, but
were not included in the computation of diluted net loss per
share because their impact would be anti-dilutive.

46



---



##### Table of Contents



Note 6  Supplemental Cash Flow
Information

|                                                              |                                                                  |                          |   |       |  |      |   |       |  |  |   |       | 
|------------------------------------------------------------- | ---------------------------------------------------------------- | ------------------------ | - | ----- |  | ---- | - | ----- |  |  | - | ----- | 
|                                                              |                                                                  |                         
|                                                              |                                                                  | Year Ended September 30,
|                                                              |                                                                  |                         
|                                                              |                                                                  | 2003                     |   | 2002  |  | 2001
|                                                              |                                                                  |                          |   |       |  |     
|                                                              |                                                                  |                         
|                                                              |                                                                  | (in thousands)          
|Supplemental cash flow information:                           |                                                                  |                          |   |       |  |      |   |       |  |  |   |      
|                                                              | Cash paid during the year for interest                           |                          | $ |      |  |      | $ | 8     |  |  | $ | 15    | 
|                                                              | Cash paid during the year for income taxes                       |                          |   | 8     |  |      |   | 206   |  |  |   | 1,424 | 
|                                                              | Cash received during the year from refund of
    income taxes    |                          |   | 2,660 |  |      |   | 1,208 |  |  |   | 1,375 | 
|Supplemental non-cash investing and financing
    activities: |                                                                  |                          |   |       |  |      |   |       |  |  |   |      
|                                                              | Common stock issued upon purchase of intellectual
    property   |                          |   |      |  |      |   | 2,202 |  |  |   |      | 
|                                                              | Common stock issued in settlement of class action
    litigation |                          |   | 2,700 |  |      |   |      |  |  |   |      | 

Note 7  Stock Options and
Employee Benefits



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

The 1996 Equity Incentive Plan (the 1996
Plan) had 4,949,900 shares of the Companys Common
Stock reserved for issuance pursuant to nonqualified and
incentive stock options and restricted stock awards. The 1996
Plan is administered by the Board of Directors of the Company or
its designees and provides generally that nonqualified stock
options and restricted stock may be awarded at a price not less
than 85% of the fair market value of the stock at the date of
the award. Incentive stock options must be awarded at a price
not less than 100% of the fair market value of the stock at the
date of the award, or 110% of fair market value for awards to
more than 10% stockholders. Options granted under the 1996 Plan
may have a term of up to 10 years. Options typically vest
at a rate of 25% of the total grant per year over a four-year
period. However, the Company may, at its discretion, implement a
different vesting schedule with respect to any new stock option
grant. As a result of early exercise features as provided for by
the 1996 Plan, options granted are immediately exercisable
subject to the Companys repurchase rights which expire as
options vest.

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

In February 2001, the Board of Directors of the
Company adopted the 2001 NonStatutory Stock Option Plan (the
2001 Plan) whereby 1,500,000 shares of the
Companys Common Stock were reserved for issuance pursuant
to nonqualified stock options. In June 2002, 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

47



---



##### Table of Contents



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.


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

|                              |                              |                   |           |             |   |                     |           |            |   |   |       |       | 
|----------------------------- | ---------------------------- | ----------------- | --------- | ----------- | - | ------------------- | --------- | ---------- | - | - | ----- | ----- | 
|                              |                              |                   |           |             |   | Weighted Average   
|                              |                              |                   |           |             |   | Exercise Price (per
|                              |                              | Options Available |           | Options     |   | share) of Options  
|                              |                              | for Grant         |           | Outstanding |   | Outstanding        
|                              |                              |                   |           |             |   |                    
|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 |      
|                              | Additional shares authorized |                   |           | 500,000     |   |                     |           |            |   |   |       |       | 
|                              | Options granted              |                   |           | (900,574    | ) |                     |           | 900,574    |   |   |       | 4.74  | 
|                              | Options exercised            |                   |           |            |   |                     |           | (248,851   | ) |   |       | 3.88  | 
|                              | Options cancelled            |                   |           | 474,731     |   |                     |           | (497,143   | ) |   |       | 15.42 | 
|                              |                              |                   |           |             |   |                     |           |            |   |   |       |      
|Balance at September 30, 2003 |                              |                   | 2,134,769 |             |   |                     | 3,593,946 |            |   |   | 11.14 |      
|                              |                              |                   |           |             |   |                     |           |            |   |   |       |      

The following table summarizes options
outstanding at September 30, 2003 and related weighted
average exercise prices and lives as follows:

|                |  |                                     |           |                    |  |                |      |          |  |                |       |  |  |  |           |  |  |   |       | 
|--------------- |  | ----------------------------------- | --------- | ------------------ |  | -------------- | ---- | -------- |  | -------------- | ----- |  |  |  | --------- |  |  | - | ----- | 
|                |  |                                     |           |                   
|                |  | Options Outstanding and Exercisable |           | Options Vested and
|                |  |                                     |           | Exercisable       
|                |  |                                     |           | Weighted           |  |                |      |         
|                |  |                                     |           | Average            |  | Weighted       |      |          |  | Weighted      
|Range of        |  |                                     |           | Remaining Life     |  | Average        |      |          |  | Average       
|Exercise Prices |  | Quantity                            |           | (in years)         |  | Exercise Price |      | Quantity |  | Exercise Price
|                |  |                                     |           |                    |  |                |      |          |  |               
|$  0.60-$  3.15 |  |                                     | 179,526   |                    |  |                | 4.41 |          |  | $              | 2.44  |  |  |  | 179,526   |  |  | $ | 2.44  | 
|3.91-   4.12    |  |                                     | 442,626   |                    |  |                | 9.00 |          |  |                | 4.11  |  |  |  | 275,799   |  |  |   | 4.12  | 
|4.65-   5.35    |  |                                     | 420,649   |                    |  |                | 7.96 |          |  |                | 5.14  |  |  |  | 132,878   |  |  |   | 5.00  | 
|5.36-   6.00    |  |                                     | 163,502   |                    |  |                | 8.74 |          |  |                | 5.69  |  |  |  | 36,094    |  |  |   | 5.81  | 
|6.09-   6.66    |  |                                     | 768,735   |                    |  |                | 6.84 |          |  |                | 6.64  |  |  |  | 611,343   |  |  |   | 6.65  | 
|6.97-  13.93    |  |                                     | 406,027   |                    |  |                | 8.07 |          |  |                | 11.51 |  |  |  | 201,542   |  |  |   | 11.85 | 
|13.94-  13.94   |  |                                     | 4,000     |                    |  |                | 7.46 |          |  |                | 13.94 |  |  |  | 2,500     |  |  |   | 13.94 | 
|14.69-  14.69   |  |                                     | 412,000   |                    |  |                | 7.42 |          |  |                | 14.69 |  |  |  | 258,429   |  |  |   | 14.69 | 
|14.72-  16.00   |  |                                     | 483,020   |                    |  |                | 7.93 |          |  |                | 15.76 |  |  |  | 245,733   |  |  |   | 15.78 | 
|16.19- 125.50   |  |                                     | 313,861   |                    |  |                | 6.76 |          |  |                | 35.68 |  |  |  | 258,791   |  |  |   | 37.94 | 
|                |  |                                     |           |                    |  |                |      |          |  |                |       |  |  |  |           |  |  |   |       | 
|0.60- 125.50    |  |                                     | 3,593,946 |                    |  |                | 7.55 |          |  |                | 11.14 |  |  |  | 2,202,635 |  |  |   | 12.00 | 
|                |  |                                     |           |                    |  |                |      |          |  |                |       |  |  |  |           |  |  |   |       | 

48



---



##### Table of Contents



The weighted average fair value of options
granted during 2003, 2002 and 2001 were $3.09, $5.42 and $9.56,
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 2003, 2002 and
2001: annual dividend yield of 0.0% for all periods; risk-free
annual interest rates of 2.49%, 3.77% and 4.66%, respectively; a
weighted average expected stock award term of 4.0 years for
all periods; and an expected volatility factor of 90%, 80% and
70%, 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, 174,265 and
69,746 shares were issued during fiscal 2003 and 2002,
respectively, at weighted average prices of $4.48 and $10.10 per
share, respectively.

The fair value of shares issued during fiscal
2003, 2002 and 2001 were $5.27, $11.89 and $29.58, 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 1.23%, 1.92% and 4.66%; weighted average
expected stock award term of 0.50 years for each of the
fiscal years; and an expected volatility factor of 70%, 80% and
70%.

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

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 a
straight-line basis over the vesting period of the related
options, ranging from six months to four years. Amortization of
deferred stock compensation of $355,000 and $1.1 million
was recorded during the fiscal years ended September 30,
2003 and 2002, respectively. In connection with the voluntary
option exchange program in fiscal 2002, 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.



| |                     
| | --------------------
| | 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. The Plan provides for
employer contributions; however, the Company has not made any
contributions to the Plan since its inception.

49



---



##### Table of Contents



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,
|                                          |         |                         
|                                          |         | 2003                     |        | 2002   |   | 2001
|                                          |         |                          |        |        |   |     
|Current:                                  |         |                          |        |        |   |      |       |       |  |   |        |       
|                                          | Federal |                          | $      | (1,670 | ) |      | $     |      |  |   | $      | 1,475  |  
|                                          | State   |                          |        | (172   | ) |      |       |      |  |   |        | 310    |  
|                                          | Foreign |                          |        |       |   |      |       | 55    |  |   |        | 63     |  
|                                          |         |                          |        |        |   |      |       |       |  |   |        |       
|                                          |         |                          | (1,842 | )      |   |      | 55    |       |  |   | 1,848  |       
|                                          |         |                          |        |        |   |      |       |       |  |   |        |       
|Deferred:                                 |         |                          |        |        |   |      |       |       |  |   |        |       
|                                          | Federal |                          |        |       |   |      |       | 5,959 |  |   |        | (2,393 | )
|                                          | State   |                          |        |       |   |      |       |      |  |   |        | (1,115 | )
|                                          |         |                          |        |        |   |      |       |       |  |   |        |       
|                                          |         |                          |       |        |   |      | 5,959 |       |  |   | (3,508 | )     
|                                          |         |                          |        |        |   |      |       |       |  |   |        |       
|Provision for (benefit from) income taxes |         | $                        | (1,842 | )      |   | $    | 6,014 |       |  | $ | (1,660 | )     
|                                          |         |                          |        |        |   |      |       |       |  |   |        |       

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

|                                         |                        |               |         |      |  |   |         |   | 
|---------------------------------------- | ---------------------- | ------------- | ------- | ---- |  | - | ------- | - | 
|                                         |                        |              
|                                         |                        | September 30,
|                                         |                        |              
|                                         |                        | 2003          |         | 2002
|                                         |                        |               |         |     
|Net operating loss                       |                        | $             | 13,843  |      |  | $ | 8,100   |  
|Property and equipment                   |                        |               | 439     |      |  |   | 448     |  
|Inventory valuation accounts             |                        |               | 1,097   |      |  |   | 1,407   |  
|Accruals and reserves                    |                        |               | 3,960   |      |  |   | 3,570   |  
|Research and development credit          |                        |               | 6,670   |      |  |   | 1,907   |  
|Amortization of intangibles and goodwill |                        |               | 2,761   |      |  |   | 21      |  
|                                         |                        |               |         |      |  |   |         |  
|                                         |                        |               | 28,970  |      |  |   | 15,453  |  
|                                         | Deferred tax liability |               |         | 159  |  |   |         |  | 
|Valuation allowance                      |                        |               | (28,610 | )    |  |   | (15,453 | )
|                                         |                        |               |         |      |  |   |         |  
|                                         |                        | $             |        |      |  | $ |        |  
|                                         |                        |               |         |      |  |   |         |  

As of September 30, 2003, the Company had
approximately $39.3 million of federal and
$7.7 million of state net operating loss carryforwards
available to offset future taxable income. The Company also had
approximately $4.4 million of federal and $3.5 million
of state research and development tax credit carryforwards.
These tax attributes expire in varying amounts between 2004 and
2022. 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.

50



---



##### Table of Contents



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,
|                                                        |  |                         
|                                                        |  | 2003                     |        | 2002 |  | 2001
|                                                        |  |                          |        |      |  |     
|Tax at federal statutory rate                           |  | $                        | (7,542 | )    |  | $    | (20,939 | ) |  | $ | (5,084 | )
|State taxes, net of federal tax benefit                 |  |                          | (1,569 | )    |  |      |        |   |  |   | (805   | )
|Nondeductible intangible amortization and
    write-off |  |                          |       |      |  |      | 12,295  |   |  |   | 3,204  |  
|Stock compensation                                      |  |                          | 115    |      |  |      | 960     |   |  |   | 1,310  |  
|Research and development credits                        |  |                          | (3,590 | )    |  |      |        |   |  |   |       |  
|Net operating loss carryback refund                     |  |                          | (1,670 | )    |  |      |        |   |  |   |       |  
|Deferred stock benefits not recognized                  |  |                          | 12,902 |      |  |      | 13,629  |   |  |   |       |  
|Other                                                   |  |                          | (488   | )    |  |      | 69      |   |  |   | (285   | )
|                                                        |  |                          |        |      |  |      |         |   |  |   |        |  
|                                                        |  | $                        | (1,842 | )    |  | $    | 6,014   |   |  | $ | (1,660 | )
|                                                        |  |                          |        |      |  |      |         |   |  |   |        |  

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

The Company operates in one industry segment
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 34%, 46% and 36% of the
Companys net revenues for the fiscal years ended
September 30, 2003, 2002 and 2001, respectively. Revenues
from another customer, through its manufacturing subcontractor,
represented 23% of the Companys net revenues for fiscal
years ended September 30, 2003. Revenues from another
customer represented 17% of net revenues for the fiscal year
ended September 30, 2001.

Note 10  Commitments and
Contingencies



| |       
| | ------
| | 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, |                              |   |       |      
|2004                             |                              | $ | 2,874 |      
|2005                             |                              |   | 2,259 |      
|2006                             |                              |   | 895   |      
|2007                             |                              |   | 906   |      
|Thereafter                       |                              |   | 229   |      
|                                 |                              |   |       |      
|                                 | Total minimum lease payments |   | $     | 7,163 | 
|                                 |                              |   |       |      

51



---



##### Table of Contents



Total rental expense under operating leases was
$3.3 million, $3.1 million and $2.9 million for
fiscal years ended September 30, 2003, 2002 and 2001,
respectively. The Company recorded sub-lease income of $274,000
during fiscal year ended September 30, 2001. During fiscal
2002, 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.



| |           
| | ----------
| | Guarantees

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

As permitted under Delaware law, the Company has
agreements that provide indemnification of officers and
directors for certain events or occurrences while the officer or
director is, or was serving, at the Companys request in
such capacity. The indemnification period is effective for the
officer or directors lifetime. The maximum potential
amount of future payments that the Company could be required to
make under these indemnification agreements is unlimited;
however, the Company has a Director and Officer insurance policy
that limits its exposure and enables the Company to recover a
portion of any future amounts paid. All of the indemnification
agreements were grandfathered under the provisions of
FIN 45 as they were in effect prior to December 31,
2002. As a result of the insurance policy coverage, the Company
believes the estimated fair value of these indemnification
agreements is minimal. Accordingly, the Company has not recorded
any liabilities for these agreements as of September 30,
2003.

The Company enters into standard indemnification
agreements in the ordinary course of business. Pursuant to these
agreements, the Company indemnifies, holds harmless, and agrees
to reimburse the indemnified party, generally business partners
or customers, for losses suffered or incurred in connection with
patent, copyright or other intellectual property infringement
claims by any third party with respect to the Companys
products. The term of these indemnification agreements is
generally perpetual, effective after execution of the agreement.
The maximum potential amount of future payments the Company
could be required to make under these indemnification agreements
is unlimited. To date, the Company has not incurred costs to
defend lawsuits or settle claims related to these
indemnification agreements. Accordingly, the Company believes
the estimated fair value of these indemnifications is minimal
and no liabilities have been recorded for these agreements as of
September 30, 2003.

The Company warrants that its hardware products
are free from defects in material and workmanship under normal
use and service and that its hardware and software products will
perform in all material respects in accordance with the standard
published specifications in effect at the time of delivery of
the licensed products to the customer. The warranty periods
generally range from three months to one year. Additionally, the
Company warrants that its maintenance services will be performed
consistent with generally accepted industry standards through
completion of the agreed upon services. If necessary, the
Company would provide for the estimated cost of product and
service warranties based on specific warranty claims and claim
history, however, the Company has not incurred significant
expense under its product or service warranties. As a result,
the Company has not recorded any liabilities for warranties as
of September 30, 2003.

52



---



##### Table of Contents



Note 11  Litigation

During fiscal 2003, the Company completed the
settlement terms of the class action complaint and had
shareholder derivative actions dismissed. As of
September 30, 2003, there were no outstanding claims and
the Company did not have any outstanding obligations. Details
relating to the class action complaint and the shareholder
derivative actions are as follows:

In 1999, a class action complaint was filed
against the Company and certain of its officers and directors
alleging 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 May
2002, a settlement agreement was reached and in September 2002,
a final judgment and order of dismissal with prejudice was
issued by the court. Under the terms of the settlement, all
claims were dismissed without any admission of liability or
wrongdoing by any defendant, and the shareholder class received
$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 aggregating 285,412 shares, valued
at $2.7 million, based on the agreed price of $9.46 per
share. The cash and Common Stock settlements were distributed in
September 2003. Hifn is not obligated to perform any additional
action and considers the class action litigation to be resolved.

In March 2002, two purported shareholder
derivative actions were filed against the Company and certain of
its current and former officers and directors, alleging
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. In May
2003, the court entered an order dismissing the action against
the Company and all of the individual defendants with prejudice.

Note 12  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 2003:                          |  |                                          |         |         |  |          |         |             |  |   |        |   |  |   |        |  
|Net revenues                          |  | $                                        | 6,249   |         |  | $        | 5,267   |             |  | $ | 4,549  |   |  | $ | 4,415  |  
|Total costs and operating expenses    |  |                                          | 1,809   |         |  |          | 1,767   |             |  |   | 1,557  |   |  |   | 1,434  |  
|Net loss                              |  |                                          | (5,835  | )       |  |          | (4,085  | )           |  |   | (5,298 | ) |  |   | (5,123 | )
|Net loss per share, basic and diluted |  |                                          | (0.53   | )       |  |          | (0.38   | )           |  |   | (0.50  | ) |  |   | (0.48  | )
|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  | )

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

Not applicable.

Item 9A.     Controls
and Procedures

(a) Evaluation of disclosure controls and
procedures.Based on their evaluation, 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.

53



---



##### Table of Contents



(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 III






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

The information required by Item 10 is
incorporated by reference from Hifns Proxy Statement for
the fiscal year ended September 30, 2003. The information
required by Item 10 regarding our executive officers
appears immediately following Item 4 under Part I of this
report.

While Nasdaq made certain proposed rules
regarding the adoption of a code of ethics and conduct, Hifn has
not yet adopted a code of ethics and conduct that applies to its
principal executive officer, principal financial officer,
principal accounting officer or controller, or persons
performing similar functions. Hifn determined that it would be
prudent to wait for final SEC approval of amendments to NASD
Rule 4350, which sets forth the requirements for the code,
prior to the adoption of a code of ethics and conduct. Now that
SEC approval has been given to the proposed amendments, Hifn is
working to adopt a code of ethics and conduct as soon as
possible, but no later than May 4, 2004, in conformance
with NASD Rule 4350. Once adopted, such code of ethics and
conduct shall be promptly made available on Hifns website
at www.hifn.com.






|         |                       
|-------- | ----------------------
|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, 2003.






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

The information required by this item is
incorporated by reference from Hifns Proxy Statement for
the fiscal year ended September 30, 2003.






|         |                                                   
|-------- | --------------------------------------------------
|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, 2003.






|         |                                           
|-------- | ------------------------------------------
|Item 14. | Principal Accounting Fees and
    Services

The information required by this item is
incorporated by reference from Hifns Proxy Statement for
the fiscal year ended September 30, 2003.




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 58.

54



---



##### Table of Contents





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

|        |          |         |  |                                                                                                                                                           
|------- | -------- | ------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |          |        
|Number  |          | Exhibit
|        |          |        
|        | 3.1*     |         |  | Form of Third Amended and Restated Certificate of
    Incorporation of hi/fn, inc.                                                                        
|        | 3.2*     |         |  | Amended and Restated Bylaws of hi/fn, inc.                                                                                                                
|        | 10.1*    |         |  | Amended and Restated 1996 Equity Incentive Plan
    of hi/fn, inc.                                                                                        
|        | 10.2*    |         |  | Assignment, Assumption and License Agreement
    dated as of November 21, 1996 between Stac, Inc. and hi/fn,
    inc.                                     
|        | 10.3*    |         |  | Cross License Agreement dated as of
    November 21, 1996 between Stac, Inc. and hi/fn, inc.                                                              
|        | 10.4*    |         |  | Form of Distribution Agreement.                                                                                                                           
|        | 10.5*    |         |  | Form of Employee Benefits and Other Matters
    Allocation Agreement.                                                                                     
|        | 10.6*    |         |  | Form of Tax Allocation and Indemnity Agreement.                                                                                                           
|        | 10.7*    |         |  | Form of Transitional Services Agreement.                                                                                                                  
|        | 10.8*    |         |  | Form of Indemnification Agreement.                                                                                                                        
|        | 10.9*    |         |  | Agreement dated as of April 1, 1994 between
    International Business Machines Corporation and Stac, Inc.
    (Program Patent License Agreement).        
|        | 10.10*   |         |  | Agreement dated as of April 1, 1994 between
    International Business Machines Corporation and Stac, Inc.
    (Cross License Agreement).                 
|        | 10.11*   |         |  | License Agreement dated as of June 20, 1994
    between Microsoft Corporation and Stac, Inc.                                                              
|        | 10.12*   |         |  | License Agreement dated as of February 16,
    1996 between Microsoft Corporation and Stac, Inc.                                                          
|        | 10.13*   |         |  | License Agreement dated as of December 15,
    1995 between Motorola, Inc. and Stac, Inc.                                                                 
|        | 10.14*   |         |  | Agreement dated as of November 13, 1997
    between 750 University, LLC and hi/fn, inc.                                                                   
|        | 10.15*   |         |  | 1998 Employee Stock Purchase Plan of hi/fn, inc.                                                                                                          
|        | 10.16*   |         |  | Form of Director Change of Control Agreement.                                                                                                             
|        | 10.17*   |         |  | Form of Employee Change of Control Agreement.                                                                                                             
|        | 10.18*   |         |  | Promissory Note dated as of September 28,
    1998 made by hi/fn, inc. in favor of Stac, Inc.                                                             
|        | 10.19*   |         |  | Security Agreement dated as of September 28,
    1998 between Stac, Inc. and hi/fn, inc.                                                                  
|        | 10.20**  |         |  | Agreement and Plan of Reorganization, dated
    May 12, 2000 between hi/fn, inc. and Apptitude, Inc. and
    amendments thereto.                          
|        | 10.21*** |         |  | Apptitude, Inc. 1995 Stock Option Plan.                                                                                                                   
|        | 10.22   |         |  | Agreement dated as of October 23, 2000
    between Spieker Properties, L.P. and hi/fn, inc.                                                               
|        | 10.23   |         |  | Agreement dated as of October 24, 2000
    between Sally Spencer and hi/fn, inc.                                                                          
|        | 10.24  |         |  | Agreement dated as of April 6, 2001 between
    Sally Spencer and hi/fn, inc.                                                                             
|        | 10.25 |         |  | 2001 Nonstatutory Stock Option Plan of hi/fn, inc.                                                                                                        
|        | 21.1     |         |  | Subsidiaries of the Registrant                                                                                                                            
|        | 23.1     |         |  | Consent of PricewaterhouseCoopers LLP,
    independent accountants.                                                                                       
|        | 24.1     |         |  | Power of Attorney (see page 53).                                                                                                                          
|        | 31.1     |         |  | Certification of Chief Executive Officer pursuant
    to Section 302(a) of the Sarbanes-Oxley Act of 2002.                                                
|        | 31.2     |         |  | Certification of Chief Financial Officer pursuant
    to Section 302(a) of the Sarbanes-Oxley Act of 2002.                                                
|        | 32.1     |         |  | Certification of Chief Executive Officer pursuant
    to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.

55



---



##### Table of Contents



|        |      |         |  |                                                                                                                                                           
|------- | ---- | ------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |      |        
|Number  |      | Exhibit
|        |      |        
|        | 32.2 |         |  | Certification of Chief Financial Officer pursuant
    to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.



---



|    |                                                                                                                                                                                                                                 
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*   | Incorporated by reference from Registrants
    Registration Statement on Form 10 (File No. 0-24765)
    filed with the SEC on August 7, 1998, as amended.                                                                      
|   
|**  | Incorporated by reference from the exhibits to
    Registrants Report on Form 8-K (File
    No. 0-24765) filed with the SEC on August 25, 2000.                                                                                
|   
|*** | Incorporated by reference from Registrants
    Registration Statement on Form S-8 (File
    No. 333-48232) filed with the SEC on October 19, 2000.                                                                             
|   
|   | Incorporated by reference from Registrants
    Report on Form 10-K (File No. 0-24765) filed with the
    SEC on December 26, 2000.                                                                                             
|   
|  | Incorporated by reference from Registrants
    Report on Form 10-Q (File No. 0-24765) filed with the
    SEC on May 1, 2001.                                                                                                   
|   
| | Incorporated by reference from Registrants
    Report on Form 10-Q (File No. 0-24765) and
    Registration Statement on Form S-8 (File No. 333-61070)
    filed with the SEC on May 1, 2001 and May 16, 2001,
    respectively.



| |     |                                 
| | --- | --------------------------------
| | (b) | Reports on Form 8-K: 
     None.

(c) Exhibits: See Item 14(a) above.



| |     |                                                                                   
| | --- | ----------------------------------------------------------------------------------
| | (d) | Financial Statement Schedules 
     Schedule II  Valuation Qualifying Accounts 58

56



---



##### 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 15, 2003

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 12,
2003.

|                                                 |  |                                                                                                                    
|------------------------------------------------ |  | -------------------------------------------------------------------------------------------------------------------
|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                                                                                                           

57



---



##### 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, 2001 |                | $ | 369        |  |            | $ | 309        |  |            |  |  |  |  | $ | (507 | ) |  | $ | 171 | 
|                                  | Year ended September 30, 2002 |                |   | 171        |  |            |   | 75         |  |            |  |  |  |  |   | (82  | ) |  |   | 164 | 
|                                  | Year ended September 30, 2003 |                |   | 164        |  |            |   | 75         |  |            |  |  |  |  |   | (34  | ) |  |   | 205 | 

58



---



##### 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.                                                                                                    
|        | 21.1     |         |  | Subsidiaries of the Registrant                                                                                                                            
|        | 23.1     |         |  | Consent of PricewaterhouseCoopers LLP,
    independent accountants.                                                                                       
|        | 24.1     |         |  | Power of Attorney (see page 58).                                                                                                                          
|        | 31.1     |         |  | Certification of Chief Executive Officer pursuant
    to Section 302(a) of the Sarbanes-Oxley Act of 2002.                                                
|        | 31.2     |         |  | Certification of Chief Financial Officer pursuant
    to Section 302(a) of the Sarbanes-Oxley Act of 2002.                                                
|        | 32.1     |         |  | Certification of Chief Executive Officer pursuant
    to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.

59



---



##### Table of Contents



|        |      |         |  |                                                                                                                                                           
|------- | ---- | ------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |      |        
|Number  |      | Exhibit
|        |      |        
|        | 32.2 |         |  | Certification of Chief Financial Officer pursuant
    to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.



---



|    |                                                                                                                                                                                                                                 
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*   | Incorporated by reference from Registrants
    Registration Statement on Form 10 (File No. 0-24765)
    filed with the SEC on August 7, 1998, as amended.                                                                      
|   
|**  | Incorporated by reference from the exhibits to
    Registrants Report on Form 8-K (File
    No. 0-24765) filed with the SEC on August 25, 2000.                                                                                
|   
|*** | Incorporated by reference from Registrants
    Registration Statement on Form S-8 (File
    No. 333-48232) filed with the SEC on October 19, 2000.                                                                             
|   
|   | Incorporated by reference from Registrants
    Report on Form 10-K (File No. 0-24765) filed with the
    SEC on December 26, 2000.                                                                                             
|   
|  | Incorporated by reference from Registrants
    Report on Form 10-Q (File No. 0-24765) filed with the
    SEC on May 1, 2001.                                                                                                   
|   
| | Incorporated by reference from Registrants
    Report on Form 10-Q (File No. 0-24765) and
    Registration Statement on Form S-8 (File
    No. 333-61070) filed with the SEC on May 1, 2001 and
    May 16, 2001, respectively.

60