Table of Contents

UNITED STATESSECURITIES AND
EXCHANGE COMMISSIONWashington, D.C. 20549

---

# FORM 10-Q

|                                                 |   |  |                                                                                         
|------------------------------------------------ | - |  | ----------------------------------------------------------------------------------------
|                                                 | þ |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|For the Quarterly Period Ended December 31, 2004
|                                                
|                                                 |  ̈ |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|For the Transition Period From _____ to _____   

COMMISSION FILE NUMBER
0-24765

hi/fn, inc.(Exact
Name of Registrant as specified in its Charter)

| |                                                                |  |                                     | 
| | -------------------------------------------------------------- |  | ----------------------------------- | 
| | Delaware                                                       |  | 33-0732700                          | 
| | (State or other jurisdiction of
incorporation or organization) |  | (I.R.S. EmployerIdentification No.) | 

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.

YESþ
NO ̈

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

YESþ
NO ̈

The number of shares outstanding of
the Registrants Common Stock, par value $.001 per share, was 13,988,201 at
February 8, 2005.

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# TABLE OF CONTENTS

|                              |                                                                                               |                                                     
|----------------------------- | --------------------------------------------------------------------------------------------- | ----------------------------------------------------
|                              |                                                                                               |                                                     
|PART I. FINANCIAL INFORMATION
|                              | Item 1. Financial Statements (unaudited)                                                     
|                              |                                                                                               | Condensed Consolidated Balance Sheets               
|                              |                                                                                               | Condensed Consolidated Statements of Operations     
|                              |                                                                                               | Condensed Consolidated Statements of Cash Flows     
|                              |                                                                                               | Notes to Condensed Consolidated Financial Statements
|                              | Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
|                              | Item 3. Quantitative and Qualitative Disclosure About Market Risks                           
|                              | Item 4. Controls and Procedures                                                              
|PART II. OTHER INFORMATION   
|                              | Item 6. Exhibits and Reports on Form 8-K                                                     
|Signatures                   
|Index to Exhibits            
|Exhibit 31.1                 
|Exhibit 31.2                 
|Exhibit 32.1                 
|Exhibit 32.2                 

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Table of Contents

# HIFN, INC.

# INDEX TO FORM 10-Q

|                  |  |                                                                                                       |  |        
|----------------- |  | ----------------------------------------------------------------------------------------------------- |  | -------
|PART I.           |  | FINANCIAL INFORMATION                                                                                 |  |        
|Item 1.           |  | Financial Statements (unaudited)                                                                      |  |        
|                  |  | Condensed Consolidated Balance Sheets as of December 31, 2004 and September 30, 2004                  |  | 3      
|                  |  | Condensed Consolidated Statements of Operations for the three months ended December 31, 2004 and 2003 |  | 4      
|                  |  | Condensed Consolidated Statements of Cash Flows for the three months ended December 31, 2004 and 2003 |  | 5      
|                  |  | Notes to Condensed Consolidated Financial Statements                                                  |  | 6 - 9  
|Item 2.           |  | Management's Discussion and Analysis of Financial Condition and Results of Operations                 |  | 10 - 27
|Item 3.           |  | Quantitative and Qualitative Disclosure About Market Risks                                            |  | 27     
|Item 4.           |  | Controls and Procedures                                                                               |  | 27 - 28
|Part II.          |  | OTHER INFORMATION                                                                                     |  | 29     
|Item 6.           |  | Exhibits and Reports on From 8-K                                                                      |  | 29     
|Signatures        |  | 30                                                                                                   
|Index to Exhibits |  |                                                                                                      

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Table of Contents

PART
1  FINANCIAL INFORMATION

Item 1.
Financial Statements

HIFN, INC.CONDENSED CONSOLIDATED
BALANCE SHEETS(in thousands)(unaudited)

|                                               | December 31,
2004 |  | September 30,
2004 |        
|---------------------------------------------- | ----------------- |  | ------------------ | -------
|                                               |                   |  |                    |        
|ASSETS                                        
|CURRENT ASSETS:                                |                   | 
|Cash and cash equivalents                      |                   |  | $                  | 15,139 
|Short-term investments                         |                   |  |                    | 34,784 
|Accounts receivable, net                       |                   |  |                    | 5,739  
|Inventories                                    |                   |  |                    | 2,735  
|Prepaid expenses and other current assets      |                   |  |                    | 1,200  
|                                               |                   |  |                    |        
|Total current assets                           |                   |  |                    | 59,597 
|Property and equipment, net                    |                   |  |                    | 1,850  
|Intangible assets, net                         |                   |  |                    | 12,510 
|Other assets                                   |                   |  |                    | 2,317  
|                                               |                   |  |                    |        
|                                               |                   |  | $                  | 76,274 
|                                               |                   |  |                    |        
|LIABILITIES AND STOCKHOLDERS EQUITY          
|CURRENT LIABILITIES:                          
|Accounts payable                               |                   |  | $                  | 4,143  
|Accrued expenses and other current liabilities |                   |  |                    | 7,854  
|                                               |                   |  |                    |        
|Total current liabilities                      |                   |  |                    | 11,997 
|                                               |                   |  |                    |        
|STOCKHOLDERS' EQUITY:                         
|Common stock                                   |                   |  |                    | 14     
|Additional paid-in capital                     |                   |  |                    | 162,112
|Accumulated other comprehensive loss           |                   |  |                    | (38    
|Accumulated deficit                            |                   |  |                    | (97,811
|                                               |                   |  |                    |        
|Total stockholders' equity                     |                   |  |                    | 64,277 
|                                               |                   |  |                    |        
|                                               |                   |  | $                  | 76,274 
|                                               |                   |  |                    |        
|                                               |                   | 

See accompanying notes to condensed consolidated financial statements.

-3-

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Table of Contents

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

|                                                       | Three Months Ended
December 31, | 
|------------------------------------------------------ | ------------------------------- | 
|
|Net revenues                                           |                                 | 
|Processors                                             |                                 | 
|Software licenses and other                            |                                 | 
|                                                       |                                 | 
|Total net revenues                                     |                                 | 
|                                                       |                                 | 
|Costs and operating expenses:                         
|Cost of revenues - processors                          |                                 | 
|Cost of revenues - software licenses and other         |                                 | 
|Research and development                               |                                 | 
|Sales and marketing                                    |                                 | 
|General and administrative                             |                                 | 
|Amortization of intangible assets                      |                                 | 
|Purchased in-process research and development          |                                 | 
|                                                       |                                 | 
|Total costs and operating expenses                     |                                 | 
|                                                       |                                 | 
|Loss from operations                                   |                                 | 
|Interest and other income, net                         |                                 | 
|                                                       |                                 | 
|Loss before income taxes                               |                                 | 
|Provision for income taxes                             |                                 | 
|                                                       |                                 | 
|Net loss                                               |                                 | 
|                                                       |                                 | 
|Net loss per share, basic and diluted                  |                                 | 
|                                                       |                                 | 
|Weighted average shares outstanding, basic and diluted |                                 | 
|                                                       |                                 | 

See
accompanying notes to condensed consolidated financial statements.

-4-

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

|                                                     | Three Months Ended
December 31, | 
|---------------------------------------------------- | ------------------------------- | 
|
|Cash flows from operating activities:                |                                 | 
|Net loss                                             |                                 | 
|Adjustments to reconcile net loss to                
|net cash used in operating activities:              
|Depreciation                                         |                                 | 
|Amortization of intangible assets                    |                                 | 
|Amortization of deferred stock compensation          |                                 | 
|Purchased in-process research and development        |                                 | 
|Changes in assets and liabilities:                   |                                 | 
|Accounts receivable                                  |                                 | 
|Inventories                                          |                                 | 
|Prepaid expenses and other current assets            |                                 | 
|Other assets                                         |                                 | 
|Accounts payable                                     |                                 | 
|Accrued expenses and other current liabilities       |                                 | 
|                                                     |                                 | 
|Net cash used in operating activities                |                                 | 
|                                                     |                                 | 
|Cash flows from investing activities:                |                                 | 
|Purchase of certain assets and intellectual property |                                 | 
|Purchases of short-term investments, net             |                                 | 
|Purchases of property and equipment                  |                                 | 
|                                                     |                                 | 
|Net cash used in investing activities                |                                 | 
|                                                     |                                 | 
|Cash flows from financing activities:               
|Proceeds from issuance of common stock               |                                 | 
|Installment payments on acquired software licenses   |                                 | 
|                                                     |                                 | 
|Net cash provided by financing activities            |                                 | 
|                                                     |                                 | 
|Net decrease in cash and cash equivalents            |                                 | 
|Cash and cash equivalents at beginning of period     |                                 | 
|                                                     |                                 | 
|Cash and cash equivalents at end of period           |                                 | 
|                                                     |                                 | 

See accompanying notes to condensed consolidated financial statements.

-5-

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Table of Contents

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 wholly-owned
subsidiaries, Hifn Limited, Hifn Netherlands B.V. and Hifn International, and its
wholly-owned subsidiary, Saian Microsystems, Inc. All significant intercompany accounts
and transactions have been eliminated. The preparation of financial statements in
conformity with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and liabilities at
the date of the financial statements and reported amounts of revenues and expenses during
the reporting period. Actual results could differ from those estimates.

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, 2004. 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 December
31, 2004 and its results of operations for the three months ended December 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, cash equivalents and short-term investments
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 $30.9 million, net of
expenses of approximately $2.1 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 by the Securities and Exchange Commission.

# Note 2  Stock
Options

The
Company uses the intrinsic value method of Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees, in accounting for its employee stock
options, and presents disclosure of pro forma information required under Statement of
Financial Accounting Standards Board (FASB) Statement No. 123,
Accounting for Stock-Based Compensation as amended by FASB Statement No. 148,
Accounting for Stock-Based Compensation  Transition and Disclosure  an
amendment of FASB Statement No. 123.

-6-

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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:

|                                                      | Three Months Ended
December 31, | 
|----------------------------------------------------- | ------------------------------- | 
|
|
|Net loss:                                             |                                 | 
|As reported                                           |                                 | 
|Add: stock-based employee compensation recorded      
|in the Statement of Operations                        |                                 | 
|Less: fair value of stock-based employee compensation |                                 | 
|                                                      |                                 | 
|Pro forma                                             |                                 | 
|                                                      |                                 | 
|Net loss per share:                                   |                                 | 
|Basic and diluted                                    
|As reported                                           |                                 | 
|Pro forma                                             |                                 | 

The
fair value of 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
December 31, | 
|------------------------------------- | ------------------------------- | 
|
|Estimated option life                 |                                 | 
|Risk-free interest rate               |                                 | 
|Expected volatility                   |                                 | 
|Expected dividend yield               |                                 | 
|Weighted average estimated fair value |                                 | 

# 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 excluded from the
computation of diluted earnings because of their anti-dilutive impact were as follows:

|                                             | Three Months Ended
December 31, | 
|-------------------------------------------- | ------------------------------- | 
|
|Outstanding options to purchase common stock |                                 | 
|Weighted equivalent shares                   |                                 | 

-7-

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# Note 4  Detailed
Balance Sheet

|                                                | December 31,
2004 |  | September 30,
2004 |       
|----------------------------------------------- | ----------------- |  | ------------------ | ------
|
|Property and equipment:                         |                   |  |                    |       
|Computer equipment                              |                   |  | $                  | 6,584 
|Furniture and fixtures                          |                   |  |                    | 1,044 
|Leasehold improvements                          |                   |  |                    | 979   
|Office equipment                                |                   |  |                    | 799   
|                                                |                   |  |                    |       
|                                                |                   |  |                    | 9,406 
|Less: accumulated depreciation                  |                   |  |                    | (7,556
|                                                |                   |  |                    |       
|                                                |                   |  | $                  | 1,850 
|                                                |                   |  |                    |       
|Intangible assets:                             
|Developed and core technology                   |                   |  | $                  | 17,460
|Workforce                                       |                   |  |                    | 413   
|Patents                                         |                   |  |                    | 600   
|                                                |                   |  |                    |       
|                                                |                   |  |                    | 18,473
|Less: accumulated amortization                  |                   |  |                    | (6,992
|                                                |                   |  |                    |       
|                                                |                   |  |                    | 11,481
|Goodwill                                        |                   |  |                    | 1,029 
|                                                |                   |  |                    |       
|                                                |                   |  | $                  | 12,510
|                                                |                   |  |                    |       
|Accrued expenses and other current liabilities: |                   | 
|Accrued vacant facility lease cost              |                   |  | $                  | 2,350 
|Accrued non-recurring engineering costs         |                   |  |                    | 2,095 
|Deferred revenue                                |                   |  |                    | 1,294 
|Compensation and employee benefits              |                   |  |                    | 1,517 
|Other                                           |                   |  |                    | 598   
|                                                |                   |  |                    |       
|                                                |                   |  | $                  | 7,854 
|                                                |                   |  |                    |       

# Note 5 
Comprehensive Income (Loss)

Other
comprehensive income (loss) is defined as the change in equity of a business enterprise
during a period from transactions and other events and circumstances from non-owner
sources. Comprehensive income (loss) includes unrealized gains and losses on the
Companys available-for-sale investments. The components of comprehensive loss are as
follows:

|                                         | Three Months Ended
December 31, | 
|---------------------------------------- | ------------------------------- | 
|
|
|Net loss                                 |                                 | 
|Unrealized gain on financial instruments |                                 | 
|                                         |                                 | 
|Comprehensive loss                       |                                 | 
|                                         |                                 | 

# Note 6  Segment
and Geographic Information

The
Company operates in one industry segment comprising the design, development and marketing
of high-performance, multi-protocol packet processors  semiconductor devices and
software. Sales by major geographic area are based on the geographic location of the
distributor, manufacturing subcontractor or OEM who purchased our products which may be
different from the geographic locations of our end customers.

-8-

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Table of Contents

|                    | Three Months Ended
December 31, | 
|------------------- | ------------------------------- | 
|
|
|North America:      |                                 | 
|United States       |                                 | 
|Other               |                                 | 
|                    |                                 | 
|Total North America |                                 | 
|                    |                                 | 
|Asia:              
|Hong Kong           |                                 | 
|Malaysia            |                                 | 
|Singapore           |                                 | 
|Japan               |                                 | 
|Taiwan              |                                 | 
|Other               |                                 | 
|                    |                                 | 
|Total Asia          |                                 | 
|                    |                                 | 
|Europe and other    |                                 | 
|                    |                                 | 
|Total               |                                 | 
|                    |                                 | 

The
Companys long-lived assets, consisting of net property and equipment, are primarily
in the United States.

# Note 7  Income Taxes

The
Company has a valuation allowance for its net deferred tax asset associated with its U.S.
operations.  Until such time as the Company utilizes its U.S. net operating loss
carryforwards and unused tax credits, a provision for taxes on the Companys U.S.
operations is expected to be substantially offset by a reduction in the valuation
allowance.  The provision for income taxes for the quarter ended December 31, 2004
primarily reflect taxes on the Companys non-U.S. operations.

# Note 8  Recent
Accounting Pronouncements

In
December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R
(SFAS No. 123R), Share-Based Payment, an amendment to Statement
of Financial Accounting Standards No. 123 (SFAS No. 123), Accounting for
Stock-Based Compensation and Statement on Financial Accounting Standards No. 95,
Statement of Cash Flows. The revised standard addresses the accounting for
share-based payment transactions in which a company receives employee services in exchange
for either equity instruments of the company or liabilities that are based on the fair
value of the companys equity instruments or that may be settled by the issuance of
such equity instruments. Under the new standard, companies will no longer be able to
account for share-based compensation transactions using the intrinsic method in accordance
with APB 25. Instead, companies will be required to account for such transactions using a
fair-value method and recognize the expense in the consolidated statement of income. SFAS
No. 123R will be effective for periods beginning after June 15, 2005 and allows, but does
not require, companies to restate the full fiscal year of 2005 to reflect the impact of
expensing share-based payments under SFAS No. 123R. The Company has not yet determined
which fair-value method and transitional provision it will follow. Currently, we disclose
the pro forma net income (loss) and related pro forma income (loss) per share information
in accordance with SFAS 123 and Statement on Financial Accounting Standards No. 148,
Accounting for Stock-Based Compensation CostsTransition and Disclosure.
We will continue to evaluate the impact of the new standard on our financial position and
results of operations.

-9-

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Table of Contents

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 processor 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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Table of Contents

# Critical Accounting
Policies

The
Companys critical accounting policies are disclosed in the Companys Form 10-K
for the year ended September 30, 2004 and have not changed materially as of December 31,
2004.

# Results of Operations

The
following table sets forth the percentage relationship of certain items to the
Companys revenue during the periods shown:

Net
Revenues.

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

|                            | Three Months Ended
December 31, |  |  
|--------------------------- | ------------------------------- |  | -
|
|
|Processors                  |                                 |  | $
|Software licenses and other |                                 |  |  
|                            |                                 |  |  
|                            |                                 |  | $
|                            |                                 |  |  
|                            |                                 |  |  

Net
revenues increased by $5.4 million for the quarter ended December 31, 2004 as compared to
net revenues for the quarter ended December 31, 2003. Our data compression and encryption
processors revenues increased $6.5 million and was attributable to $4.8 million in
revenues generated from the sale of network processors related to the technology acquired
from IBM on December 31, 2003 and an increase of $1.7 million in revenues from our other
processor products. The average selling price of these processors remained at relatively
the same levels. Accordingly, the increase in processor revenues between 2004 and 2003 is
attributable to the increase in processor unit sales. The increase in processor revenues was offset by a decrease in
revenues from software license and royalties of $1.1 million resulting from the
variability in demand for and timing of customers purchase of certain of the
Companys licensed software products.

Semiconductor
and software sales to Cisco, an OEM producer of networking equipment, comprised 46% and
53% of revenues for the three months ended December 31, 2004 and 2003, respectively.
Semiconductor sales to Quantum, an OEM producer of high-performance tape storage devices,
through its manufacturing subcontractor, comprised 13% and 24% of revenues for the three
months ended December 31, 2004 and 2003, respectively. Semiconductor sales to Huawei, an
OEM producer of networking equipment, comprised 10% of revenues for the three months ended
December 31, 2004.

Cost
of Revenues.

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

|                            | Three Months Ended
December 31, |  |  
|--------------------------- | ------------------------------- |  | -
|
|
|Processors                  |                                 |  | $
|Software licenses and other |                                 |  |  
|                            |                                 |  |  
|                            |                                 |  | $
|                            |                                 |  |  
|                            |                                 |  |  

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Cost
of revenues consists primarily of semiconductors which were manufactured to our
specifications by third parties for resale by us. Cost of processor revenues as a
percentage of net processor revenues increased five percentage points for the three months
ended December 31, 2004 as compared to the same period in fiscal 2003. The Companys
product offerings in the three months ended December 31, 2004 includes the network
processor, which carries a higher cost of revenues as compared to all other processors. As
a result, processor cost of revenues as a percentage of net revenues increased. During the
three months ended December 31, 2004 and 2003, we sold $31,000 and $186,000, respectively,
in inventories that had previously been written down.

Cost
of software licenses and other revenues is primarily comprised of engineering labor
related to support and maintenance of sold licenses. The fluctuation in software licenses
and other costs as a percentage of software licenses and other revenues is dependent upon
the mix of licensed software and royalties earned during the period.

Operating
Expenses

Research
and Development.

|                                | Three Months Ended
December 31, |  | Year-over- |      
|------------------------------- | ------------------------------- |  | ---------- | -----
|
|Research & development expenses |                                 |  | $          | 5,414
|As a percentage of net revenues |                                 |  |            | 43   

Research
and development costs consist primarily of salaries, employee benefits, overhead, outside
contractors and non-recurring engineering fees. Such research and development expenses
increased $725,000 for the three months ended December 31, 2004 over the same period in
the prior year. The net increase reflects increases in salaries and benefits expense of
$307,000, of which $107,000 relates to headcount additions in our China subsidiary of an
average of twenty-nine engineers, and the remaining $200,000 of which is a result of a
combination of salary increases in connection with the employee performance reviews in October
2004 and higher average salary rates reflecting a shift in the composition of the
engineering staff, corresponding with the changing requirements in technical skill sets.
Also contributing to the net increase in research and development costs are an increase of
$533,000 in non-recurring engineering costs associated with tape-out, mask activities and
qualification testing of products under development, $67,000 in expenses related to travel
between design facilities, including China, for training and product development planning
and $175,000 in consulting fees related to the transfer of the technical designs of the
IBM network processors. These increases were offset by a reduction in building expenses of
$80,000 as a result of reduced allocation of rental and other costs due to the expiration
of a portion of the lease at our corporate facility, a decrease in the purchase of
engineering materials of $104,000, the timing of which is contingent upon the stage of
product development, and a decrease in software maintenance expense of $161,000 resulting
from the consolidation of certain software maintenance arrangements coupled with the
termination of maintenance arrangements related to completed projects.

Sales
and Marketing.

|                                | Three Months Ended
December 31, |  | Year-over- |      
|------------------------------- | ------------------------------- |  | ---------- | -----
|
|Sales & marketing expenses      |                                 |  | $          | 1,919
|As a percentage of net revenues |                                 |  |            | 15   

Sales
and marketing expenses consist primarily of salaries, commissions and benefits of sales,
marketing and support personnel as well as consulting, advertising, promotion and overhead
expenses. Such expenses increased $231,000 for the three months ended December 31, 2004
over the same period in the prior year. The increase primarily relates to an increase in
sales representative commissions of $92,000 due to a higher level of sales made through
sales representatives, increased salaries and benefits of $65,000 due to salary increases
in connection with the employee performance reviews in October 2004 and an increase in average
headcount during the period of one sales and two marketing staff as well as an increase in
travel expenses of $64,000 as a result of a sales conference

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held during the period as well as
increased travel to Asia to pursue and evaluate potential market opportunities in the
region.

General
and Administrative.

|                                  | Three Months Ended
December 31, |  | Year-over- |      
|--------------------------------- | ------------------------------- |  | ---------- | -----
|
|General & administrative expenses |                                 |  | $          | 1,177
|As a percentage of net revenues   |                                 |  |            | 9    

General
and administrative expenses are comprised primarily of salaries for administrative and
corporate services personnel, legal and other professional fees. Such expenses increased
$184,000 for the three months ended December 31, 2004 over the same period in the prior
year as a result of increases in salaries and benefits expense of $112,000 in connection
with the employee performance reviews in October 2004 and in low value office equipment
purchases of $36,000 coupled with an increase in legal expenses of $45,000, related mainly
to patent filings, offset by a reduction in building expenses of $65,000 as a result of
reduced allocation of rental and other costs due to the expiration of a portion of the
lease at our corporate facility.

Amortization
of Intangibles.

|                                | Three Months Ended
December 31, |  | Year-over- |    
|------------------------------- | ------------------------------- |  | ---------- | ---
|
|Amortization of intangibles     |                                 |  | $          | 828
|As a percentage of net revenues |                                 |  |            | 7  

Amortization
of intangibles relate to acquired technology, workforce and patents. Amortization of
intangibles increased $677,000 for the three months ended December 31, 2004 over the same
period in the prior year mainly as a result of the amortization of developed and core
technologies acquired in fiscal year 2004 related to the IBM network processor and pattern
matching of $588,000 and $155,000, respectively, slightly offset by a reduction in
amortization of previously capitalized intangible assets as they reached their estimated
useful lives.

Purchased
In-Process Research and Development.

|                                            | Three Months Ended
December 31, |  | Year-over- |  
|------------------------------------------- | ------------------------------- |  | ---------- | -
|
|Purchased in-process research & development |                                 |  | $          | -
|As a percentage of net revenues             |                                 |  |            | -

Purchased
in-process research and development during the three months ended December 31, 2003
related to the purchase of certain assets and intellectual property for programmable
network processors designed for network traffic related to the IBM network processor
product line. The allocated amount of $3.3 million, related to two projects, was
determined by management based on established valuation techniques in the semiconductor
industry and was expensed upon acquisition because technological feasibility had not been
established and no alternative future uses exist. The acquired technology includes
development work on the next generation network processor (increasing speed and density
while reducing die size) which was approximately 85% complete and estimated to be
completed in late 2005 at an estimated cost of $5 million, and future development of the
network processor (with further increase in speed) which was approximately 15% complete
and estimated to be completed in late 2006 at an estimated cost of $4 million. The fair
value of the projects containing in-process technology in development was determined using
the income approach, which discounts expected future cash flows to present value. The
discount rates used in the present value calculations were derived from a weighted-average
cost of capital analysis adjusted to reflect additional risks inherent in the development
life cycle including the failure to achieve technical viability, rapid changes in customer
markets and required standards for new products as well as potential competition in the
market for such products. Failure to bring these products to market in a timely manner
could result in a loss of market share

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or a lost opportunity to capitalize
on emerging markets, and could have a material adverse impact on our business and
operating results.

Interest
and Other Income, net.

|                                | Three Months Ended
December 31, |  | Year-over- |    
|------------------------------- | ------------------------------- |  | ---------- | ---
|
|Interest & other income, net    |                                 |  | $          | 189
|As a percentage of net revenues |                                 |  |            | 2  

Interest
and other income, net, increased $87,000 during the three months ended December 31, 2004
as compared to the same period in the prior fiscal year. The increase was primarily a
result of a higher average cash balance during the period as a result of additional cash
generated from the private financing completed in February 2004 as well as a shift in the
investment mix to higher average yield short-term investments with the purchase of
commercial paper and municipal bonds.

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 months ended December 31, 2004 and 2003. We maintain a full
valuation allowance against deferred tax assets as we believe that it is more likely than
not that the Company will not realize the benefits of the deferred tax assets. We continue
to consider future taxable income and ongoing prudent and feasible tax planning strategies
in assessing the valuation allowance.

# Liquidity and Capital
Resources

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

|                                          | Three Months Ended
December 31, | 
|----------------------------------------- | ------------------------------- | 
|
|
|Net cash used in operating activities     |                                 | 
|Net cash used in investing activities     |                                 | 
|Net cash provided by financing activities |                                 | 
|                                          |                                 | 
|Net decrease in cash and cash equivalents |                                 | 
|                                          |                                 | 

Net
cash used in operating activities of $220,000 for the three months ended December 31,
2004 was the result of net loss of $576,000 as adjusted for non-cash items including
depreciation costs of $221,000 related to property and equipment and amortization of
intangibles of $828,000 as well as a decrease in other assets of $126,000 as a result of a
decrease in software licenses and an increase in accrued and other current liabilities of
$164,000 mainly as a result of increases in deferred revenues, related to the timing of
maintenance contract purchases amortizable over the service term, and in accrued
non-recurring engineering costs, related to projects under development. These adjustments
were offset by an increase in accounts receivable of $86,000, inventories of $684,000
reflecting increased purchases based on anticipated sales for the upcoming periods and in
prepaid expenses and in other current assets of $212,000 mainly as a result of insurance
policy renewals during the period.

Net
cash used in operating activities of $2.6 million for the three months ended
December 31, 2003 was the result of net loss of $5.1 million as adjusted for
non-cash items including purchased in-process research and development of
$3.3 million, depreciation costs of $346,000 related to property and equipment,
amortization of intangibles of $151,000, amortization of deferred stock compensation of
$44,000, as well as a decrease in accounts receivable of $713,000, related to the timing
of sales during the period and the collection of previously outstanding receivable
balances, and in other assets of $191,000 due to a decrease in software licenses. These adjustments were offset by an increase in
inventories of $493,000 and in prepaid expenses and other current assets of $770,000, mainly

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as a result of insurance policy and
software maintenance renewals, as well as a decrease in accounts payable and accrued
expenses and other current liabilities of approximately $1.0 million primarily as a
result of a reduction in accrued non-recurring engineering costs.

Net
cash used in investing activities of $1.9 million for the three months ended
December 31, 2004 primarily reflects the net purchase of short-term investments of
$1.6 million and the purchase of property and equipment of $334,000. Net cash used in
investing activities of $22.0 million for the three months ended December 31,
2003 primarily reflects the purchase of certain assets and intellectual property from IBM
for $15.8 million, the purchase of short-term investments of $6.0 million and
the purchase of property and equipment of $238,000.

Net
cash provided by financing activities for the three months ended December 31, 2004 was
$433,000 and was comprised of cash proceeds from the issuance of common stock for stock
option exercises and employee stock purchase plan purchases which aggregated $612,000 offset by installment payments on acquired
software licenses of $179,000. Cash provided by financing activities in the three months
ended December 31, 2003 of $1.2 million reflects proceeds from stock option exercises
and employee stock purchase plan purchases during the period.

The
Companys inventory balance increased by $684,000 to $2.7 million at December 31,
2004 as compared to $2.1 million as of September 30, 2004. The increase in inventory is a
result of the timing of inventory purchases relative to manufacturer lead-time coupled
with anticipated shipment schedules to fill customer orders for the succeeding quarter. Also as a result
of the inventory increase, annualized inventory turns in the quarter ended December 31, 2004 decreased to 6.4 times as
compared to 8.9 times in the quarter ended September 30, 2004.
The Companys accounts receivable balance, which is contingent upon the timing of
product shipment within the respective periods, remained at the same level, at $5.7
million, as of December 31, 2004 and September 30, 2004.

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

The
Company requires substantial working capital to fund its business, particularly to finance
accounts receivable and inventory, and for investments in property and equipment. The
Companys need to raise capital in the future will depend on many factors including
the rate of sales growth, market acceptance of the Companys existing and new
products, the amount and timing of research and development expenditures, the timing and
size of acquisitions of businesses or technologies, the timing of the introduction of new
products and the expansion of sales and marketing efforts. We believe that our existing
cash resources will fund any anticipated operating losses, purchases of capital equipment
and provide adequate working capital for the next twelve months. Our liquidity is affected
by many factors including, among others, the extent to which we pursue additional capital
expenditures, the level of our product development efforts, and other factors related to
the uncertainties of the industry and global economies. Accordingly, there can be no
assurance that events in the future will not require us to seek additional capital sooner
or, if so required, that such capital will be available at all or on terms acceptable to
us.

On
February 6, 2004, the Company entered into a securities purchase agreement with certain
investors for the private placement of 2.2 million shares of the Companys common
stock at a price of $15.00 per share for aggregate proceeds of $30.9 million, net of
expenses of approximately $2.1 million. The shares were issued and paid for on February 6,
2004. 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 April 2009, and which contain renewal options. Additionally,
contractual obligations were also entered into related to non-recurring engineering
services and inventory purchases. Payment obligations for such commitments as of December
31, 2004 are as follows:

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

# Off-Balance Sheet
Arrangements

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

# Guarantees

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

As
permitted under Delaware law, the Company has agreements that provide indemnification of
officers and directors for certain events or occurrences while the officer or director is,
or was serving, at the Companys request in such capacity. The indemnification period
is effective for the officers or directors lifetime. The maximum potential
amount of future payments that the Company could be required to make under these
indemnification agreements is unlimited; however, the Company has a Director and Officer
insurance policy that limits its exposure and enables the Company to recover a portion of
any future amounts paid. All of the indemnification agreements were grandfathered under
the provisions of FIN 45 as they were in effect prior to December 31, 2002. As a result of
the insurance policy coverage, the Company believes the estimated fair value of the
potential liability under these agreements is minimal. Accordingly, the Company has not
recorded any liabilities for these agreements as of December 31, 2004.

The Company enters into standard
indemnification agreements in the ordinary course of business. Pursuant to these
agreements, the Company indemnifies, holds harmless, and agrees to reimburse the
indemnified party, generally business partners or customers, for losses suffered or
incurred in connection with patent, copyright or other intellectual property infringement
claims by any third party with respect to the Companys products. The term of these
indemnification agreements is generally perpetual, effective after execution of the
agreement. The maximum potential amount of future payments the Company could be required
to make under these indemnification agreements is unlimited. To date, the Company has not
incurred costs to defend lawsuits or settle claims related to these indemnification
agreements. Accordingly, the Company has not recorded any liabilities for these agreements as
of December 31, 2004. However, the Company may, in the future, record charges related to
indemnification obligations and, depending upon the nature of any such lawsuit or claim,
the estimated fair value of such indemnification obligations may be material.

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The
Company warrants that its hardware products are free from defects in material and
workmanship under normal use and service and that its hardware and software products will
perform in all material respects in accordance with the standard published specifications
in effect at the time of delivery of the licensed products to the customer. The warranty
periods generally range from three months to one year for software and one year for
hardware. Additionally, the Company warrants that its maintenance services will be
performed consistent with generally accepted industry standards through completion of the
agreed upon services. The
Companys policy is to provide for the estimated cost of product and service warranties based on
specific warranty claims and claim history as a charge to cost of revenues. To date, the Company has not incurred
significant expense under its product or service warranties. As a result, the Company has
not recorded an accrual related to product or warranty services as of December 31, 2004. The Company assesses
the need for a warranty accrual every quarter. There is no assurance that a warranty accrual will not be
necessary in the future.

# Other Commitments

In
connection with the purchase of a pattern matching technology in September 2004, the
Company has potential obligations aggregating $900,000, the payments for which are
contingent upon achievement of certain development milestones. Such payments, if any, are
due within fiscal 2005. As of December 31, 2004, none of the development milestones have
been met.

Trends, Risks and
Uncertainties

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

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

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

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

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

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

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| |  | Capital
spending levels;
| | - | ------------------------

| |  | Additions
to, changes in or lack of industry standards;
| | - | -------------------------------------------------------

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

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

| |  | The
adoption of security as a necessary feature in iSCSI.
| | - | ---------------------------------------------------------

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

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

Cisco
Systems, Inc. (Cisco), an OEM producer of network equipment, comprised 46%,
53% and 41% of our net revenues for the three months ended December 31, 2004 and 2003 and
the year ended September 30, 2004, respectively. Quantum Corporation
(Quantum), through its manufacturing subcontractor, accounted for
approximately 13%, 24% and 14% of our net revenues during the three months ended December
31, 2004 and 2003 and the year ended September 30, 2004, respectively. Huawei
Technologies, Inc. (Huawei), an OEM producer of network equipment, comprised
10% and 14% of our net revenues for the three months ended December 31, 2004 and the year
ended September 30, 2004, respectively.

Cisco,
Quantum and Huawei are not under any binding obligation to order from us. If our sales to
Cisco, Quantum or Huawei decline, our business, financial condition and results of
operations could suffer. 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 Operating Results
May Fluctuate Significantly.

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

| |  | General
 business  conditions  in our  markets  as well  as  global         economic uncertainty;
| | - | -------------------------------------------------------------------------------------------------

| |  | Increases
or reductions in demand for our customers' products;
| | - | --------------------------------------------------------------

| |  | The
timing and volume of orders we receive from our customers;
| | - | --------------------------------------------------------------

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| |  | Cancellations
or delays of customer product orders;
| | - | ---------------------------------------------------

| |  | Acquisitions
  or  mergers   involving  us,  our   competitors   or         customers;
| | - | --------------------------------------------------------------------------------------

| |  | Any
new product introductions by us or our competitors;
| | - | -------------------------------------------------------

| |  | Our
 suppliers   increasing  costs  or  changing  the  delivery  of         products to us;
| | - | -------------------------------------------------------------------------------------------

| |  | Increased
 competition  or  reductions  in the  prices  that we are         able to charge;
| | - | -------------------------------------------------------------------------------------------

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

| |  | The
availability of manufacturing capacity necessary to make our products.
| | - | --------------------------------------------------------------------------

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

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

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

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

We
depend on our suppliers to deliver sufficient quantities of finished product to us in a
timely manner. Since we place orders on a purchase order basis and do not have long-term
volume purchase agreements with any of our suppliers, our suppliers may allocate
production capacity to 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.
| | - | ---------------------------------------------------------

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

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

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

# We Face Risks Associated
With Acquisitions.

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

| |  | Difficulties
 in  assimilating  acquired  operations,  technologies         and products;
| | - | -----------------------------------------------------------------------------------------

| |  | Diversion
of management's attention from other business concerns;
| | - | -----------------------------------------------------------------

| |  | Risks
of  entering  markets  in which  we have  little  or no prior         experience; and
| | - | -------------------------------------------------------------------------------------------

| |  | Loss
of key employees of acquired organizations.
| | - | ------------------------------------------------

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

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

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 continuing relationship with
IBMs established customer base and our third party supplier, in this case, IBM.
Without the successful integration of this significant asset acquisition, there can be no
assurance that we will be able to maintain the revenue

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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.

We Will Be Subject To And Are
Currently Undergoing Procedures Related To Compliance with Section 404 of the
Sarbanes-Oxley Act of 2002 And May Not Be Able To Satisfy Regulatory Requirements Relating
To Internal Controls Over Financial Reporting Or May Encounter Difficulties In
Implementing Any New Or Improved Internal Controls.

As
required by Section 404 of the Sarbanes-Oxley Act, we are conducting a review of all of
our internal control processes and procedures. In our review, we have identified areas
that may potentially require that we modify or strengthen controls over processes to
improve internal controls and we intend to continue to evaluate and, where necessary,
effect modifications. Our areas of focus for review include, but are not limited to, our
financial system and segregation of duties. We made substantial progress in our review
process and will continue to perform our review and testing. While the design of any
system of controls is based in part upon certain assumptions about the likelihood of
future events, we cannot assure that our system of controls will succeed in achieving its
stated goals under all conditions. Any failure to implement required new or improved
controls, or difficulties encountered in the implementation of such new or improved
controls, could have implications on our consolidated operating results or could result in
a material weakness that would be required to be reported in the Companys Form 10-K.

# 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 2001, we wrote off
excess inventory of $3.4 million as a result of a significant decrease in forecasted
demand for our products. We recognize revenue upon shipment of products to our customers.
Revenue from products sold to distributors are deferred until the distributor sells the
products to a third party. An unanticipated level of returns could harm our business,
financial condition and results of operations.

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

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

| |  | Properly
   identify    emerging   target   markets   and   related         technological trends;
| | - | -------------------------------------------------------------------------------------------------

| |  | Develop
and maintain competitive products;
| | - | ------------------------------------------

| |  | Develop
end-to-end, ubiquitous systems solutions;
| | - | -------------------------------------------------

| |  | Develop,
  or  partner  with   providers  of,   security   services         processors;
| | - | ---------------------------------------------------------------------------------------

| |  | Develop
both hardware and software security services solutions;
| | - | ---------------------------------------------------------------

| |  | Enhance
 our   products   by  adding   innovative   features   that         differentiate our
products from those of competitors;
| | - | ---------------------------------------------------------------------------------------------------------------------------------

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| |  | Bring
products to market on a timely basis at  competitive  prices;         and
| | - | -------------------------------------------------------------------------------

| |  | Respond
effectively to new technological changes or new product announcements by others.
| | - | ----------------------------------------------------------------------------------------

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

In
evaluating new product decisions, we must anticipate future demand for product features
and performance characteristics, as well as available supporting technologies,
manufacturing capacity, competitive product offerings and industry standards. We must also
continue to make significant investments in research and development in order to continue
to enhance the performance and functionality of our products to keep pace with competitive
products and customer demands for improved performance, features and functionality. The
technical innovations required for us to remain competitive are complicated and require a
significant amount of time and money. During fiscal 2004, we acquired certain technology
for embedded processors, pattern matching and network processors. We may experience
substantial difficulty in introducing new products, such as new products containing the
acquired technologies and we may be unable to offer enhancements to existing products on a
timely or cost-effective basis, if at all. For instance, the performance of our
encryption/compression and public key processors depends upon the integrity of our
security technology. If any significant advances in overcoming cryptographic systems are
made, then the security of our encryption/compression and public key processors will be
reduced or eliminated unless we are able to develop further technical innovations that
adequately enhance the security of these products. Our inability to develop and introduce
new products or 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., Cavium Networks, Freescale Technologies, Inc., Intel Corporation, Agere
Systems and Applied Micro Circuits Corporation. Hifn was a wholly-owned subsidiary of
Stac, Inc. until Hifns spin-off from Stac in 1996 upon which Stac assigned two
license agreements entered into with IBM in 1994 in which Stac granted IBM the right to
use, but not sublicense, our patented compression technology in IBM hardware and software
products. Stac also assigned to us its license agreement with Microsoft Corporation
(Microsoft) in 1994 whereby Stac granted Microsoft the right to use, but not
sublicense, our compression technology in their software products. We expect significant
future competition from major domestic and international semiconductor suppliers. Several
established electronics and semiconductor suppliers have recently entered, or expressed an
interest to enter, the network equipment market. We also may face competition from
suppliers of products based on new or emerging technologies. Furthermore, many of our
existing and potential customers internally develop solutions which attempt to perform all
or a portion of the functions performed by our products.

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

Many
of our current and prospective competitors offer broader product lines and have
significantly greater financial, technical, manufacturing and marketing resources than us.
As a result, they may be able to adapt more

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

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

| |  | Performance;
| | - | ------------

| |  | Price;
| | - | ------

| |  | The
 time  that  is   required   to  develop  a  new  product  or          enhancements to
existing products;
| | - | -------------------------------------------------------------------------------------------------------------

| |  | The
 ability to achieve  product  acceptance  with major  network          and storage
equipment vendors;
| | - | ---------------------------------------------------------------------------------------------------------

| |  | The
support that exists for new network and storage standards;
| | - | --------------------------------------------------------------

| |  | Features
and functionality;
| | - | ---------------------------

| |  | Adaptability
of products to specific applications;
| | - | --------------------------------------------------

| |  | Reliability;
and
| | - | ----------------

| |  | Technical
service and support as well as effective intellectual property protection.
| | - | ------------------------------------------------------------------------------------

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

# Our Success Depends Upon
Protecting Our Intellectual Property.

Our
proprietary technology is critical to our future success. We rely in part on patent,
trade, trademark, mask work and copyright law to protect our intellectual property. We own
twenty-two (22) United States patents and six foreign patents. Our issued patents and
patent applications primarily cover various aspects of our compression, flow
classification, bandwidth management, cryptographic packet processing, rate shaping and
pattern matching technologies and have expiration dates ranging from 2006 to 2022. We also
have four pending patent applications in the United States and a total of seventeen (17)
in Europe, Asia and Australia covering flow classification, cryptographic packet
processing, and pattern matching. Patents may not be issued under our current or future
patent applications, and the patents issued under such patent applications could be
invalidated, circumvented or challenged. In addition, third parties could make
infringement claims against us in the future. Such infringement claims could result in
costly litigation. We may not prevail in any such litigation or be able to license any
valid and infringed patents from third parties on commercially reasonable terms, if at
all. Regardless of the outcome, an infringement claim would likely result in substantial
cost and diversion of our resources. Any infringement claim or other litigation against us
or by us could harm our business, financial condition and results of operations. The
patents issued to us may not be adequate to protect our proprietary rights, to deter
misappropriation or to prevent an unauthorized third party from copying our technology,
designing around the patents we own or otherwise obtaining

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and using our products, designs or
other information. In addition, others could develop technologies that are similar or
superior to our technology.

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

# Network And Storage
Equipment Prices Typically Decrease.

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

| |  | Rapidly
changing technologies;
| | - | ------------------------------

| |  | Price-performance
enhancements; and
| | - | -----------------------------------

| |  | Product
obsolescence.
| | - | ---------------------

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

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

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

# 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

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qualified personnel. These claims
could result in material litigation. We could incur substantial costs in defending
against any such claims, regardless of their merits.

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

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

# We Face Risks Associated
With Our International Business Activities.

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

| |  | The
imposition of governmental controls;
| | - | ----------------------------------------

| |  | Export
license/technical review requirements;
| | - | ---------------------------------------------

| |  | Restrictions
on the export of technology;
| | - | -----------------------------------------

| |  | Currency
exchange fluctuations;
| | - | -------------------------------

| |  | Political
instability;
| | - | ----------------------

| |  | Financial
and stock market dislocations;
| | - | ----------------------------------------

| |  | Military
and related activities;
| | - | --------------------------------

| |  | Trade
restrictions; and
| | - | -----------------------

| |  | Changes
in tariffs.
| | - | -------------------

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

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

# Our Products Are Subject
To Export Restrictions.

The
encryption algorithms embedded in our products are a key element of our packet processor
architecture. These products are subject to U.S. Department of Commerce export control
restrictions. Our network equipment customers may only export products incorporating
encryption technology if they obtain a one-time technical review. These U.S. export laws
also prohibit the export of encryption products to a number of countries deemed by the
U.S. to be hostile. Many foreign countries also restrict exports to many of these
countries deemed to be terrorist-supporting states by the U.S. government.
Because the restrictions on exports of encryption products have been liberalized, we,
along with our network equipment customers have an opportunity to effectively compete with
our

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foreign competitors. The existence
of these restrictions until recently may have enabled foreign competitors facing less
stringent controls on their products to become more established and, therefore, more
competitive in the global market than our network equipment customers. In addition, the
list of products and countries for which export approval is required, and the
regulatory policies with respect thereto, could be revised, and laws limiting the
domestic use of encryption could be enacted. While the U.S. government now allows U.S.
companies to assume that exports to non-government end-users will be approved within 30
days of official registration with the Department of Commerce, the sale of our packet
processors could be harmed by the failure of our network equipment customers to obtain
the required approvals or by the costs of compliance.

# Our Stock Price May Be
Volatile.

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

| |  | Quarterly
variations in operating results;
| | - | ------------------------------------------

| |  | Announcements
of new products by us or our competitors;
| | - | -------------------------------------------------------

| |  | The
gain or loss of significant customers;
| | - | ------------------------------------------

| |  | Changes
in analysts' estimates;
| | - | -------------------------------

| |  | Short-selling
of our Common Stock; and
| | - | --------------------------------------

| |  | Events
affecting other companies that investors deem to be comparable to us.
| | - | ----------------------------------------------------------------------------

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

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

We
perform impairment analyses of goodwill and long-lived and intangible assets on an annual
basis. During fiscal 2003 and 2002, we determined that impairment had been realized on
certain developed technology and goodwill, resulting in recognition of impairment charges
of $3.9 million and $27.4 million, respectively. Pursuant to SFAS 142, Goodwill and
Other Intangible Assets, we will continue to perform an annual impairment test and
if, as a result of this analysis, we determine that there has been an impairment of our
goodwill and other long-lived and intangible assets, asset impairment charges will be
recognized. Approximately $1.0 million of goodwill remains as of December 31, 2004. 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.

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# We Have Been Engaged in
Securities Class-Action Lawsuits.

In
the past, the Company has been engaged in securities class-action lawsuits. During fiscal
2003, we completed the settlement terms of a class action complaint and had shareholder
derivative actions dismissed. As of December 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.

# Recent Accounting
Pronouncements

In
December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R
(SFAS No. 123R), Share-Based Payment, and amendment to Statement
of Financial Accounting Standards No. 123 (SFAS No. 123), Accounting for
Stock-Based Compensation and Statement on Financial Accounting Standards No. 95,
Statement of Cash Flows. The revised standard addresses the accounting for
share-based payment transactions in which a company receives employee services in exchange
for either equity instruments of the company or liabilities that are based on the fair
value of the companys equity instruments or that may be settled by the issuance of
such equity instruments. Under the new standard, companies will no longer be able to
account for share-based compensation transactions using the intrinsic method in accordance
with APB 25. Instead, companies will be required to account for such transactions using a
fair-value method and recognize the expense in the consolidated statement of income. SFAS
No. 123R will be effective for periods beginning after June 15, 2005 and allows, but does
not require, companies to restate the full fiscal year of 2005 to reflect the impact of
expensing share-based payments under SFAS No. 123R. The Company has not yet determined
which fair-value method and transitional provision it will follow. Currently, we disclose
the pro forma net income (loss) and related pro forma income (loss) per share information
in accordance with SFAS 123 and Statement on Financial Accounting Standards No. 148,
Accounting for Stock-Based Compensation CostsTransition and Disclosure.
We will continue to evaluate the impact that the exposure draft will have on our financial
position and results of operations.

# 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 December 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. We maintain disclosure controls and procedures
that are designed to ensure that information required to be disclosed by us in reports
that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded,
processed, summarized and reported within the time periods specified in Securities and
Exchange Commission rules and forms, and that such information is accumulated and
communicated to our management, including our Chief Executive Officer and Chief Financial
Officer, as appropriate, to allow timely decisions regarding required disclosure. In
designing and evaluating our disclosure controls and procedures, management recognized
that disclosure controls and procedures, no matter how well conceived and operated, can
provide only reasonable, not absolute, assurance that the objectives of the disclosure
controls and procedures are met. Additionally, in designing disclosure controls and
procedures, our management necessarily was required to apply
its judgment in evaluating the cost-benefit relationship of possible disclosure

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controls
and procedures. The design of any disclosure controls and procedures also is based in
part upon certain assumptions about the likelihood of future events, and there can be no
assurance that any design will succeed in achieving its stated goals under all potential
future conditions.

Based
on their evaluation as of the end of the period covered by this Quarterly Report on Form
10-Q, our Chief Executive Officer and Chief Financial Officer have concluded that, subject
to the limitations noted above, our disclosure controls and procedures were effective to
ensure that material information relating to us, including our consolidated subsidiaries,
that is required to be disclosed in this Quarterly Report on Form 10-Q (i) is recorded,
processed, summarized and reported within the time periods specified in SEC rules and
forms, and (ii) is made known to management, including our principal executive officer and
principal financial officer, as appropriate to allow timely decisions regarding required
disclosure.

Changes
in internal control over financial reporting. There was no change in our internal
control over financial reporting, or in other factors that could significantly affect
these internal controls, identified in connection with the evaluation described in Item
4(a) above 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.

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PART
II  OTHER INFORMATION

# Item 6. Exhibits and
Reports on Form 8-K

|(a) | Exhibits
|--- | --------

| | Exhibit Index
| | -------------

| | Exhibit Number | Description
| | -------------- | -----------
| |                | 3.1        
| |                |            
| |                | 3.2        
| |                |            
| |                | 31.1       
| |                |            
| |                | 31.2       
| |                |            
| |                | 32.1       
| |                |            
| |                | 32.2       

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

| | None.
| | -----

---

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

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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.

|Date: February 9, 2005 |  | hi/fn, inc.(Registrant)By:  /s/ William R. Walker
William R. WalkerVice President, Finance, Chief Financial Officer and Secretary (principal financial and accounting officer)
|---------------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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# INDEX TO EXHIBITS

| | Exhibit Number | Exhibit
| | -------------- | -------
| |                | 3.1    
| |                |        
| |                | 3.2    
| |                |        
| |                | 31.1   
| |                |        
| |                | 31.2   
| |                |        
| |                | 32.1   
| |                |        
| |                | 32.2   

---

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

---