##### 



U.S. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the Quarterly Period Ended March 31, 2004 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the Transition Period From _____ to _____ COMMISSION FILE NUMBER 0-24765 hi/fn, inc.  Delaware
(State or other jurisdiction of
Incorporation or Organization)
    
    33-0732700
(IRS Employer
Identification Number)
 750 University Avenue, Los Gatos, California 95032
(Address of principal executive offices and Zip Code) Registrants telephone number, including area code: (408) 399-3500 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 x       No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes x       No o The number of shares outstanding of the Registrants Common Stock, par value
$.001 per share, was 13,807,288 at May 3, 2004.




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HIFN, INC. INDEX TO FORM 10-Q PART I.
    
    FINANCIAL INFORMATIONItem 1.
    
    Financial Statements (unaudited)Condensed Consolidated Balance Sheets
as of March 31, 2004 and September 30, 2003
    
    3Condensed Consolidated Statements of Operations
for the three and six months ended March 31, 2004 and 2003
    
    4Condensed Consolidated Statements of Cash Flows
for the six months ended March 31, 2004 and 2003
    
    5Notes to Condensed Consolidated Financial Statements
    
    6  9Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    10  25Item 3.
    
    Quantitative and Qualitative Disclosure About Market Risks
    
    26Item 4.
    
    Controls and Procedures
    
    26PART II.
    
    OTHER INFORMATIONItem 4.
    
    Submission of Matters to a Vote of Security Holders
    
    27Item 5.
    
    Other Information
    
    27Item 6.
    
    Exhibits and Reports on Form 8-K
    
    28Signatures
    
    29Index to ExhibitsExhibit 31.1
    
    
    Certification of Chief Executive Officer pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.Exhibit 31.2
    
    
    Certification of Chief Financial Officer pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.Exhibit 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.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.
 2




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##### 



PART 1  FINANCIAL INFORMATION Item 1. Financial Statements HIFN, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited) March 31,
    
    September 30,2004
    
    2003ASSETSCURRENT ASSETS:Cash and cash equivalents
    
    $
    22,930
    
    
    $
    41,080Short-term investments
    
    
    31,395
    
    
    
    1,994Accounts receivable, net
    
    
    4,080
    
    
    
    2,715Inventories
    
    
    1,089
    
    
    
    355Prepaid expenses and other current assets
    
    
    1,856
    
    
    
    1,025Total current assets
    
    
    61,350
    
    
    
    47,169Property and equipment, net
    
    
    1,609
    
    
    
    2,107Intangible assets, net
    
    
    12,984
    
    
    
    2,035Other assets
    
    
    1,077
    
    
    
    1,510$
    77,020
    
    
    $
    52,821LIABILITIES AND STOCKHOLDERS EQUITYCURRENT LIABILITIES:Accounts payable
    
    $
    2,623
    
    
    $
    2,123Accrued expenses and other current liabilities
    
    
    7,432
    
    
    
    9,581Total current liabilities
    
    
    10,055
    
    
    
    11,704STOCKHOLDERS EQUITY:Common stock
    
    
    14
    
    
    
    11Additional paid-in capital
    
    
    160,968
    
    
    
    127,473Accumulated deficit
    
    
    (94,017
    )
    
    
    (86,367
    )Total stockholders equity
    
    
    66,965
    
    
    
    41,117$
    77,020
    
    
    $
    52,821
 See accompanying notes to condensed consolidated financial statements. 3




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##### 



HIFN, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited) Three Months Ended
    
    Six Months EndedMarch 31,
    
    March 31,2004
    
    2003
    
    2004
    
    2003Net revenues:Processors
    
    $
    8,564
    
    
    $
    3,707
    
    
    $
    13,286
    
    
    $
    7,479Software licenses and other
    
    
    1,809
    
    
    
    842
    
    
    
    4,224
    
    
    
    1,485Total net revenues
    
    
    10,373
    
    
    
    4,549
    
    
    
    17,510
    
    
    
    8,964Costs and operating expenses:Cost of revenues  processors
    
    
    2,753
    
    
    
    1,458
    
    
    
    4,103
    
    
    
    2,793Cost of revenues  software licenses and other
    
    
    120
    
    
    
    99
    
    
    
    240
    
    
    
    198Research and development
    
    
    5,681
    
    
    
    5,417
    
    
    
    10,370
    
    
    
    10,631Sales and marketing
    
    
    1,943
    
    
    
    1,741
    
    
    
    3,631
    
    
    
    3,516General and administrative
    
    
    1,228
    
    
    
    885
    
    
    
    2,221
    
    
    
    1,872Amortization of intangible assets
    
    
    1,318
    
    
    
    359
    
    
    
    1,469
    
    
    
    717Purchased in-process research and development
    
    
    
    
    
    
    
    
    
    
    3,337
    
    
    
    Total costs and operating expenses
    
    
    13,043
    
    
    
    9,959
    
    
    
    25,371
    
    
    
    19,727Loss from operations
    
    
    (2,670
    )
    
    
    (5,410
    )
    
    
    (7,861
    )
    
    
    (10,763
    )Interest and other income, net
    
    
    109
    
    
    
    112
    
    
    
    211
    
    
    
    342Loss before income taxes
    
    
    (2,561
    )
    
    
    (5,298
    )
    
    
    (7,650
    )
    
    
    (10,421
    )Provision for income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    $
    (2,561
    )
    
    $
    (5,298
    )
    
    $
    (7,650
    )
    
    $
    (10,421
    )Net loss per share, basic and diluted
    
    $
    (0.20
    )
    
    $
    (0.50
    )
    
    $
    (0.63
    )
    
    $
    (0.98
    )Weighted average shares outstanding,
basic and diluted
    
    
    12,892
    
    
    
    10,599
    
    
    
    12,141
    
    
    
    10,592
 See accompanying notes to condensed consolidated financial statements. 4




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HIFN, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited) Six Months EndedMarch 31,2004
    
    2003Cash flows from operating activities:Net loss
    
    $
    (7,650
    )
    
    $
    (10,421
    )Adjustments to reconcile net loss to
net cash used in operating activities:Depreciation and amortization
    
    
    670
    
    
    
    784Amortization of intangible assets
    
    
    1,469
    
    
    
    1,214Amortization of deferred stock compensation
    
    
    87
    
    
    
    223Loss on disposal of fixed assets
    
    
    175
    
    
    
    Purchased in-process research and development
    
    
    3,337
    
    
    
    Changes in assets and liabilities:Accounts receivable
    
    
    (1,365
    )
    
    
    309Inventories
    
    
    (734
    )
    
    
    123Prepaid expenses and other current assets
    
    
    (831
    )
    
    
    (1,230
    )Other assets
    
    
    433
    
    
    
    368Accounts payable
    
    
    500
    
    
    
    882Accrued expenses and other current liabilities
    
    
    (2,149
    )
    
    
    (284
    )Net cash used in operating activities
    
    
    (6,058
    )
    
    
    (8,032
    )Cash flows from investing activities:Purchase of certain assets and intellectual property
    
    
    (15,755
    )
    
    
    Sale (purchase) of short-term investments, net
    
    
    (29,401
    )
    
    
    1,606Purchase of property and equipment
    
    
    (347
    )
    
    
    (704
    )Net cash provided by (used in) investing activities
    
    
    (45,503
    )
    
    
    902Cash flows from financing activities:Proceeds from private placement financing, net
    
    
    30,980
    
    
    
    Proceeds from issuance of common stock, net
    
    
    2,431
    
    
    
    511Net cash provided by financing activities
    
    
    33,411
    
    
    
    511Net decrease in cash and cash equivalents
    
    
    (18,150
    )
    
    
    (6,619
    )Cash and cash equivalents at beginning of period
    
    
    41,080
    
    
    
    53,060Cash and cash equivalents at end of period
    
    $
    22,930
    
    
    $
    46,441
 See accompanying notes to condensed consolidated financial statements. 5




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HIFN, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited) Note 1  Basis of Presentation The condensed consolidated financial statements of hi/fn, inc. (Hifn or
the Company) include the accounts of the Company and its subsidiaries, Hifn
Limited and Hifn Netherlands B.V. All significant intercompany accounts and
transactions have been eliminated. 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. The accompanying condensed consolidated financial statements have been
prepared pursuant to the rules and regulations of the Securities and Exchange
Commission regarding interim financial reporting. Accordingly, they do not
include all of the information and footnotes required by generally accepted
accounting principles for complete financial statements and should be read in
conjunction with the Financial Statements and notes thereto included in the
Companys Form 10-K for period ending September 30, 2003. In the opinion of
management, the accompanying condensed consolidated financial statements
contain all adjustments, consisting only of normal recurring adjustments, which
the Company believes is necessary for a fair statement of the Companys
financial position as of March 31, 2004 and its results of operations for the
three and six months ended March 31, 2004 and 2003, respectively. These
condensed consolidated financial statements are not necessarily indicative of
the results to be expected for the entire year. 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. On February 6, 2004, the Company entered into a securities purchase
agreement with certain investors for the private placement of 2.2 million
shares of the Companys Common Stock at a price of $15.00 per share for
aggregate proceeds of $31.0 million, net of expenses of approximately $2.0
million. The shares were issued and paid for on February 6, 2004. The Company
intends to apply the net proceeds for working capital and general corporate
purposes, as well as for strategic purposes in connection with selected
acquisitions that may be considered in the future to expand its product and
service offerings. On April 9, 2004, the Registration Statement related to the
private placement was declared effective. Note 2  Stock Options The Company has adopted Statement of Financial Accounting Standards No.
148 (SFAS 148), Accounting for Stock-Based Compensation  Transition and
Disclosure, issued by the Financial Accounting Standards Board (FASB) which
amends Statement of Financial Accounting Standards No. 123 (SFAS 123),
Accounting for Stock-Based Compensation, and provides alternative methods of
transition for a voluntary change to the fair value based method of accounting
for stock-based employee compensation. SFAS 148 requires prominent disclosures
in both annual and interim financial statements about the method of accounting
for stock-based employee compensation and the effect of the method used on
reported results. SFAS 148 also amends certain disclosure requirements under
Accounting Principle Board Opinion No. 25, Accounting for Stock Issued to
Employees (APB 25). 6




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In accordance with the provisions of SFAS 148, the Company has elected to
continue to account for stock-based compensation plans using the intrinsic
value method prescribed in APB 25 and related interpretations. Accordingly, the
Company does not recognize compensation expense for stock options when the
stock price at the grant date is equal to or greater than the fair market value
of the stock at that date.

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

Three Months Ended
    
    Six Months Ended(in thousands, except per share information):
    
    March 31,
    
    March 31,2004
    
    2003
    
    2004
    
    2003Net loss:As reported
    
    $
    (2,561
    )
    
    $
    (5,298
    )
    
    $
    (7,650
    )
    
    $
    (10,421
    )Add: stock-based employee compensation
recorded in the Statement of Operations
    
    
    87
    
    
    
    95
    
    
    
    223
    
    
    
    222Less: fair value of stock-based employee
compensation
    
    
    (2,054
    )
    
    
    (2,671
    )
    
    
    (4,330
    )
    
    
    (5,854
    )Pro forma
    
    $
    (4,528
    )
    
    $
    (7,874
    )
    
    $
    (11,757
    )
    
    $
    (16,053
    )Net loss per share:Basic and
dilutedAs reported
    
    $
    (0.20
    )
    
    $
    (0.50
    )
    
    $
    (0.63
    )
    
    $
    (0.98
    )Pro forma
    
    
    (0.35
    )
    
    
    (0.74
    )
    
    
    (0.97
    )
    
    
    (1.52
    )


The fair value of each stock option is estimated on the date of grant
using the Black-Scholes model with the following assumptions used for grants
during the respective periods:

Three Months Ended
    
    Six Months EndedMarch 31,
    
    March 31,2004
    
    2003
    
    2004
    
    2003Estimated option life
    
    4.0 years
    
    4.0 years
    
    4.0 years
    
    4.0 yearsRisk-free interest rate
    
    
    2.66
    %
    
    
    2.04
    %
    
    
    2.78
    %
    
    
    2.48
    %Expected volatility
    
    
    81.3
    %
    
    
    90.0
    %
    
    
    87.5
    %
    
    
    90.0
    %Expected dividend yield
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %Weighted average estimated fair value
    
    $
    8.87
    
    
    $
    3.46
    
    
    $
    7.49
    
    
    $
    3.00


Note 3  Net Loss Per Share

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

Three Months Ended
    
    Six Months EndedMarch 31,
    
    March 31,2004
    
    2003
    
    2004
    
    2003Outstanding options to
purchase common stock
    
    
    3,994,304
    
    
    
    4,072,910
    
    
    
    4,183,654
    
    
    
    4,282,640Weighted equivalent shares
    
    
    981,118
    
    
    
    194,837
    
    
    
    828,239
    
    
    
    210,453


7



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##### 



Note 4  Detailed Balance Sheet: March 31,
    
    September 30,(in thousands)
    
    2004
    
    2003(unaudited)Property and equipment:Computer equipment
    
    $
    5,888
    
    
    $
    5,557Furniture and fixtures
    
    
    985
    
    
    
    1,161Leasehold improvements
    
    
    928
    
    
    
    1,188Office equipment
    
    
    639
    
    
    
    6368,440
    
    
    
    8,542Less: accumulated depreciation
    
    
    (6,831
    )
    
    
    (6,435
    )$
    1,609
    
    
    $
    2,107Intangible assets:Developed and core technology
    
    $
    15,672
    
    
    $
    3,903Workforce
    
    
    255
    
    
    
    255Patents
    
    
    600
    
    
    
    600Contract backlog
    
    
    649
    
    
    
    17,176
    
    
    
    4,758Less: accumulated amortization
    
    
    (5,221
    )
    
    
    (3,752
    )11,955
    
    
    
    1,006Goodwill
    
    
    1,029
    
    
    
    1,029$
    12,984
    
    
    $
    2,035Accrued expenses and other current liabilities:Accrued vacant facility lease cost
    
    $
    3,110
    
    
    $
    3,492Accrued non-recurring engineering costs
    
    
    1,135
    
    
    
    2,120Deferred revenue
    
    
    1,311
    
    
    
    2,013Compensation and employee benefits
    
    
    1,394
    
    
    
    1,486Other
    
    
    482
    
    
    
    470$
    7,432
    
    
    $
    9,581
 Note 5  Acquisition of Certain Assets and Intellectual Property In December 2003, the Company acquired certain assets and intellectual
property related to International Business Machines Corporation (IBM)s
network processor product line for approximately $15.7 million in cash. The
purchase price of the acquisition of $15.9 million, which included $200,000 in
estimated acquisition related costs, was used to acquire the technical designs
to the network processors. The purchase price was allocated by management to
assets acquired based on the book value of inventory and fixed assets, which
management believes approximates its fair value, and after considering input
provided by an independent appraisal, to all other identifiable assets. The
excess of the purchase price over the net tangible and intangible assets
acquired has been allocated to the intangible assets and fixed assets. The
allocation of the purchase price was as follows (in thousands): Developed and core technology
    
    $
    11,769Contract backlog
    
    
    649Fixed assets
    
    
    48Inventory
    
    
    67Purchased in-process research and development
    
    
    3,337$
    15,870
 The acquired backlog, developed and core technology are recorded on the
balance sheet as intangibles and other assets. Acquired backlog will be
amortized based upon fulfillment of the identifiable backlog. Developed and
core technology will be amortized on a straight-line basis over their estimated
useful life of five years. 8




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##### 



The amount allocated to purchased in-process research and development was
determined based on established valuation methods and was expensed at the time
of the acquisition as a one-time charge because technological feasibility had
not been established and no alternative future uses exist. The fair value of
two projects containing in-process technology in development was determined
using the income approach, which discounts expected future cash flows to
present value. The discount rates used in the present value calculations was
derived from a weighted-average cost of capital analysis adjusted to reflect
additional risks inherent in the development life cycle including the failure
to achieve technical viability, rapid changes in customer markets and required
standards for new products as well as potential competition in the market for
such products. 9




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations Cautionary Statement Regarding Forward-Looking Statements The section entitled Managements Discussion and Analysis of Financial
Condition and Results of Operations set forth below contains 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). Words such as believes, anticipates, estimates,
expects, and words of similar expressions are intended to identify
forward-looking statements that involve risks and uncertainties. Such
statements are expectations based on information currently available and are
subject to risk, uncertainties and changes in condition, significance, value
and effect, including those discussed under the heading Trends, Risks and
Uncertainties below and reports filed by Hifn with the Securities and Exchange
Commission, specifically Forms 10-K, 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. 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 virtual private networks (VPNs), which enable
businesses to reduce wide area networking costs by replacing dedicated
leased-lines with lower-cost IP-based networks such as the Internet. Using
VPNs, businesses can also provide trading partners and others with secure,
authenticated access to the corporate network, increasing productivity through
improved communications. Storage equipment vendors use our compression
processor products to improve the performance and capacity of mid- to high-end
tape back-up systems. Hifns flow classification technology enables network equipment vendors to
add unique traffic differentiation capabilities to their products. Our flow
classification solutions provide precise details about packets and data
traversing a network and are used in deploying 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. In December 2003, Hifn acquired certain assets and intellectual property
related to International Business Machines Corporation (IBM)s network
processor product line. This acquisition complements our security
provider business, expands our product
offerings to include programmable network processors designed for network
traffic and provides us with technology upon which we can build our
next generation processors. These products feature efficient programming models that eliminate
stage processing and reduce packet latency, thereby optimizing packet
processing at high speeds. 10




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##### 



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 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 March 31, 2004 was $1.3 million and
included approximately $157,000 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
March 31, 2004, inventories of $2.4 million that were previously written down
were still on hand as compared to $2.7 million at September 30, 2003. The
decrease in reserve resulted from the sale of previously written off
inventories. Subsequent increases in projected demand will not result in a
reversal of these reserves until the sale of the related inventory. 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 first quarter of fiscal 2004, the Company acquired certain assets and
intellectual property related to the IBM network processor product line.
Long-lived and intangibles assets associated with the acquisition 11




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include contract backlog valued at $649,000 and developed and core
technology of $11.8 million. Long-lived assets are amortized over periods
ranging from two to five years from the date the assets are acquired. In
accordance with SFAS 142, Goodwill and Other Intangible Assets, goodwill and
intangible assets deemed to have indefinite lives are not 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. 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. 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. Results of Operations The following table sets forth the percentage relationship of certain
items to the Companys revenue during the periods shown: Three Months Ended
    
    Six Months EndedMarch 31,
    
    March 31,2004
    
    2003
    
    2004
    
    2003Net revenues:Processors
    
    
    83
    %
    
    
    81
    %
    
    
    76
    %
    
    
    83
    %Software licenses and other
    
    
    17
    
    
    
    19
    
    
    
    24
    
    
    
    17Total net revenues
    
    
    100
    
    
    
    100
    
    
    
    100
    
    
    
    100Costs and operating expenses:Cost of revenues  processors
    
    
    27
    
    
    
    32
    
    
    
    24
    
    
    
    31Cost of revenues  software licenses and other
    
    
    1
    
    
    
    2
    
    
    
    1
    
    
    
    2Research and development
    
    
    54
    
    
    
    119
    
    
    
    59
    
    
    
    119Sales and marketing
    
    
    19
    
    
    
    38
    
    
    
    21
    
    
    
    39General and administrative
    
    
    12
    
    
    
    20
    
    
    
    13
    
    
    
    21Amortization of intangible assets
    
    
    13
    
    
    
    8
    
    
    
    8
    
    
    
    8Purchased in-process research and development
    
    
    
    
    
    
    
    
    
    
    19
    
    
    
    Total costs and operating expenses
    
    
    126
    
    
    
    219
    
    
    
    145
    
    
    
    220Loss from operations
    
    
    (26
    )
    
    
    (119
    )
    
    
    (45
    )
    
    
    (120
    )Interest and other income, net
    
    
    1
    
    
    
    3
    
    
    
    1
    
    
    
    4Loss before income taxes
    
    
    (25
    )
    
    
    (116
    )
    
    
    (44
    )
    
    
    (116
    )Provision for income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    
    (25
    )%
    
    
    (116
    )%
    
    
    (44
    )%
    
    
    (116
    )%
 12




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Net Revenues.Net revenues increased 128% to $10.4 million for the
quarter ended March 31, 2004 from $4.5 million for the quarter ended March 31,
2003. Net revenues for the first six months of fiscal 2004 was $17.5 million,
an increase of 95% from the $9.0 million reported for the first six months of
fiscal 2003. The increase in revenues for the three months ended March 31, 2004
over the same period in the prior year reflects an increase in sales of Hifns
data compression and encryption processors of $2.8 million, revenues of $2.1
million generated from the sale of network processors related to certain assets
and intellectual property acquired from IBM, as well as an increase in revenues
from software license and royalties of $967,000. The increase in revenues for the six months ended March 31, 2004 over the
same period in the prior year reflects an increase in sales of Hifns data
compression and encryption processors of $3.7 million, revenues of $2.1 million
generated from the sale of network processors related to related to certain
assets and intellectual property acquired from IBM, as well as an increase in
revenues from software license and royalties of $2.7 million. Semiconductor and software sales to Cisco, an OEM producer of networking
equipment, comprised 36% and 43% of revenues for the three and six months ended
March 31, 2004, respectively. Semiconductor sales to Quantum, an OEM producer
of high-performance tape storage devices, through its manufacturing
subcontractor, comprised 17% and 20% of revenues for the three and six months
ended March 31, 2004, respectively. Cost of Revenues.Cost of revenues consists primarily of semiconductors
which were manufactured to our specifications by third parties for resale by
us. Cost of processor revenues as a percentage of net processor revenues
decreased to 32.1% for the three months ended March 31, 2004 from 39.3% for the
same period in fiscal 2003 primarily as a result of the mix of processor
revenues sold during the respective periods. During the three months ended
March 31, 2004 and 2003, we sold $186,000 and $72,000, respectively, in
inventories that had previously been written down. Cost of processor revenues as a percentage of net processor revenues
decreased to 30.9% for the six months ended March 31, 2004 from 37.3% for the
same period in fiscal 2003 primarily as a result of the mix of processor
revenues sold during the respective periods. During the six months ended March
31, 2004 and 2003, we sold $372,000 and $345,000, respectively, in inventories
that had previously been written down. Cost of software licenses and other revenues is primarily comprised of
engineering labor related to support and maintenance of sold licenses and was
$120,000 and $99,000 during the three months ended March 31, 2004 and 2003,
respectively, and $240,000 and $198,000 for the six months ended March 31, 2004
and 2003, respectively. Research and Development.The cost of product development consists
primarily of salaries, employee benefits, overhead, outside contractors and
non-recurring engineering fees. Such research and development expenses were
approximately $5.7 million and $5.4 million for the quarters ended March 31,
2004 and 2003, respectively. The increase mainly reflects an increase in
engineering services and materials costs of $146,000 related to samples testing
of new products, transition services costs of $180,000 related to the transfer
of the technical designs of the IBM network processors and $125,000 in costs
related to the establishment of a network security laboratory in China offset
by a reduction in non-recurring engineering costs of $684,000 as a result of
the timing of tape-out and mask activities related to products in development. Research and development costs were $10.4 million and $10.6 million for
the six months ended March 31, 2004 and 2003, respectively. The decrease mainly
reflects the net effect of an increase in engineering services and materials
costs of $355,000 related to samples testing of new products, transition
services costs of $180,000 related to the transfer of the technical designs of
the IBM network processors and $125,000 in costs related to the establishment
of a network security laboratory in China offset by a reduction in
non-recurring engineering costs of $1.1 million as a result of the timing of
tape-out and mask activities related to products in development. Sales and Marketing.Sales and marketing expenses consist primarily of
salaries, commissions and benefits of sales, marketing and support personnel as
well as consulting, advertising, promotion and overhead expenses. Such expenses
were approximately $1.9 million and $1.7 million for the three months ended
March 31, 2004 and 2003, respectively. The increase primarily relates to an
increase in sales representative commissions of $129,000 due to 13




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higher level of sales made through sales representatives and an increase
in travel expenses aggregating $71,000 related to participation in trade shows
held during the period. Sales and marketing expense for the six months ended March 31, 2004 and
2003 were approximately $3.6 million and $3.5 million, respectively. The
increase primarily relates to an increase in sales representative commissions
of $215,000 due to higher level of sales made through sales representatives
offset by a reduction in salaries and benefits of $109,000 as a result of a
decrease in marketing headcount. General and Administrative.General and administrative expenses are
comprised primarily of salaries for administrative and corporate services
personnel, legal and other professional fees. Such expenses were $1.2 million
and $885,000 for the three months ended March 31, 2004 and 2003, respectively.
General and administrative expenses for the six months ended March 31, 2004 and
2003 were $2.2 million and $1.9 million, respectively. The increase in general
and administrative expenses was primarily attributable to increased legal and
accounting costs during the three and six month periods ended March 31, 2004. Amortization of Intangibles.Amortization of intangibles relate to
acquired technology, workforce and patents. Amortization of intangibles was
$1.3 million and $359,000 for the three months ended March 31, 2004 and 2003,
respectively, and $1.5 million and $717,000 for the six months ended March 31,
2004 and 2003, respectively. The increase in amortization of intangibles is
mainly comprised of the amortization of developed and core technology and
contract backlog related to the IBM network processor of $1.2 million offset by
a reduction in amortization of previously capitalized intangible assets as they
reached their estimated useful lives. Purchased In-Process Research and Development.Purchased in-process
research and development during the six months ended March 31, 2004 related to
the purchase of certain assets and intellectual property for programmable
network processors designed for network traffic related to the IBM network
processor product line. The allocated amount was determined by management after
considering, among other factors, input provided by an independent appraisal
based on established valuation techniques in the semiconductor industry and was
expensed upon acquisition because technological feasibility had not been
established and no alternative future uses exist. The fair value of two
projects containing in-process technology in development was determined using
the income approach, which discounts expected future cash flows to present
value. The discount rates used in the present value calculations was derived
from a weighted-average cost of capital analysis adjusted to reflect additional
risks inherent in the development life cycle including the failure to achieve
technical viability, rapid changes in customer markets and required standards
for new products as well as potential competition in the market for such
products. Interest and Other Income, net.Net interest and other income was $109,000
and $112,000 for the three months ended March 31, 2004 and 2003, respectively,
and $211,000 and $342,000 for the six months ended March 31, 2004 and 2003,
respectively. The decrease in interest and other income for the three and six
months ended March 31, 2004 compared to the same periods in the prior fiscal
year was mainly due to the shift in the investment mix from stock instruments
to commercial paper and municipal bonds, lower average cash and short-term
investments balances during the past two years as well as a decrease in market
interest rates. Income Taxes.In fiscal 2002, we recorded a valuation allowance of $9.8
million to reduce the carrying value of our deferred tax assets and in fiscal
2003, we recognized a tax benefit of $1.8 million related to carry back of net
operating losses to prior years. As a result of continuing losses over a longer
period than previously expected, we have not recognized tax benefits for the
three and six months ended March 31, 2004 and 2003. We continue to consider
future taxable income and ongoing prudent and feasible tax planning strategies
in assessing the valuation allowance. 14




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Liquidity and Capital Resources Net cash used in operating activities of $6.1 million for the six months
ended March 31, 2004 was the result of net loss of $7.7 million as adjusted for
non-cash items including purchased in-process research and development of $3.3
million, depreciation and amortization costs of fixed assets of $670,000,
amortization of intangibles related to acquired technologies of $1.5 million,
of which $1.3 million represents amortization of the acquired backlog and
technology related to the IBM network processor product line, amortization of
deferred stock compensation of $87,000 and loss on disposal of leasehold
improvements of $175,000 related to an expired lease, as well as a decrease in
intangibles and other assets of $433,000 and in accounts payable of $500,000.
These adjustments were offset by an increase in accounts receivable of $1.4
million, inventories of $734,000 and in prepaid expenses and other current
assets of $831,000, related to prepaid insurance and engineering and
maintenance tools. Additionally, accrued expenses and other current liabilities
decreased by approximately $2.1 million as a result of the payment of
previously-accrued engineering costs. Net cash used in operating activities was $8.0 million for the six months
ended March 31, 2003 was the result of net loss of $10.4 million as adjusted
for non-cash items including amortization of intangibles related to acquired
technology of $1.2 million, amortization of deferred stock compensation of
$223,000, depreciation and amortization costs of fixed assets of $784,000 as
well as decreases in accounts receivable of $309,000, in inventories of
$123,000 and in intangibles and other assets of $368,000 and an increase in
accounts payable of $882,000. These adjustments were offset by increases in
prepaid expenses and other current assets of $1.2 million, related to prepaid
insurance, licenses and software tools and maintenance, and a decrease in
accrued expenses and other current liabilities of $284,000. Net cash used in investing activities of $45.5 million for the six months
ended March 31, 2004 reflects the purchase of certain assets and intellectual
property related to the IBM network processor product line for $15.7 million,
the purchase of short-term investments of $29.4 million utilizing the proceeds
from the private placement financing and the purchase of property and equipment
of $347,000. Net cash provided by investing activities of $902,000 for the six
months ended March 31, 2003 primarily reflects a decrease in short-term
investments of $1.6 million partially offset by the purchase of property and
equipment of $704,000. Net cash provided by financing activities was $33.4 million and $511,000
for the six months ended March 31, 2004 and 2003, respectively. The net cash
provided by financing activities during the six months ended March 31, 2004 is
mainly attributable to net proceeds from the private placement financing of
$31.0 million. Cash proceeds from the issuance of common stock for stock option
exercises and employee stock purchase plan purchases aggregated $2.4 million
and $511,000 for the six months ended March 31, 2004 and 2003, respectively. 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 on terms acceptable to us. 15




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On February 6, 2004, the Company entered into a securities purchase
agreement with certain investors for the private placement of 2.2 million
shares of the Companys Common Stock at a price of $15.00 per share for
aggregate proceeds of $31.0 million, net of expenses of approximately $2.0
million. The shares were issued and paid for on February 6, 2004. The Company
intends to apply the net proceeds for working capital and general corporate
purposes, as well as for strategic purposes in connection with selected
acquisitions that may be considered in the future to expand its product and
service offerings. 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 as of March
31, 2004 are as follows (in thousands): Operating LeaseCommitmentsFiscal year ending September 30,2004
    
    $
    1,3832005
    
    
    2,4302006
    
    
    1,0372007
    
    
    973Thereafter
    
    
    242Total minimum lease payments
    
    $
    6,065
 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; 16




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
    
    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. 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 the quarter ended December 31, 2003, we completed the acquisition
of certain assets and intellectual property related to the IBM network
processor product line for approximately $15.7 million in cash. The purchase
price of the acquisition of $15.9 million, which included $200,000 in estimated
acquisition related costs, was used to acquire the technical designs to the
network processors. The purchase price was allocated to assets acquired based
on the book value of inventory and fixed assets, which management believes
approximates their fair value, and after considering input provided by an
independent appraisal, to all other identifiable assets. The excess of the
purchase price over the net tangible and intangible assets acquired has been
allocated to the intangibles and fixed assets. Pursuant to SFAS 142, Goodwill
and Other Intangible Assets, we will 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. As of March 31, 2004, we have approximately $1.0
million of goodwill related to the acquisition of Apptitude in August 2000. We Depend Upon A Small Number Of Customers. Cisco Systems, Inc. (Cisco), an OEM producer of network equipment,
comprised 36%, 43% and 23% of our net revenues for the three and six months
ended March 31, 2004 and the year ended September 30, 2003. Quantum Corporation
(Quantum), through its manufacturing subcontractor, accounted for
approximately 17%, 20% and 34% of our net revenues during the three and six
months ended March 31, 2004 and in fiscal 2003, respectively. Neither Cisco nor
Quantum 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, 17




---



##### 



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 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 18




---



##### 



remain competitive are complicated and require a significant amount of
time and money. We may experience substantial difficulty in introducing new
products and we may be unable to offer enhancements to existing products on a
timely or cost-effective basis, if at all. For instance, the performance of our
encryption/compression and public key processors depends upon the integrity of
our security technology. If any significant advances in overcoming
cryptographic systems are made, then the security of our encryption/compression
and public key processors will be reduced or eliminated unless we are able to
develop further technical innovations that adequately enhance the security of
these products. Our inability to develop and introduce new products or
enhancements directed at new industry standards could harm our business,
financial condition and results of operations. Our Markets Are Highly Competitive. We compete in markets that are intensely competitive and are expected to
become increasingly competitive as current competitors expand their product
offerings and new competitors enter the market. The markets that we compete in
are subject to frequent product introductions with improved price-performance
characteristics, rapid technological change, and the continued emergence of new
industry standards. Our products compete with offerings from companies such as
Analog Devices, Inc., SafeNet, Inc., IBM, Broadcom Corporation, Motorola, Inc.
and 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; 19




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
    
    The support that exists for new network and storage standards;
    
    Features and functionality;
    
    Adaptability of products to specific applications;
    
    Reliability; and
    
    Technical service and support as well as effective intellectual property protection. If we are unable to successfully develop and market products that compete
with those of other suppliers, our business, financial condition and results of
operations could be harmed. In addition, we must compete for the services of
qualified distributors and sales representatives. To the extent that our
competitors offer distributors or sales representatives more favorable terms,
these distributors and sales representatives may decline to carry, or
discontinue carrying, our products. Our business, financial condition and
results of operations could be harmed by any failure to maintain and expand our
distribution network. Our Business Depends Upon The Growth Of The Network Equipment And Storage Equipment Markets. Our success is largely dependent upon continued growth in the market for
network security equipment, such as routers, remote access concentrators,
switches, broadband access equipment, security gateways, firewalls and network
interface cards. In addition, our success depends upon storage equipment
vendors 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, mask work 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. 20




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The Length Of Time It Takes To Develop Our Products And Make A Sale To Our Customers May Impair Our Operating Results. Our customers typically take a long time to evaluate our products. In
fact, it usually takes our customers 3 to 6 months or more to test our products
with an additional 9 to 18 months or more before they commence significant
production of equipment incorporating our products. As a result of this lengthy
sales cycle, we may experience a delay between increasing expenses for research
and development and sales and marketing efforts on the one hand, and the
generation of higher revenues, if any, on the other hand. In addition, the
delays inherent in such a lengthy sales cycle raise additional risks of
customer decisions to cancel or change product plans, which could result in the
loss of anticipated sales. Our business, financial condition and results of
operations could suffer if customers reduce or delay orders or choose not to
release products using our technology. We Depend Upon Independent Manufacturers And Limited Sources Of Supply. We rely on subcontractors to manufacture, assemble and test our packet
processors. We currently subcontract our semiconductor manufacturing to Atmel
Corporation, Toshiba Corporation, Philips Semiconductor and IBM. Since we
depend upon independent manufacturers, we do not directly control product
delivery schedules or product quality. None of our products are manufactured by
more than one supplier. Since the semiconductor industry is highly cyclical,
foundry capacity has been very limited at times in the past and may become
limited in the future. We depend on our suppliers to deliver sufficient quantities of finished
product to us in a timely manner. Since we place orders on a purchase order
basis and do not have long-term volume purchase agreements with any of our
suppliers, our suppliers may allocate production capacity to 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. 21




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We regularly consider using smaller semiconductor dimensions for each of
our products in order to reduce costs. We have begun to decrease the dimensions
in our new product designs, and believe that we must do so to remain
competitive. We may have difficulty decreasing the dimensions of our products.
In the future, we may change our supply arrangements to assume more product
manufacturing responsibilities. We may subcontract for wafer manufacturing,
assembly and test rather than purchase finished products. However, there are
additional risks associated with manufacturing, including variances in
production yields, the ability to obtain adequate test and assembly capacity at
reasonable cost and other general risks associated with the manufacture of
semiconductors. We may also enter into volume purchase agreements that would
require us to commit to minimum levels of purchases and which may require
up-front investments. If we fail to effectively assume greater manufacturing
responsibilities or manage volume purchase arrangements, our business,
financial condition and results of operations will suffer. Network And Storage Equipment Prices Typically Decrease. Average selling prices in the networking, storage and semiconductor
industries have rapidly declined due to many factors, including:  
    
    Rapidly changing technologies;
    
    Price-performance enhancements; and
    
    Product obsolescence. 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 wrote off excess inventory of
$3.4 million as a result of a significant decrease in forecasted demand for our
products. We recognize revenue upon shipment of products to our customers, net
of an allowance for estimated returns. An unanticipated level of returns could
harm our business, financial condition and results of operations. 22




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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. 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; 23




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
    
    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 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 24




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
    
    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 March 31,
2004, there were no outstanding claims against us nor do we have any
outstanding obligations related to claims or lawsuits. There can be no
assurance there will not be any actions against us in the future. Any such
actions may have a material adverse effect on our financial condition and
results of operations. The Common Stock Sold In Our Private Offering Increased The Supply Of Our Common Stock On The Public Market, Which May Cause Our Stock Price To Decline. On April 9, 2004, the Registration Statement related to 2,200,000 shares
of our Common Stock sold in a private equity offering on February 6, 2004 was
declared effective. The shares of Common Stock becoming eligible for immediate
and unrestricted resale into the public market at any time could adversely
affect the market price of our Common Stock and the presence of these
additional shares of Common Stock in the public market may further depress our
stock price. We Face Risks Associated With The Integration Of Recently Acquired Assets Into Our Business. During the fiscal quarter ended December 31, 2003, we acquired certain
assets and intellectual property related to the IBM network processor product
line. Our success in integrating these assets into our business will depend on
our ability to merge the acquired assets into our ongoing operations, including
maintaining a good relationship with IBMs established customer base and our
third party supplier, in this case, IBM. Without the successful integration of
this significant asset acquisition, there can be no assurance that we will be
able to maintain the revenue and profit performance levels experienced by IBM.
If we fail to integrate these products into our operations successfully, our
business, financial condition and results of operations could suffer. Additionally, prior to our acquisition of these assets, we understand IBM
informed its customers that it was discontinuing selected research and
development activities in connection with the assets and would not be
developing any related follow-on products with respect to the products
associated with the acquired assets. As a result of such announcement, there
can be no assurance that the established customer base will continue to
purchase the products based on the acquired assets from us and maintain their
relationship with us in the future for follow-on products. If we fail to
maintain the established customer base, we may not be able to maintain the
revenue and profit performance levels of IBM. Loss of the established customer
base could negatively impact our results of operations, business and financial
condition. 25




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Item 3. Quantitative and Qualitative Disclosures About Market Risk Interest Rate Risk  The Company does not use derivative financial
instruments in its investment portfolio. The Companys investment portfolio is
generally comprised of commercial paper. The Company places 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 the Companys
investment portfolio, the Company does not expect any material loss with
respect to its investment portfolio. A 10% change in interest rates at March
31, 2004 would not have a material effect on the Companys pre-tax earnings and
the fair value of its investments. Foreign Currency Exchange Rate Risk All of the Companys sales, cost of
manufacturing and marketing are transacted in US dollars. Accordingly, the
Companys results of operations are not subject to foreign exchange rate
fluctuations. Gains and losses from such fluctuations have not been incurred by
the Company to date. Item 4. Controls and Procedures Evaluation of disclosure controls and procedures. Our management
evaluated, with the participation of our Chief Executive Officer and our Chief
Financial Officer, the effectiveness of our disclosure controls and procedures
as of the end of the period covered by this Quarterly Report on Form 10-Q.
Based on this evaluation, our Chief Executive Officer and our Chief Financial
Officer have concluded that our disclosure controls and procedures are
effective to ensure that information we are required to disclose in reports
that we file or submit under the Securities Exchange Act of 1934 is recorded,
processed, summarized and reported within the time periods specified in
Securities and Exchange Commission rules and forms. Changes in internal control over financial reporting. There was no change
in our internal control over financial reporting that occurred during the
period covered by this Quarterly Report on Form 10-Q that has materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting. 26




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PART II  OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders The Company held its Annual Meeting of Stockholders on February 23, 2004.
At the meeting, the following proposals received the votes listed below: Proposal I. Election of Class II Directors for three-year terms expiring 2007. Votes for:
    
    Votes against:Dennis DeCoste
    
    
    10,612,056
    
    
    
    287,357Taher Elgamal
    
    
    10,415,350
    
    
    
    484,063Robert Johnson
    
    
    10,612,045
    
    
    
    287,368
 The Companys Board of Directors is currently comprised of six members
who are divided into three classes with overlapping three-year terms. The
term for Class III directors (Albert E. Sisto and Douglas L. Whiting) will
expire at the meeting of stockholders to be held in 2005. The term for Class
I directors (Christopher G. Kenber) will expire at the meeting of
stockholders to be held in 2006. Proposal II: Approval of an amendment to the Companys 1996 Amended and
Restated Equity Incentive Plan to provide for an increase in the number of shares of common stock available for issuance thereunder by 500,000 shares
to 5,449,900 shares. Votes for:
    
    
    1,370,914Votes against:
    
    
    5,546,877Abstentions:
    
    
    39,107
 Proposal III: Approval of an amendment to the Companys 1998 Employee Stock
Purchase Plan to provide for an increase in the number of shares of common
stock available for issuance thereunder by 500,000 shares to 900,000 shares. Votes for:
    
    
    6,083,236Votes against:
    
    
    845,020Abstentions:
    
    
    28,642
 Proposal IV: Approval of ratification of the appointment of
PricewaterhouseCoopers LLP as independent auditors of the Company for the
fiscal year ending September 30, 2004. Votes for:
    
    
    10,735,505Votes against:
    
    
    161,447Abstentions:
    
    
    2,461
 Item 5. Other Information In accordance with Section 10A(i)(2) of the Securities Exchange Act of
1934, as added by Section 202 of the Sarbanes-Oxley Act of 2002 (the Act),
we are required to disclose the non-audit services approved by our Audit
Committee to be performed by PricewaterhouseCoopers LLP, our external
accountants. Non-audit services are defined in the Act as services other
than those provided in connection with an audit or a review of the financial
statements of a company. The Audit Committee approved the engagement of
PricewaterhouseCoopers LLP for work related to the acquisition of certain
assets and intellectual property from IBM Corporation. 27




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Item 6. Exhibits and Reports on Form 8-K  (a)
    
    ExhibitsExhibit Index Exhibit Number
    
    Description3.1*
    
    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**
    
    Securities Purchase Agreement dated February 6, 200431.1
    
    Certification of Chief Executive Officer pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
  (b)
    
    Reports on Form 8-KCurrent Reports on Form 8-K were filed during the quarter for which
this report is filed on January 6, 2004 (as amended January 14,
2004 and April 8, 2004) and February 9, 2004.   *
    
    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 to Current Report on Form 8-K/A, filed with the
Securities and Exchange Commission on February 9, 2004. 28




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SIGNATURES Pursuant to the requirements 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. hi/fn, inc.(Registrant)Date: May 6, 2004
    
    By:
    
    /s/ WILLIAM R. WALKERWilliam R. Walker
Vice President, Finance, Chief Financial Officer and Secretary (principal financial and accounting officer)
 29




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INDEX TO EXHIBITS ExhibitNumber
    
    Exhibit3.1*
    
    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**
    
    Securities Purchase Agreement dated February 6, 200431.1
    
    Certification of Chief Executive Officer pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
   *
    
    Incorporated by reference from Registrants Registration Statement on
Form 10 (File No. 0-24765) filed with the SEC on August 7, 1998 as
amended.**
    
    Incorporated by reference to Current Report on Form 8-K/A, filed with the
Securities and Exchange Commission on February 9, 2004.