##### Table of Contents



U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549







FORM 10-Q


|    |  |                                                                                        
|--- |  | ---------------------------------------------------------------------------------------
|[X] |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the Quarterly Period Ended March 31, 2003

|     |  |                                                                                          
|---- |  | -----------------------------------------------------------------------------------------
|[  ] |  | 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
(State or other jurisdiction of
Incorporation or Organization) |  | 33-0732700
(IRS Employer
Identification Number)

750 University Avenue, Los Gatos, California 95032

(Address of principal executive offices and Zip Code)


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

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

Yes [X]   No [  ]

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

Yes [  ]   No [X]

The number of shares outstanding of the Registrants Common Stock, par value
$.001 per share, was 10,610,043 at April 23, 2003.





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TABLE OF CONTENTS



|                               |                                                                                               |                                                      |  |  |  |  |  | 
|------------------------------ | --------------------------------------------------------------------------------------------- | ---------------------------------------------------- |  |  |  |  |  | 
|PART 1  FINANCIAL INFORMATION
|                               | Item 1. Financial Statements                                                                 
|                               |                                                                                               | CONDENSED CONSOLIDATED BALANCE SHEETS               
|                               |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS     
|                               |                                                                                               | 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 Disclosures About Market Risk                           
|                               | Item 4. Controls and Procedures                                                              
|PART II  OTHER INFORMATION   
|                               | Item 1. Legal Proceedings                                                                    
|                               | Item 4. Submission of Matters to a Vote of Security Holders                                  
|                               | Item 6. Exhibits and Reports on Form 8-K                                                     
|SIGNATURES                    
|CERTIFICATION                 
|INDEX TO EXHIBITS             
|EXHIBIT 99.1                  
|EXHIBIT 99.2                  



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HIFN, INC.

INDEX TO FORM 10-Q

|                                                                                              |              |                                                                                                            |       |    |      | 
|--------------------------------------------------------------------------------------------- | ------------ | ---------------------------------------------------------------------------------------------------------- | ----- | -- | ---- | 
|PART I. FINANCIAL INFORMATION                                                                 |              |                                                                                                            |       |   
|Item 1. Financial Statements                                                                  |              |                                                                                                            |       |   
|                                                                                              |              | Condensed Consolidated Balance Sheets
as of March 31, 2003 and September 30, 2002                          |       |    | 3    | 
|                                                                                              |              | Condensed Consolidated Statements of Operations
for the three and six months ended March 31, 2003 and 2002 |       |    | 4    | 
|                                                                                              |              | Condensed Consolidated Statements of Cash Flows
for the six months ended March 31, 2003 and 2002           |       |    | 5    | 
|                                                                                              |              | Notes to Condensed Consolidated Financial Statements                                                       |       |    | 6-11 | 
|Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations |              |                                                                                                            | 12-28 |   
|Item 3. Quantitative and Qualitative Disclosure About Market Risks                            |              |                                                                                                            | 28    |   
|Item 4. Controls and Procedures                                                               |              |                                                                                                            | 28    |   
|PART II. OTHER INFORMATION                                                                    |              |                                                                                                            |       |   
|Item 1. Legal Proceedings                                                                     |              |                                                                                                            | 29    |   
|Item 4. Submission of Matters to a Vote of Security Holders                                   |              |                                                                                                            | 30    |   
|Item 6. Exhibits and Reports on Form 8-K                                                      |              |                                                                                                            | 30    |   
|Signatures                                                                                    |              |                                                                                                            | 31    |   
|Certifications                                                                                |              |                                                                                                            | 32-33 |   
|Index to Exhibits                                                                             |              |                                                                                                            | 34    |   
|                                                                                              | Exhibit 99.1 |                                                                                                            |       | 35 |     
|                                                                                              | Exhibit 99.2 |                                                                                                            |       | 36 |     

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PART 1  FINANCIAL INFORMATION




Item 1. Financial Statements




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

|                                  |                                                                                            |                           |                                      |                            |        |             |        |               |        |  |        | 
|--------------------------------- | ------------------------------------------------------------------------------------------ | ------------------------- | ------------------------------------ | -------------------------- | ------ | ----------- | ------ | ------------- | ------ |  | ------ | 
|                                  |                                                                                            |                           |                                      |                            |        | March 31,   |        | September 30,
|                                  |                                                                                            |                           |                                      |                            |        | 2003        |        | 2002         
|                                  |                                                                                            |                           |                                      |                            |        |             |        |              
|                                  |                                                                                            |                           |                                      |                            |        | (unaudited) |        |               |        | 
|                                  |                                                                                            |                           |                                      | ASSETS                     |        |             |        |               |        |  |        | 
|CURRENT ASSETS:                   |                                                                                            |                           |                                      |                            |        |             |        |              
|                                  | Cash and cash equivalents                                                                  |                           | $                                    | 46,441                     |        |             | $      | 53,060        |       
|                                  | Short-term investments                                                                     |                           |                                      |                           |        |             |        | 1,606         |       
|                                  | Accounts receivable, net of allowance for
doubtful accounts of $201 and $164, respectively |                           |                                      | 1,954                      |        |             |        | 2,263         |       
|                                  | Inventories                                                                                |                           |                                      | 581                        |        |             |        | 704           |       
|                                  | Prepaid expenses and other current assets                                                  |                           |                                      | 4,018                      |        |             |        | 2,788         |       
|                                  |                                                                                            |                           |                                      |                            |        |             |        |               |       
|                                  |                                                                                            | Total current assets      |                                      |                            | 52,994 |             |        |               | 60,421 | 
|Property and equipment, net       |                                                                                            |                           | 2,500                                |                            |        |             | 2,580  |              
|Goodwill                          |                                                                                            |                           | 1,029                                |                            |        |             | 1,029  |              
|Intangibles and other assets, net |                                                                                            |                           | 6,667                                |                            |        |             | 8,249  |              
|                                  |                                                                                            |                           |                                      |                            |        |             |        |               |       
|                                  |                                                                                            | $                         | 63,190                               |                            |        | $           | 72,279 |              
|                                  |                                                                                            |                           |                                      |                            |        |             |        |               |       
|                                  |                                                                                            |                           | LIABILITIES AND STOCKHOLDERS EQUITY |                            |        |             |        |               |        |  |       
|CURRENT LIABILITIES:              |                                                                                            |                           |                                      |                            |        |             |        |              
|                                  | Accounts payable                                                                           |                           | $                                    | 4,568                      |        |             | $      | 3,686         |       
|                                  | Accrued expenses and other current liabilities                                             |                           |                                      | 11,653                     |        |             |        | 11,937        |       
|                                  |                                                                                            |                           |                                      |                            |        |             |        |               |       
|                                  |                                                                                            | Total current liabilities |                                      |                            | 16,221 |             |        |               | 15,623 | 
|                                  |                                                                                            |                           |                                      |                            |        |             |        |               |       
|STOCKHOLDERS EQUITY:             |                                                                                            |                           |                                      |                            |        |             |        |              
|                                  | Common stock                                                                               |                           |                                      | 11                         |        |             |        | 10            |       
|                                  | Additional paid-in capital                                                                 |                           |                                      | 123,405                    |        |             |        | 122,672       |       
|                                  | Accumulated deficit                                                                        |                           |                                      | (76,447                    | )      |             |        | (66,026       | )     
|                                  |                                                                                            |                           |                                      |                            |        |             |        |               |       
|                                  |                                                                                            |                           |                                      | Total stockholders equity |        |             | 46,969 |               |        |  | 56,656 | 
|                                  |                                                                                            |                           |                                      |                            |        |             |        |               |       
|                                  |                                                                                            | $                         | 63,190                               |                            |        | $           | 72,279 |              
|                                  |                                                                                            |                           |                                      |                            |        |             |        |               |       

See accompanying notes to condensed consolidated financial statements.

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

|                                                       |                                                |                                    |        |                    |       |                  |        |       |        |      |         |        |        |   |         |       |        | 
|------------------------------------------------------ | ---------------------------------------------- | ---------------------------------- | ------ | ------------------ | ----- | ---------------- | ------ | ----- | ------ | ---- | ------- | ------ | ------ | - | ------- | ----- | ------ | 
|                                                       |                                                |                                    |        | Three Months Ended |       | Six Months Ended
|                                                       |                                                |                                    |        | March 31,          |       | March 31,       
|                                                       |                                                |                                    |        |                    |       |                 
|                                                       |                                                |                                    |        | 2003               |       | 2002             |        | 2003  |        | 2002
|                                                       |                                                |                                    |        |                    |       |                  |        |       |        |     
|Net revenues:                                          |                                                |                                    |        |                    |       |                  |        |       |        |      |         |        |        |   |         |      
|                                                       | Processors                                     |                                    | $      | 3,707              |       |                  | $      | 5,118 |        |      | $       | 7,479  |        |   | $       | 9,639 |       
|                                                       | Software licenses and other                    |                                    |        | 842                |       |                  |        | 608   |        |      |         | 1,485  |        |   |         | 2,491 |       
|                                                       |                                                |                                    |        |                    |       |                  |        |       |        |      |         |        |        |   |         |       |       
|                                                       |                                                | Total net revenues                 |        |                    | 4,549 |                  |        |       | 5,726  |      |         |        | 8,964  |   |         |       | 12,130 | 
|                                                       |                                                |                                    |        |                    |       |                  |        |       |        |      |         |        |        |   |         |       |       
|Costs and operating expenses:                          |                                                |                                    |        |                    |       |                  |        |       |        |      |         |        |        |   |         |      
|                                                       | Cost
of revenues - processors                  |                                    |        | 1,458              |       |                  |        | 2,029 |        |      |         | 2,793  |        |   |         | 3,641 |       
|                                                       | Cost of revenues - software licenses and other |                                    |        | 99                 |       |                  |        | 45    |        |      |         | 198    |        |   |         | 90    |       
|                                                       | Research and development                       |                                    |        | 5,417              |       |                  |        | 4,347 |        |      |         | 10,631 |        |   |         | 9,458 |       
|                                                       | Sales and marketing                            |                                    |        | 1,741              |       |                  |        | 2,169 |        |      |         | 3,516  |        |   |         | 4,359 |       
|                                                       | General and administrative                     |                                    |        | 885                |       |                  |        | 2,841 |        |      |         | 1,872  |        |   |         | 4,417 |       
|                                                       | Amortization of goodwill                       |                                    |        |                   |       |                  |        | 2,356 |        |      |         |       |        |   |         | 4,712 |       
|                                                       | Amortization of intangibles                    |                                    |        | 359                |       |                  |        | 611   |        |      |         | 717    |        |   |         | 1,033 |       
|                                                       |                                                |                                    |        |                    |       |                  |        |       |        |      |         |        |        |   |         |       |       
|                                                       |                                                | Total costs and operating expenses |        |                    | 9,959 |                  |        |       | 14,398 |      |         |        | 19,727 |   |         |       | 27,710 | 
|                                                       |                                                |                                    |        |                    |       |                  |        |       |        |      |         |        |        |   |         |       |       
|Loss from operations                                   |                                                |                                    | (5,410 | )                  |       |                  | (8,672 | )     |        |      | (10,763 | )      |        |   | (15,580 | )    
|Interest and other income, net                         |                                                |                                    | 112    |                    |       |                  | 249    |       |        |      | 342     |        |        |   | 613     |      
|                                                       |                                                |                                    |        |                    |       |                  |        |       |        |      |         |        |        |   |         |       |       
|Loss before income taxes                               |                                                |                                    | (5,298 | )                  |       |                  | (8,423 | )     |        |      | (10,421 | )      |        |   | (14,967 | )    
|Benefit from income taxes                              |                                                |                                    |       |                    |       |                  | (2,283 | )     |        |      |        |        |        |   | (3,814  | )    
|                                                       |                                                |                                    |        |                    |       |                  |        |       |        |      |         |        |        |   |         |       |       
|Net loss                                               |                                                | $                                  | (5,298 | )                  |       | $                | (6,140 | )     |        | $    | (10,421 | )      |        | $ | (11,153 | )    
|                                                       |                                                |                                    |        |                    |       |                  |        |       |        |      |         |        |        |   |         |       |       
|Net loss per share, basic and diluted                  |                                                | $                                  | (0.50  | )                  |       | $                | (0.59  | )     |        | $    | (0.98   | )      |        | $ | (1.08   | )    
|                                                       |                                                |                                    |        |                    |       |                  |        |       |        |      |         |        |        |   |         |       |       
|Weighted average shares outstanding,
basic and diluted |                                                |                                    | 10,599 |                    |       |                  | 10,432 |       |        |      | 10,592  |        |        |   | 10,350  |      
|                                                       |                                                |                                    |        |                    |       |                  |        |       |        |      |         |        |        |   |         |       |       

See accompanying notes to condensed consolidated financial statements.

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

|                                                     |                                                                                 |                                                |                                           |         |                  |        |        |         |        |        |  
|---------------------------------------------------- | ------------------------------------------------------------------------------- | ---------------------------------------------- | ----------------------------------------- | ------- | ---------------- | ------ | ------ | ------- | ------ | ------ | -
|                                                     |                                                                                 |                                                |                                           |         | Six Months Ended
|                                                     |                                                                                 |                                                |                                           |         | March 31,       
|                                                     |                                                                                 |                                                |                                           |         |                 
|                                                     |                                                                                 |                                                |                                           |         | 2003             |        | 2002  
|                                                     |                                                                                 |                                                |                                           |         |                  |        |       
|Cash flows from operating activities:                |                                                                                 |                                                |                                           |         |                  |        |        |        
|                                                     | Net loss                                                                        |                                                | $                                         | (10,421 | )                |        | $      | (11,153 | )     
|                                                     | Adjustments to reconcile net loss to
net cash provided by operating activities: |                                                |                                           |         |                  |        |        |         |       
|                                                     |                                                                                 | Depreciation and amortization                  |                                           |         | 784              |        |        |         | 967    |       
|                                                     |                                                                                 | Amortization of goodwill                       |                                           |         |                 |        |        |         | 4,712  |       
|                                                     |                                                                                 | Amortization of intangibles                    |                                           |         | 1,214            |        |        |         | 1,033  |       
|                                                     |                                                                                 | Amortization of deferred stock compensation    |                                           |         | 223              |        |        |         | 2,433  |       
|                                                     |                                                                                 | Deferred income taxes                          |                                           |         |                 |        |        |         | (1,920 | )     
|                                                     | Changes in assets and liabilities:                                              |                                                |                                           |         |                  |        |        |         |       
|                                                     |                                                                                 | Accounts receivable                            |                                           |         | 309              |        |        |         | 380    |       
|                                                     |                                                                                 | Inventories                                    |                                           |         | 123              |        |        |         | 922    |       
|                                                     |                                                                                 | Prepaid expenses and other current assets      |                                           |         | (1,230           | )      |        |         | (1,447 | )     
|                                                     |                                                                                 | Intangibles and other assets                   |                                           |         | 368              |        |        |         | (2,502 | )     
|                                                     |                                                                                 | Accounts payable                               |                                           |         | 882              |        |        |         | (83    | )     
|                                                     |                                                                                 | Accrued expenses and other current liabilities |                                           |         | (284             | )      |        |         | 930    |       
|                                                     |                                                                                 |                                                |                                           |         |                  |        |        |        
|                                                     |                                                                                 |                                                | Net cash used in operating activities     |         |                  | (8,032 | )      |         |        | (5,728 | )
|                                                     |                                                                                 |                                                |                                           |         |                  |        |        |        
|Cash flows from investing activities:                |                                                                                 |                                                |                                           |         |                  |        |        |        
|                                                     | Sale of short-term investments, net                                             |                                                |                                           | 1,606   |                  |        |        | 6,746   |       
|                                                     | Purchases of property and equipment                                             |                                                |                                           | (704    | )                |        |        | (70     | )     
|                                                     |                                                                                 |                                                |                                           |         |                  |        |        |        
|                                                     |                                                                                 |                                                | Net cash provided by investing activities |         |                  | 902    |        |         |        | 6,676  |  
|                                                     |                                                                                 |                                                |                                           |         |                  |        |        |        
|Cash flows from financing activities:                |                                                                                 |                                                |                                           |         |                  |        |        |        
|                                                     | Proceeds from issuance of common stock, net                                     |                                                |                                           | 511     |                  |        |        | 502     |       
|                                                     | Payment on capital lease obligations                                            |                                                |                                           |        |                  |        |        | (26     | )     
|                                                     |                                                                                 |                                                |                                           |         |                  |        |        |        
|                                                     |                                                                                 |                                                | Net cash provided by financing activities |         |                  | 511    |        |         |        | 476    |  
|                                                     |                                                                                 |                                                |                                           |         |                  |        |        |        
|Net increase (decrease) in cash and cash equivalents |                                                                                 |                                                | (6,619                                    | )       |                  |        | 1,424  |        
|Cash and cash equivalents at beginning of period     |                                                                                 |                                                | 53,060                                    |         |                  |        | 54,600 |        
|                                                     |                                                                                 |                                                |                                           |         |                  |        |        |        
|Cash and cash equivalents at end of period           |                                                                                 | $                                              | 46,441                                    |         |                  | $      | 56,024 |        
|                                                     |                                                                                 |                                                |                                           |         |                  |        |        |        

See accompanying notes to condensed consolidated financial statements.

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HIFN, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 1 - Basis of Presentation

The condensed consolidated financial statements of hi/fn, inc. (Hifn or
the Company) include the accounts of the Company and its subsidiaries, Hifn
Limited, Hifn Netherlands B.V. and Apptitude Acquisition Corporation
(Apptitude). In January 2003, Apptitude was merged into Hifn. All significant
intercompany accounts and transactions have been eliminated. The preparation of
financial statements in conformity with generally accepted accounting
principles requires management to make estimates and assumptions that affect
the reported amounts of assets and liabilities at the date of the financial
statements and reported amounts of revenues and expenses during the reporting
period. Actual results could differ from those estimates.

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 the period ending September 30, 2002. In the opinion of
management, the accompanying condensed consolidated financial statements
contain all adjustments, consisting only of normal recurring items, which the
Company believes is necessary for a fair statement of the Companys financial
position as of March 31, 2003 and its results of operations for the three and
six months ended March 31, 2003 and 2002, respectively. These condensed
consolidated financial statements are not necessarily indicative of the results
to be expected for the entire year.

The Company has an accumulated deficit of $76.4 million as of March 31,
2003 and incurred losses of $10.4 million during the six months ended March 31,
2003. The Company anticipates that its existing cash resources will fund any
anticipated operating losses, purchases of capital equipment and provide
adequate working capital for the next twelve months. The Companys liquidity is
affected by many factors including, among others, the extent to which the
Company pursues additional capital expenditures, the level of the Companys
product development efforts, and other factors related to the uncertainties of
the industry and global economies. Accordingly, there can be no assurance that
events in the future will not require the Company to seek additional capital
sooner or, if so required, that such capital will be available on terms
acceptable to the Company.

Reclassifications

Certain reclassifications have been made to the prior periods
consolidated financial statements to conform to the current periods
presentation. Such reclassifications had no effect on previously reported
results of operations or retained earnings.

Note 2 - Stock Options

The Company accounts for its employee and stock option plans and employee
stock purchase plans in accordance with provisions of the Accounting Principles
Board Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees and
Interpretation No. 44, Accounting for Certain Transactions Involving Stock
Compensation.

In
December 2002, the Financial Accounting Standards Board
(FASB) issued
Statement of Financial Accounting Standards No. 148 (SFAS 148), Accounting
for Stock-Based Compensation Transition and Disclosure, which amends
Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting
for Stock-Based Compensation, and provides alternative methods of transition
for a voluntary change to the fair value based method of accounting for
stock-based compensation. Furthermore, SFAS 148 amends the disclosure
requirements of SFAS 123 to require more prominent and frequent disclosures in
financial statements about the effects of stock-based compensation. The
transition guidance and disclosure provisions of SFAS 148 are effective for
financial reports of periods ending after December 15, 2002. The Company will
continue to account for stock-based

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compensation of employees using the intrinsic value method prescribed in APB 25 and
related interpretations. However, the Company has now adopted the enhanced
disclosure provisions defined in SFAS 148.

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 |        | Six Months Ended
|(in thousands, except per share information): |                   | March 31,   |                                                                                | March 31,
|                                              |                   |             |                                                                                |          
|                                              |                   |             |                                                                                |           | 2003               |        | 2002             |        | 2003  |        | 2002
|                                              |                   |             |                                                                                |           |                    |        |                  |        |       |        |     
|Net loss:                                     |                   |             |                                                                                |           |                    |        |                  |        |       |        |      |         |       |        |   |        
|                                              | As reported       |             | $                                                                              | (5,298    | )                  |        | $                | (6,140 | )     |        | $    | (10,421 | )     |        | $ | (11,153 | )    
|                                              |                   |             | Add: stock-based employee compensation
recorded in the Statement of Operations |           |                    | 95     |                  |        |       | 330    |      |         |       | 222    |   |         |       | 2,427  |  
|                                              |                   |             | Less: fair value of stock-based employee
compensation                          |           |                    | (2,671 | )                |        |       | (3,070 | )    |         |       | (5,854 | ) |         |       | (6,233 | )
|                                              |                   |             |                                                                                |           |                    |        |                  |        |       |        |      |         |       |        |   |         |      
|                                              | Pro forma         |             | $                                                                              | (7,874    | )                  |        | $                | (8,880 | )     |        | $    | (16,053 | )     |        | $ | (14,959 | )    
|                                              |                   |             |                                                                                |           |                    |        |                  |        |       |        |      |         |       |        |   |         |      
|Net loss per share:                           |                   |             |                                                                                |           |                    |        |                  |        |       |        |      |         |       |        |   |        
|                                              | Basic and diluted |             |                                                                                |           |                    |        |                  |        |       |        |      |         |       |        |   |         |      
|                                              |                   | As reported |                                                                                | $         | (0.50              | )      |                  | $      | (0.59 | )      |      | $       | (0.98 | )      |   | $       | (1.08 | )     
|                                              |                   | Pro forma   |                                                                                |           | (0.74              | )      |                  |        | (0.85 | )      |      |         | (1.52 | )      |   |         | (1.45 | )     

The weighted average fair value of options granted during the three months
ended March 31, 2003 and 2002 were $3.46 and $8.95, respectively, and the
weighted average fair value of options granted during the six months ended
March 31, 2003 and 2002 were $3.00 and $8.54, respectively. The fair value of
each stock award is estimated on the date of grant using the Black-Scholes
model with the following assumptions used for grants during the respective
periods: annual dividend yield of 0.0% for all periods; a weighted average
expected stock award term of 4.0 years for all periods; during the three months
ended March 31, 2003 and 2002, risk-free annual interest rates of 2.04% and
3.77%, respectively; and an expected volatility factor of 90% and 80%,
respectively; and during the six months ended March 31, 2003 and 2002,
risk-free annual interest rates of 2.48% and 3.77%, respectively; and an
expected volatility factor of 90% and 80%, respectively.

Note 3 - Net Loss Per Share

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

|                                             |  |                    |           |                  |  |      |           |      |  |  |           |  |  |  |           | 
|-------------------------------------------- |  | ------------------ | --------- | ---------------- |  | ---- | --------- | ---- |  |  | --------- |  |  |  | --------- | 
|                                             |  | Three Months Ended |           | Six Months Ended
|                                             |  | March 31,          |           | March 31,       
|                                             |  |                    |           |                 
|                                             |  | 2003               |           | 2002             |  | 2003 |           | 2002
|                                             |  |                    |           |                  |  |      |           |     
|Outstanding options to
purchase common stock |  |                    | 4,072,910 |                  |  |      | 3,999,851 |      |  |  | 4,282,640 |  |  |  | 2,585,862 | 
|Weighted equivalent shares                   |  |                    | 194,837   |                  |  |      | 354,069   |      |  |  | 210,453   |  |  |  | 335,966   | 

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Note 4 - Detailed Balance Sheet:

|                                                |                                    |                 |        |             |       |               |        |        |       | 
|----------------------------------------------- | ---------------------------------- | --------------- | ------ | ----------- | ----- | ------------- | ------ | ------ | ----- | 
|                                                |                                    |                 |        | March 31,   |       | September 30,
|(in thousands)                                  |                                    | 2003            |        | 2002       
|                                                |                                    |                 |        |            
|                                                |                                    |                 |        | (unaudited) |       |               |        |       
|Prepaid expenses and other current assets:      |                                    |                 |        |             |       |               |        |       
|                                                | Prepaid income taxes               |                 | $      | 1,029       |       |               | $      | 948    |      
|                                                | Prepaid licenses                   |                 |        | 1,040       |       |               |        | 727    |      
|                                                | Prepaid insurance                  |                 |        | 571         |       |               |        | 119    |      
|                                                | Prepaid maintenance                |                 |        | 546         |       |               |        | 323    |      
|                                                | Prepaid rent                       |                 |        | 280         |       |               |        | 259    |      
|                                                | Other                              |                 |        | 552         |       |               |        | 412    |      
|                                                |                                    |                 |        |             |       |               |        |        |      
|                                                |                                    | $               | 4,018  |             |       | $             | 2,788  |       
|                                                |                                    |                 |        |             |       |               |        |        |      
|Property and equipment:                         |                                    |                 |        |             |       |               |        |       
|                                                | Computer equipment                 |                 | $      | 5,630       |       |               | $      | 4,926  |      
|                                                | Furniture and fixtures             |                 |        | 1,161       |       |               |        | 1,161  |      
|                                                | Leasehold improvements             |                 |        | 1,188       |       |               |        | 1,188  |      
|                                                | Office equipment                   |                 |        | 615         |       |               |        | 615    |      
|                                                |                                    |                 |        |             |       |               |        |        |      
|                                                |                                    |                 | 8,594  |             |       |               | 7,890  |       
|                                                | Less: accumulated depreciation     |                 |        | (6,094      | )     |               |        | (5,310 | )    
|                                                |                                    |                 |        |             |       |               |        |        |      
|                                                |                                    | $               | 2,500  |             |       | $             | 2,580  |       
|                                                |                                    |                 |        |             |       |               |        |        |      
|Intangibles and other assets:                   |                                    |                 |        |             |       |               |        |       
|                                                | Developed and core technology      |                 | $      | 8,871       |       |               | $      | 8,871  |      
|                                                | Workforce                          |                 |        | 255         |       |               |        | 255    |      
|                                                | Patents                            |                 |        | 600         |       |               |        | 600    |      
|                                                |                                    |                 |        |             |       |               |        |        |      
|                                                |                                    |                 | 9,726  |             |       |               | 9,726  |       
|                                                | Less: accumulated amortization     |                 |        | (4,402      | )     |               |        | (3,188 | )    
|                                                |                                    |                 |        |             |       |               |        |        |      
|                                                |                                    | Net intangibles |        |             | 5,324 |               |        |        | 6,538 | 
|                                                | Other assets                       |                 |        | 1,343       |       |               |        | 1,711  |      
|                                                |                                    |                 |        |             |       |               |        |        |      
|                                                |                                    | $               | 6,667  |             |       | $             | 8,249  |       
|                                                |                                    |                 |        |             |       |               |        |        |      
|Accrued expenses and other current liabilities: |                                    |                 |        |             |       |               |        |       
|                                                | Deferred revenue                   |                 | $      | 2,886       |       |               | $      | 2,788  |      
|                                                | Compensation and employee benefits |                 |        | 1,597       |       |               |        | 1,367  |      
|                                                | Accrued vacant facility lease cost |                 |        | 3,903       |       |               |        | 4,329  |      
|                                                | Accrued litigation settlement      |                 |        | 2,700       |       |               |        | 2,700  |      
|                                                | Other                              |                 |        | 567         |       |               |        | 753    |      
|                                                |                                    |                 |        |             |       |               |        |        |      
|                                                |                                    | $               | 11,653 |             |       | $             | 11,937 |       
|                                                |                                    |                 |        |             |       |               |        |        |      

Note 5 - Goodwill

In June 2001, the FASB issued Statement of Financial Accounting Standards
No. 141 (SFAS 141), Business Combinations, and Statement of Financial
Accounting Standards No. 142 (SFAS 142), Goodwill and Other Intangible
Assets. SFAS 141 applies to business combinations and eliminates the
pooling-of-interests method of accounting. Goodwill and intangible assets
deemed to have indefinite lives are no longer amortized and are subject to
annual impairment tests, the first of which was conducted as of October 1,
2002, in accordance with the Statements. Other intangible assets are amortized
over their useful lives. Under the new Statements, certain intangibles such as
workforce acquired in a business combination were reclassified as goodwill and
certain intangibles were reclassified as previously reported goodwill. In
addition, we have ceased amortization of goodwill. As of March 31, 2003, the
Company has goodwill of $1.0 million.

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If amortization expenses related to goodwill that is no longer amortized
with the adoption of SFAS 142 had been excluded from operating expenses for the
three and six months ended March 31, 2002, earnings per share would have been
as follows:

|                                      |                                     |                |              |                |            |  |   |         |  
|------------------------------------- | ----------------------------------- | -------------- | ------------ | -------------- | ---------- |  | - | ------- | -
|                                      |                                     |                | Three Months |                | Six Months
|                                      |                                     |                | Ended        |                | Ended     
|(in thousands)                        |                                     | March 31, 2002 |              | March 31, 2002
|                                      |                                     |                |              |               
|Net loss:                             |                                     |                |              |                |            |  |   |        
|                                      | Reported net loss                   |                | $            | (6,140         | )          |  | $ | (11,153 | )
|                                      | Goodwill and workforce amortization |                |              | 2,431          |            |  |   | 4,862   |  
|                                      |                                     |                |              |                |            |  |   |        
|                                      | Adjusted net loss                   |                | $            | (3,709         | )          |  | $ | (6,291  | )
|                                      |                                     |                |              |                |            |  |   |        
|Basic and diluted net loss per share: |                                     |                |              |                |            |  |   |        
|                                      | Reported net loss                   |                | $            | (0.59          | )          |  | $ | (1.08   | )
|                                      | Goodwill and workforce amortization |                |              | .23            |            |  |   | .47     |  
|                                      |                                     |                |              |                |            |  |   |        
|                                      | Adjusted net loss                   |                | $            | (0.36          | )          |  | $ | (0.61   | )
|                                      |                                     |                |              |                |            |  |   |        

Note 6 - Legal Matters

In October and November 1999, six purported class action complaints were
filed in the United States District Court for the Northern District of
California (the District Court) against the Company and certain of its
officers and directors. On March 17, 2000, these complaints were consolidated
into In re Hi/fn, Inc. Securities Litigation No. 99-04531 SI. The consolidated
complaint was filed on behalf of persons who purchased the Companys stock
between July 26, 1999 and October 7, 1999 (the class period). The complaint
sought unspecified money damages and alleged that the Company and certain of
its officers and directors violated federal securities laws in connection with
various public statements made during the class period. In August 2000, the
District Court dismissed the complaint as to all defendants, other than Raymond
J. Farnham and the Company. In February 2001, the District Court certified the
purported class.




 On June 10, 2002, the District
Court entered an order preliminarily approving a Stipulation of
Settlement, by which all claims against the Company and Mr. Farnham
would be dismissed without any
admission of liability or wrongdoing, and the shareholder
class will receive $9.5 million, comprised of $6.8 million in cash, which was
contributed by our insurance carriers, and the balance in cash or the
Companys stock,
with a minimum of 270,000 shares to be issued. On September 4,
2002, the District Court approved the settlement and entered a Final Judgment and
Order of Dismissal with Prejudice. In accordance with the
settlement, we will issue at least 270,000 shares of the Companys common
stock, supplementing the allotment with cash or additional common
stock equal to $2.7 million. To the
extent that the trading price of the common stock exceeds $10.00 at the time of
distribution, the Company would recognize an additional litigation settlement
charge equal to the aggregate fair market value of the 270,000 shares of common
stock less the $2.7 million already recognized and any such additional charge
may negatively affect our financial condition and results of operations.

In March 2002, two purported shareholder derivative actions were filed,
one in the United States District Court for the Northern District of California
and one in the Superior Court of California for the County of Santa Clara (the
federal derivative action and the state derivative action, respectively).
These complaints were filed against the Company and certain of its current and
former officers and directors. The derivative complaints alleged violations of
California Corporations Code Section 25402, breach of fiduciary duty and waste
of corporate assets, based on the same facts and events alleged in the class
action. On June 7, 2002, the federal court granted
plaintiffs motion to voluntarily dismiss that action without
prejudice. On June 26, 2002, the state court sustained the Companys demurrer,
with leave to amend, on the ground that plaintiff had failed to plead facts
showing that they were excused from making demand on the Companys board of
directors. Plaintiff filed an amended complaint. On March 18, 2003,
the court again sustained the Companys demurrer, with
leave to amend, on the ground that

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plaintiff had failed to plead facts showing that they were excused from
making a demand on the Companys board of directors. Plaintiff
did not file an amended complaint within the time
permitted. The Company and the individual director
defendants believe the allegations contained in the complaint are without merit
and intend to defend the action vigorously.

Note 7 - Recent Accounting Pronouncements

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

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

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

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result of the insurance policy coverage, the Company believes the
estimated fair value of these indemnification agreements is minimal.
Accordingly, the Company has not recorded any liabilities for these agreements
as of March 31, 2003.

The Company enters into standard indemnification agreements in the
ordinary course of business. Pursuant to these agreements, the Company
indemnifies, holds harmless, and agrees to reimburse the indemnified party,
generally business partners or customers, for losses suffered or incurred in
connection with patent, copyright or other intellectual property infringement
claims by any third party with respect to the Companys products. The term of
these indemnification agreements is generally perpetual, effective after
execution of the agreement. The maximum potential amount of future payments the
Company could be required to make under these indemnification agreements is
unlimited. However, to date, the Company has not incurred costs to defend
lawsuits or settle claims related to these indemnification agreements.
Accordingly, the Company believes the estimated fair value of these agreements
is minimal and no liabilities have been recorded for these agreements as of
March 31, 2003.

The Company warrants that its hardware products are free from defects in
material and workmanship under normal use and service and that its hardware and
software products will perform in all material respects in accordance with the
standard published specifications in effect at the time of delivery of the
licensed products to the customer. The warranty periods generally range from
three months to one year. Additionally, the Company warrants that its
maintenance services will be performed consistent with generally accepted
industry standards through completion of the agreed upon services. If
necessary, the Company would provide for the estimated cost of product and
service warranties based on specific warranty claims and claim history,
however, the Company has not incurred significant expense under its product or
service warranties. As a result, the Company believes the estimated fair value
of these agreements is minimal and has not recorded any liabilities for these
agreements as of March 31, 2003.

In January 2003, the FASB issued FASB Interpretation No. 46 (FIN
46),Consolidation of Variable Interest Entities, an Interpretation of
Accounting Research Bulletin No. 51. FIN 46 requires certain variable
interest entities to be consolidated by the primary beneficiary of the entity
if the equity investors in the entity do not have the characteristics of a
controlling financial interest or do not have sufficient equity at risk for the
entity to finance its activities without additional subordinated financial
support from other parties. FIN 46 is effective immediately for all new
variable interest entities created or acquired after January 31, 2003. For
variable interest entities created or acquired prior to February 1, 2003, the
provisions of FIN 46 must be applied for the first interim or annual period
beginning after June 15, 2003. The Company does not believe that the adoption of FIN 46
will have a material impact on our financial position, cash flows or results of
operations.

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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statement Regarding Forward-Looking Statements

The section entitled Managements Discussion and Analysis of Financial
Condition and Results of Operations set forth below contains forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended
(the Exchange Act). Words such as believes, anticipates, estimates,
expects, and words of similar expressions are intended to identify
forward-looking statements that involve risks and uncertainties. Such
statements are expectations based on information currently available and are
subject to risk, uncertainties and changes in condition, significance, value
and effect, including those discussed under the heading Trends, Risks and
Uncertainties below and reports filed by Hifn with the Securities and Exchange
Commission, specifically Forms 10-K, 8-K, 10-Q and S-8. Such risks,
uncertainties and changes in condition, significance, value and effect could
cause our actual results to differ materially from those anticipated events.
Although we believe that the assumptions underlying the forward-looking
statements are reasonable, any of the assumptions could prove inaccurate,
including, but not limited to, statements as to our future operating results
and business plans. We disclaim any intention or obligation to update or revise
any forward-looking statements, whether as a result of new information, future
events or otherwise.

Overview

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

Hifns encryption/compression and public key processors allow network
equipment vendors to add bandwidth enhancement and security capabilities to
their products. Our encryption/compression and public key processors provide
key algorithms used in virtual private networks (VPNs), which enable
businesses to reduce wide area networking costs by replacing dedicated
leased-lines with lower-cost IP-based networks such as the Internet. Using
VPNs, businesses can also provide trading partners and others with secure,
authenticated access to the corporate network, increasing productivity through
improved communications. Storage equipment vendors use our compression
processor products to improve the performance and capacity of mid- to high-end
tape back-up systems.

Hifns flow classification technology enables network equipment vendors to
add unique traffic differentiation capabilities to their products. Our flow
classification solutions provide precise details about packets and data
traversing a network and are used in deploying quality of service (QoS) and
classes of service (CoS), which enables businesses to enhance the
effectiveness of using the public Internet network. Using QoS- or CoS-enabled
network equipment, businesses can maintain more consistent and reliable
interactions with their customers and business partners.

Critical Accounting Policies

The financial statements are prepared in conformity with accounting
principles generally accepted in the United States of America and requires
management to make estimates and assumptions in certain circumstances that
affect amounts reported in the accompanying consolidated financial statements
and related footnotes. As such, we are required to make certain estimates,
judgments and assumptions that we believe are reasonable based upon the
information available. These estimates and assumptions affect the reported
amounts of assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the periods presented.

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The significant accounting policies which we believe are the most critical to
aid in fully understanding and evaluating our reported financial results
include the following:

Revenue recognition.We derive our revenue from the sale of processors and
software license fees. Customers are comprised primarily of original equipment
manufacturers (OEMs) and, to a lesser extent, distributors. Revenue from the
sale of processors is recognized upon shipment when persuasive evidence of an
arrangement exists, the price is fixed or determined and collection of the
resulting receivables is reasonably assured. Revenue from processors sold to
distributors under agreements allowing certain rights of return is deferred
until the distributor sells the product to a third party.

Software license revenue is generally recognized when a signed agreement
or other persuasive evidence of an arrangement exists, vendor-specific
objective evidence exists to allocate a portion of the total fee to any
undelivered elements of the arrangement, the software has been shipped or
electronically delivered, the license fee is fixed or determinable and
collection of the resulting receivables is reasonably assured. Returns,
including exchange rights for unsold licenses, are estimated based on
historical experience and are deferred until the return rights expire. We base
the levels of returns on historical experience. To the extent we experience
increased levels of returns, revenue will decrease resulting in decreased gross
profit.

We receive software license revenue from OEMs that sublicense our software
shipped with their products. The OEM sublicense agreements are generally valid
for a term of one year and include rights to unspecified future upgrades and
maintenance during the term of the agreement. License fees under these
agreements are recognized ratably over the term of the agreement. Revenues from
sublicenses sold in excess of the specified volume in the original license
agreement are recognized when they are reported as sold to end customers by the
OEM. Our deferred revenue balance as of March 31, 2003 was $2.9 million and
included approximately $256,000 in exchange rights for unsold licenses.

Management judgments and estimates must be made regarding the
collectibility of fees charged. Should changes in conditions cause management
to determine the collectibility criteria are not met for certain future
transactions, revenue recognized for any reporting period could be adversely
affected.

Inventories.We value our inventory at the lower of cost (determined on a
first-in, first-out cost method) or market. Inventories are comprised solely of
finished goods, which are manufactured by third party foundries for resale by
us. We provide for obsolete, slow moving or excess inventories, based on
forecasts prepared by management, in the period when obsolescence or inventory
in excess of expected demand is first identified. Reserves are established to
reduce the cost basis of inventory for excess and obsolete inventory. As of
March 31, 2003, inventories of $3.0 million that were previously written down
were still on hand. Subsequent increases in projected demand will not result in
a reversal of these reserves until the sale of the related inventory.

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

Valuation of goodwill.In accordance with SFAS 142, Goodwill and Other
Intangible Assets, goodwill and intangible assets deemed to have indefinite
lives are no longer amortized but instead are subject to annual impairment
tests. We adopted SFAS 142 during the first quarter of fiscal 2003. Other
intangible assets will continue to be amortized over their useful lives.
Goodwill amortization expense aggregated $2.4 million, $4.7 million and $8.6
million, during the three and six months ended March 31, 2002 and in fiscal
2002, respectively. As of March 31, 2003, goodwill was approximately $1.0
million. Asset impairment charges could have a material effect on our
consolidated financial position and results of operations.

Accounting for income taxes.As part of the process of preparing our
consolidated financial statements we are required to estimate our income taxes,
which involves estimating our actual current tax exposure together with
assessing temporary differences resulting from differing treatment of items for
tax and accounting purposes. These differences result in deferred tax assets
and liabilities. Significant management judgment is required to assess the
likelihood that our deferred tax assets will be recovered from future taxable
income. During fiscal 2002, we

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recorded a net tax expense of $6.0 million to establish a valuation allowance
against deferred tax assets. Continuing losses in recent reporting periods
increase the uncertainties regarding realizability of deferred tax assets. We
have provided a full valuation allowance against deferred tax assets. While we
have considered future taxable income and ongoing prudent and feasible tax
planning strategies in assessing the need for the valuation allowance, in the
event we were to determine that we would be able to realize our deferred tax
assets in the future in excess of its net recorded amount, an adjustment to the
deferred tax asset would increase income in the period such determination is
made.

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

As of March 31, 2003, in relation to the class action suit against us, the
court approved a settlement of all claims and we recognized approximately $2.7
million in accrued litigation settlement charges, which represent the uninsured
portion of the settlement amount. In accordance with the settlement, we will
issue at least 270,000 shares of our common stock, supplementing the allotment
with cash or additional shares of common stock to compensate for any shortfall
in fair value below $2.7 million. To the extent that the trading price of the
common stock exceeds $10.00 at the time of distribution, we would recognize an
additional litigation settlement charge equal to the aggregate fair market
value of the 270,000 shares of common stock less the $2.7 million already
recognized. Such an adjustment may materially affect our results of operations,
financial condition and future cash flows.

Results of Operations

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

|                                   |                                                |                    |      |                    |     |                  |      |      |     |      |      |     |     |  |      |    |     | 
|---------------------------------- | ---------------------------------------------- | ------------------ | ---- | ------------------ | --- | ---------------- | ---- | ---- | --- | ---- | ---- | --- | --- |  | ---- | -- | --- | 
|                                   |                                                |                    |      | Three Months Ended |     | Six Months Ended
|                                   |                                                |                    |      | March 31,          |     | March 31,       
|                                   |                                                |                    |      |                    |     |                 
|                                   |                                                |                    |      | 2003               |     | 2002             |      | 2003 |     | 2002
|                                   |                                                |                    |      |                    |     |                  |      |      |     |     
|Net revenues:                      |                                                |                    |      |                    |     |                  |      |      |     |      |      |     |     |  |      |   
|                                   | Processors                                     |                    |      | 81                 | %   |                  |      | 89   | %   |      |      | 83  | %   |  |      | 79 | %  
|                                   | Software licenses and other                    |                    |      | 19                 |     |                  |      | 11   |     |      |      | 17  |     |  |      | 21 |    
|                                   |                                                |                    |      |                    |     |                  |      |      |     |      |      |     |     |  |      |   
|                                   |                                                | Total net revenues |      |                    | 100 |                  |      |      | 100 |      |      |     | 100 |  |      |    | 100 | 
|                                   |                                                |                    |      |                    |     |                  |      |      |     |      |      |     |     |  |      |   
|Costs and operating expenses:      |                                                |                    |      |                    |     |                  |      |      |     |      |      |     |     |  |      |   
|                                   | Cost of revenues - processors                  |                    |      | 32                 |     |                  |      | 35   |     |      |      | 31  |     |  |      | 30 |    
|                                   | Cost of revenues - software licenses and other |                    |      | 2                  |     |                  |      | 1    |     |      |      | 2   |     |  |      | 1  |    
|                                   | Research and development                       |                    |      | 119                |     |                  |      | 76   |     |      |      | 119 |     |  |      | 78 |    
|                                   | Sales and marketing                            |                    |      | 38                 |     |                  |      | 38   |     |      |      | 39  |     |  |      | 36 |    
|                                   | General and administrative                     |                    |      | 20                 |     |                  |      | 49   |     |      |      | 21  |     |  |      | 36 |    
|                                   | Amortization of intangibles and goodwill       |                    |      | 8                  |     |                  |      | 52   |     |      |      | 8   |     |  |      | 47 |    
|                                   |                                                |                    |      |                    |     |                  |      |      |     |      |      |     |     |  |      |   
|Total costs and operating expenses |                                                |                    | 219  |                    |     |                  | 251  |      |     |      | 220  |     |     |  | 228  |   
|                                   |                                                |                    |      |                    |     |                  |      |      |     |      |      |     |     |  |      |   
|Loss from operations               |                                                |                    | (119 | )                  |     |                  | (151 | )    |     |      | (120 | )   |     |  | (128 | ) 
|Interest and other income, net     |                                                |                    | 3    |                    |     |                  | 4    |      |     |      | 4    |     |     |  | 5    |   
|                                   |                                                |                    |      |                    |     |                  |      |      |     |      |      |     |     |  |      |   
|Loss before income taxes           |                                                |                    | (116 | )                  |     |                  | (147 | )    |     |      | (116 | )   |     |  | (123 | ) 
|Benefit from income taxes          |                                                |                    |     |                    |     |                  | (40  | )    |     |      |     |     |     |  | (31  | ) 
|                                   |                                                |                    |      |                    |     |                  |      |      |     |      |      |     |     |  |      |   
|Net loss                           |                                                |                    | (116 | )%                 |     |                  | (107 | )%   |     |      | (116 | )%  |     |  | (92  | )%
|                                   |                                                |                    |      |                    |     |                  |      |      |     |      |      |     |     |  |      |   

Net Revenues.Net revenues decreased 20.6% to $4.5 million for the quarter
ended March 31, 2003 from $5.7 million for the quarter ended March 31, 2002.
Net revenues for the first six months of fiscal 2003 was $9.0 million, a
decrease of 26.1% from the $12.1 million reported for the first six months of
fiscal 2002. The decrease in revenues for the three months ended March 31, 2003
over the same period in the prior year was primarily due to decreased sales of
Hifns data compression and encryption processors of $1.4 million offset by an
increase in revenues from

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software license and royalties of $234,000. The decrease in revenues for
the six months ended March 31, 2003 over the same period in the prior year was
due to decreases in sales of Hifns data compression and encryption processors
of $2.2 million as well as in revenues from software license and royalties of
$1.0 million. Semiconductor sales to Quantum, an OEM producer of
high-performance tape storage devices, through its manufacturing subcontractor,
comprised 40% and 36% of revenues for the three and six months ended March 31,
2003, respectively. Semiconductor sales to Cisco, an OEM producer of networking
equipment, comprised 16% and 13% of revenues for the three and six months ended
March 31, 2003, respectively.

Cost of Revenues.Cost of revenues consists primarily of the cost to
produce 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 remained at approximately the same levels at 39.3% for the
three months ended March 31, 2003 and 39.6% for the same period in fiscal 2002.
During the three months ended March 31, 2003 and 2002, we sold $72,000 and
$150,000, respectively, in inventories that had previously been written down.
Cost of processor revenues as a percentage of net processor revenues remained
at approximately the same levels at 37.3% for the six months ended March 31,
2003 and 37.7% for the same period in fiscal 2002. During the six months ended
March 31, 2003 and 2002, we sold $345,000 and $150,000, respectively, in
inventories that had previously been written down. Cost of software licenses
and other revenues is primarily comprised of engineering labor related to
support and maintenance of sold licenses and was $99,000 and $45,000 during the
three months ended March 31, 2003 and 2002, respectively, and $198,000 and
$90,000 for the six months ended March 31, 2003 and 2002, respectively.

Research and Development.The cost of product development consists
primarily of salaries, employee benefits, overhead, outside contractors and
nonrecurring engineering fees. Such research and development expenses were
approximately $5.4 million and $4.3 million for the quarters ended March 31,
2003 and 2002, respectively. The increase is attributable to an increase in
non-recurring engineering and software tools and maintenance costs of $815,000
related to new and existing product development projects as well as increased
salaries and benefits of $281,000 as a result of additional headcount related
to the asset acquisition completed in September 2002. The increases were offset
by a reduction in deferred compensation amortization of $116,000. Research and
development costs were $10.6 million and $9.5 million for the six months ended
March 31, 2003 and 2002, respectively. Amortization of deferred stock
compensation decreased by $1.5 million, inclusive of $1.3 million for options
canceled during December 2001 in relation to a voluntary stock option exchange
program, while nonrecurring engineering and software tools and maintenance
costs relating to new product development increased by $1.7 million and
salaries and benefits increased by $896,000 as a result of additional headcount
related to the asset acquisition referred to above.

Sales and Marketing.Sales and marketing expenses consist primarily of the
salaries, commissions and benefits of sales, marketing and support personnel,
and consulting, advertising, promotion and overhead expenses. Such expenses
were approximately $1.7 million and $2.2 million for the three months ended
March 31, 2003 and 2002, respectively. The decrease primarily reflects
reductions in salaries and benefits costs of $188,000 as a result of the
reduction-in-force effected in October 2002 and decreases in travel and
tradeshow expenses aggregating $145,000. Sales and marketing expense for the
six months ended March 31, 2003 and 2002 were approximately $3.5 million and
$4.4 million, respectively. The decrease primarily reflects reductions in
salaries and benefits costs of $543,000 due to reduced headcount and decreases
in travel and tradeshow expenses aggregating $187,000.

General and Administrative.General and administrative expenses are
comprised primarily of salaries for administrative and corporate services
personnel, legal and other professional fees. Such expenses were $885,000 and
$2.8 million for the three months ended March 31, 2003 and 2002, respectively.
The decrease was primarily attributable to a charge recorded in March 2002 of
$1.2 million related to vacant facility lease, a decrease in legal costs of
$337,000 and a decrease in deferred compensation expense amortization of
approximately $113,000. General and administrative expenses for the six months
ended March 31, 2003 and 2002 were $1.9 million and $4.4 million, respectively.
The decrease was primarily attributable to a charge recorded in March 2002 of
$1.2 million related to vacant facility lease and decreases in legal costs of
$549,000 and in deferred compensation expense amortization of approximately
$299,000.

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Amortization of Goodwill.Goodwill amortization relates to the acquisition
of Apptitude and was $2.4 million and $4.7 million during the three and six
months ended March 31, 2002, respectively. The Company ceased amortization of
goodwill in October 2002 as a result of the adoption of SFAS 142.

Amortization of Intangibles.Amortization of intangibles relate to
acquired technology, workforce and patents. Amortization of intangibles was
$359,000 and $611,000 for the three months ended March 31, 2003 and 2002,
respectively, and $717,000 and $1.0 million for the six months ended March 31,
2003 and 2002, respectively. The decrease in amortization of intangibles is the
result of full amortization of certain intangible assets.

Interest and Other Income, net.Net interest and other income was $112,000
and $249,000 for the three months ended March 31, 2003 and 2002, respectively,
and $342,000 and $613,000 for the six months ended March 31, 2003 and 2002,
respectively. The decrease in interest and other income for the three and six
months ended March 31, 2003 compared to the same periods in the prior fiscal
year was mainly due to the continuing decrease in the average cash balance
coupled with decreasing overall interest rates.

Income Taxes.As a result of continuing losses over a longer period than
previously expected, we recorded a tax valuation allowance during fiscal 2002
to reduce the carrying value of our deferred tax assets to zero. Accordingly,
we have not recognized tax benefits for the three and six months ended March
31, 2003. The effective income tax rate for the three and six months ended
March 31, 2002 was 27% and 25%, respectively. The resulting effective tax rate
was mainly due to the non-deductibility of certain acquisition-related costs
consisting primarily of the amortization of intangibles and goodwill.

Liquidity and Capital Resources

Net cash used in operating activities was $8.0 million for the six months
ended March 31, 2003. Net cash used in operating activities for the six months
ended March 31, 2003 was the result of net loss of $10.4 million as adjusted
for non-cash items including amortization of intangibles related to acquired
technology of $1.2 million, amortization of deferred stock compensation of
$223,000, depreciation and amortization costs of fixed assets of $784,000 as
well as decreases in accounts receivable of $309,000, in inventories of
$123,000 and in intangibles and other assets of $368,000 and an increase in
accounts payable of $882,000. These adjustments were offset by increases in
prepaid expenses and other current assets of $1.2 million, related to prepaid
insurance, licenses and software tools and maintenance, and a decrease in
accrued expenses and other current liabilities of $284,000.

Net cash provided by operating activities was $5.7 million for the six
months ended March 31, 2002. During the six months ended March 31, 2002, net
cash used in operating activities was attributed to net loss of $11.2 million
as adjusted for non-cash items including amortization of goodwill and
intangibles and of deferred stock compensation of $8.2 million, depreciation and amortization
costs of fixed assets of $967,000 as well as a decrease in accounts receivable
and inventories of $380,000 and $922,000, respectively, and an increase in
accrued and other current liabilities of $930,000 as a result of an increase in
accrued compensation and benefits and vacant facility lease expense. These
adjustments were offset by increases in deferred income taxes of $1.9 million,
in prepaids and other current assets of $1.4 million, as a result of an
increase in prepaid income taxes, and in intangibles and other assets of $2.5
million as a result of acquired intellectual property.

Net cash provided by investing activities of $902,000 for the six months
ended March 31, 2003 primarily reflects a decrease in short-term investments of
$1.6 million partially offset by the purchase of property and equipment of
$704,000. Net cash provided by investing activities for the six months ended
March 31, 2002 of $6.7 million related primarily to the sale of short-term
investments.

Net cash provided by financing activities was $511,000 and $476,000 for
the six month periods ended March 31, 2003 and 2002, respectively, and were
primarily attributable to proceeds from issuance of common stock.

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-

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process inventory and to focus substantially all of its resources on the
design, development and marketing of its products.

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

The Company occupies its facilities under several non-cancelable operating
leases that expire at various dates through December 2007, and which contain
renewal options. Future minimum lease payments for operating leases as of March
31, 2003 are as follows (in thousands):

|                                 |            |                              |   |                 |       | 
|-------------------------------- | ---------- | ---------------------------- | - | --------------- | ----- | 
|                                 |            |                              |   | Operating Lease
|                                 |            |                              |   | Commitments    
|                                 |            |                              |   |                
|Fiscal year ending September 30, |            |                              |   |                
|                                 | 2003       |                              | $ | 1,639           |      
|                                 | 2004       |                              |   | 2,874           |      
|                                 | 2005       |                              |   | 2,259           |      
|                                 | 2006       |                              |   | 895             |      
|                                 | Thereafter |                              |   | 1,134           |      
|                                 |            |                              |   |                
|                                 |            | Total minimum lease payments |   | $               | 8,801 | 
|                                 |            |                              |   |                

Recent Accounting Pronouncements

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

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

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assessing, but at this point do not believe the adoption of EITF 00-21 will have a material
impact on our financial position, cash flows or results of operations.

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
software license warranties, indemnification arrangements with officer and
directors and indemnification arrangements with customers with respect to
intellectual property. To date, we have not incurred material costs, if any, in
relation to any of the above guarantees and, accordingly, adoption of this
standard did not have a material impact on our financial position, results of
operations or cash flows.

In January 2003, the FASB issued FASB Interpretation No. 46 (FIN
46),Consolidation of Variable Interest Entities, an Interpretation of
Accounting Research Bulletin No. 51. FIN 46 requires certain variable
interest entities to be consolidated by the primary beneficiary of the entity
if the equity investors in the entity do not have the characteristics of a
controlling financial interest or do not have sufficient equity at risk for the
entity to finance its activities without additional subordinated financial
support from other parties. FIN 46 is effective immediately for all new
variable interest entities created or acquired after January 31, 2003. For
variable interest entities created or acquired prior to February 1, 2003, the
provisions of FIN 46 must be applied for the first interim or annual period
beginning after June 15, 2003. We do not believe that the adoption of FIN 46
will have a material impact on our financial position, cash flows or results of
operations.

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Trends, Risks and Uncertainties

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

Our Operating Results May Fluctuate Significantly.

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



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

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

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

We Depend Upon A Small Number Of Customers.

Quantum Corporation (Quantum), through its manufacturing subcontractor,
accounted for approximately 40% and 36% of our net revenues during the three
and six months ended March 31, 2003, respectively, and 46% and 36% of our net
revenues in fiscal 2002 and 2001, respectively. Cisco, an OEM producer of
network equipment, comprised 16% and 13% of our net revenues for the three and
six months ended March 31, 2003, respectively. Neither Quantum nor Cisco is
under any binding obligation to order from us. If our sales to Quantum or Cisco
decline, our business, financial condition and results of operations could
suffer. We expect that our most significant customers in the future could be
different from our largest customers today for a number of reasons, including
customers deployment schedules and budget considerations. As a result, we
believe we may experience significant fluctuations in our results of operations
on a quarterly and annual basis.

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Limited numbers of network and storage equipment vendors account for a
majority of packet processor purchases in their respective markets. In
particular, the market for network equipment that would include packet
processors, such as routers, remote access concentrators and firewalls, is
dominated by a few large vendors, including Cisco Systems, Inc., Lucent
Technologies Inc., Nortel Networks, Inc. and 3Com Corporation. As a result, our
future success will depend upon our ability to establish and maintain
relationships with these companies. If these network equipment vendors do not
incorporate our packet processors into their products, our business, financial
condition and results of operations could suffer.

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

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

Our Business Depends Upon The Continued Growth And Our Penetration Of The
Virtual Private Network Market.

We want to be a leading supplier of packet processors that implement the
network security protocols necessary to support the deployment of virtual
private networks. This market, which continues to evolve, may not grow.
Alternatively, if it continues to grow, our products may not successfully serve
this market. Our ability to generate significant revenue in the virtual private
network market will depend upon, among other things, the following:



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

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

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

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



| |  |  | Properly identify emerging target markets and related technological trends;                                  
| | - |  | -------------------------------------------------------------------------------------------------------------
|
| |  |  | Develop and maintain competitive products;                                                                   
|
| |  |  | Enhance our products by adding innovative features that
differentiate our products from those of competitors;
|
| |  |  | Bring products to market on a timely basis at competitive prices; and                                        

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

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

In evaluating new product decisions, we must anticipate future demand for
product features and performance characteristics, as well as available
supporting technologies, manufacturing capacity, competitive product offerings
and industry standards. We must also continue to make significant investments
in research and development in order to continue to enhance the performance and
functionality of our products to keep pace with competitive products and
customer demands for improved performance, features and functionality. The
technical innovations required for us to remain competitive are complicated and
require a significant amount of time and money. We may experience substantial
difficulty in introducing new products and we may be unable to offer
enhancements to existing products on a timely or cost-effective basis, if at
all. For instance, the performance of our encryption/compression and public key
processors depends upon the integrity of our security technology. If any
significant advances in overcoming cryptographic systems are made, then the
security of our encryption/compression and public key processors will be
reduced or eliminated unless we are able to develop further technical
innovations that adequately enhance the security of these products. Our
inability to develop and introduce new products or enhancements directed at new
industry standards could harm our business, financial condition and results of
operations.

Our Markets Are Highly Competitive.

We compete in markets that are intensely competitive and are expected to
become increasingly competitive as current competitors expand their product
offerings and new competitors enter the market. The markets that we compete in
are subject to frequent product introductions with improved price-performance
characteristics, rapid technological change, and the continued emergence of new
industry standards. Our products compete with offerings from companies such as
Analog Devices, Inc., SafeNet, Inc., IBM, Broadcom Corporation, Motorola, Inc.
and Royal Philips Electronics. In 1994, Stac entered into two license
agreements with IBM in which Stac granted IBM the right to use, but not
sublicense, our patented compression technology in IBM hardware and software
products. Stac also entered into a license agreement with Microsoft Corporation
(Microsoft) in 1994 whereby Stac granted Microsoft the right to use, but not
sublicense, our compression technology in their software products. We expect
significant future competition from major domestic and international
semiconductor suppliers. Several established electronics and semiconductor
suppliers have recently entered, or expressed an interest to enter, the network
equipment market. We also may face competition from suppliers of products based
on new or emerging technologies. Furthermore, many of our existing and
potential customers internally develop solutions which attempt to perform all
or a portion of the functions performed by our products.

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

Many of our current and prospective competitors offer broader product
lines and have significantly greater financial, technical, manufacturing and
marketing resources than us. As a result, they may be able to adapt more
quickly to new or emerging technologies and changes in customer requirements or
to devote greater resources to promote the sale of their products. In
particular, companies such as Intel Corporation, Lucent Technologies Inc.,
Motorola, Inc., National Semiconductor Corporation and Texas Instruments
Incorporated have a significant advantage over us given their relationships
with many of our customers, their extensive marketing power and name
recognition and their much greater financial resources. In addition, current
and potential competitors may decide to consolidate, lower the prices of their
products or to bundle their products with other products. Any of the above

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would significantly and negatively impact our ability to compete and obtain or
maintain market share. If we are unable to successfully compete against our competitors, our business,
results of operations and financial condition will suffer.

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



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

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

Our Business Depends Upon The Growth Of The Network Equipment And Storage
Equipment Markets.

Our success is largely dependent upon continued growth in the market for
network security equipment, such as routers, remote access concentrators,
switches, broadband access equipment, security gateways, firewalls and network
interface cards. In addition, our success depends upon storage equipment
vendors incorporating our packet processors into their systems. The network
security equipment market has in the past, and may in the future, fluctuate
significantly based upon numerous factors, including the lack of industry
standards, adoption of alternative technologies, capital spending levels and
general economic conditions. We are unable to determine the rate or extent to
which these markets will grow, if at all. Any decrease in the growth of the
network or storage equipment market or a decline in demand for our products
could harm our business, financial condition and results of operations.

Our Success Depends Upon Protecting Our Intellectual Property.

Our proprietary technology is critical to our future success. We rely in
part on patent, trade, trademark, maskwork and copyright law to protect our
intellectual property. We own 17 United States patents and seven foreign
patents. We also have two pending patent applications in Japan. Our issued
patents and patent applications primarily cover various aspects of our
compression, bandwidth management and rate shaping technologies and have
expiration dates ranging from 2006 to 2017. In addition to compression, we have
six pending patent applications in the United States, four in Europe and Asia
(Japan) covering our flow classification technology. Patents may not be issued
under our current or future patent applications, and the patents issued under
such patent applications could be invalidated, circumvented or challenged. In
addition, third parties could make infringement claims against us in the
future. Such infringement claims could result in costly litigation. We may not
prevail in any such litigation or be able to license any valid and infringed
patents from third parties on commercially reasonable terms, if at all.
Regardless of the outcome, an infringement claim would likely result in
substantial cost and diversion of our

22



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##### Table of Contents



resources. Any infringement claim or other litigation against us or by us could harm our
business, financial condition and results of operations. The patents issued to
us may not be adequate to protect our proprietary rights, to deter
misappropriation or to prevent an unauthorized third party from copying our
technology, designing around the patents we own or otherwise obtaining and
using our products, designs or other information. In addition, others could
develop technologies that are similar or superior to our technology.

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

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

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

We Depend Upon Independent Manufacturers And Limited Sources Of Supply.

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

We depend on our suppliers to deliver sufficient quantities of finished
product to us in a timely manner. Since we place orders on a purchase order
basis and do not have long-term volume purchase agreements with any of our
suppliers, our suppliers may allocate production capacity to other products
while reducing deliveries to us on short notice. In the past, one of our
suppliers delayed the delivery of one of our products. As a result, we switched
production of the product to a new manufacturer that caused a 3-month delay in
shipments to customers. We have also experienced yield and test anomalies on a
different product manufactured by another subcontractor that could have
interrupted our customer shipments. In this case, the manufacturer was able to
correct the problem in a timely manner and customer shipments were not
affected. The delay and expense associated with qualifying a new supplier or
foundry and commencing volume production can result in lost revenue, reduced
operating margins and possible harm to customer relationships. The steps
required for a new manufacturer to begin production of a semiconductor product
include:



| |  |  | Adapting our product design, if necessary, to the new manufacturers process;                      
| | - |  | ---------------------------------------------------------------------------------------------------
|
| |  |  | Creating a new mask set to manufacture the product;                                                
|
| |  |  | Having the new manufacturer prepare sample products so we can verify the product specification; and
|
| |  |  | Providing sample products to customers for qualification.                                          

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

23



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##### Table of Contents



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

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

Network And Storage Equipment Prices Typically Decrease.

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



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

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.

24



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##### Table of Contents



We Face Order And Shipment Uncertainties.

We generally make our sales under individual purchase orders that may be
canceled or deferred by customers on short notice without significant penalty,
if any. Cancellation or deferral of product orders could cause us to hold
excess inventory, which could harm our profit margins and restrict our ability
to fund our operations. During fiscal 2002, we recorded an excess inventory
reserve of $3.4 million as a result of a significant decrease in forecasted
demand for our products. We recognize revenue upon shipment of products to our
customers, net of an allowance for estimated returns. An unanticipated level of
returns could harm our business, financial condition and results of operations.

We Depend Upon Key Personnel.

Our success greatly depends on the continued contributions of our key
management and other personnel, many of whom would be difficult to replace. We
do not have employment contracts with any of our key personnel, nor do we
maintain any key man life insurance on any of our personnel. Several members of
our management team have joined us in the last 24 months. It may be difficult
for us to integrate new members of our management team. We must also attract
and retain experienced and highly skilled engineering, sales and marketing and
managerial personnel. Competition for such personnel has, in the past, been
intense in the geographic areas and market segments in which we compete, and we
may not be successful in hiring and retaining such people. If we lose the
services of any key personnel, or cannot attract or retain qualified personnel,
particularly engineers, our business, financial condition and results of
operations could suffer. In addition, companies in technology industries whose
employees accept positions with competitors have in the past claimed that their
competitors have engaged in unfair competition or hiring practices. We could
receive such claims in the future as we seek to hire qualified personnel. These
claims could result in material litigation. We could incur substantial costs in
defending against any such claims, regardless of their merits.

Our Products Are Subject To Export Restrictions.

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

We Face Risks Associated With Our International Business Activities.

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



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

25



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| |  |  | Export license/technical review requirements;
| | - |  | ---------------------------------------------
|
| |  |  | Restrictions on the export of technology;    
|
| |  |  | Currency exchange fluctuations;              
|
| |  |  | Political instability;                       
|
| |  |  | Financial and stock market dislocations;     
|
| |  |  | Military and related activities;             
|
| |  |  | Trade restrictions; and                      
|
| |  |  | Changes in tariffs.                          

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

We Face Risks Associated With Acquisitions.

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



| |  |  | Difficulties in assimilating acquired operations, technologies
and products, in particular, if we fail to successfully integrate
the acquisition of Apptitude and certain other assets and
intellectual property acquired in September 2002, the anticipated
benefits of these transaction will not occur;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Diversion of managements attention from other business concerns;                                                                                                                                                                                                                                         
|
| |  |  | Risks of entering markets in which we have little or no prior experience; and                                                                                                                                                                                                                             
|
| |  |  | Loss of key employees of acquired organizations.                                                                                                                                                                                                                                                          

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

The Cyclicality Of The Semiconductor Industry May Harm Our Business.

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

26



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Our Stock Price May Be Volatile.

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



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

We Are Currently Engaged in Securities Class-Action Lawsuits.

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

In March 2002, two purported shareholder derivative actions were filed,
one in the United States District Court for the Northern District of California
and one in the Superior Court of California for the County of Santa Clara (the
federal derivative action and the state derivative action, respectively).
These complaints were filed against Hifn and certain of its current and former
officers and directors. The derivative complaints alleged violations of
California Corporations Code Section 25402, breach of fiduciary duty and waste
of corporate assets, based on the same facts and events alleged in the class
action. On June 7, 2002, the federal court granted plaintiff's
motion to voluntarily dismiss that action without
prejudice. On June 26, 2002, the state court sustained Hifns demurrer, with
leave to amend, on the ground that plaintiff had failed to plead facts showing
that they were excused from making demand on Hifns board of
directors. Plaintiff filed an amended complaint. On March 18,
2003, the court again sustained Hifns demurrer, with leave to amend,
on the ground that plaintiff had failed to plead facts showing that they were
excused from making a demand on Hifns board of directors. Plaintiff did not file an amended complaint
within the time permitted. Hifn and the individual director
defendants believe the allegations contained in the complaint are without merit
and intend to defend the action vigorously.

27



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##### Table of Contents






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% move in interest rates at March 31,
2003 would not have a material effect on the Companys pre-tax earnings and the
carrying value of its investments over the next fiscal year.

Foreign Currency Exchange Rate Risk All of the Companys sales, cost of
manufacturing and marketing are transacted in U.S. 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

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

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

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PART II - OTHER INFORMATION




Item 1.     Legal Proceedings

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

In March 2002, two purported shareholder derivative actions were filed,
one in the United States District Court for the Northern District of California
and one in the Superior Court of California for the County of Santa Clara (the
federal derivative action and the state derivative action, respectively).
These complaints were filed against Hifn and certain of its current and former
officers and directors. The derivative complaints alleged violations of
California Corporations Code Section 25402, breach of fiduciary duty and waste
of corporate assets, based on the same facts and events alleged in the class
action. On June 7, 2002, the federal court granted
plaintiffs motion to voluntarily dismiss that action without
prejudice. On June 26, 2002, the state court sustained Hifns demurrer, with
leave to amend, on the ground that plaintiff had failed to plead facts showing
that they were excused from making demand on Hifns board of
directors. Plaintiff filed an amended complaint. On
March 18, 2003, the court again sustained Hifns demurrer, with leave to amend,
on the ground that plaintiff had failed to plead facts showing that they were
excused from making a demand on Hifns board of directors. Plaintiff did not file an amended complaint
within the time permitted. Hifn and the individual director
defendants believe the allegations contained in the complaint are without merit
and intend to defend the action vigorously.

29



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##### Table of Contents






Item 4.     Submission of Matters to a Vote of Security Holders

The Company held its Annual Meeting of Stockholders on February 24, 2003.
At the meeting, the following proposals received the votes listed below:

Proposal I.     Election of Class III Director for three-year terms expiring 2006.

|                      |  |            |  |               
|--------------------- |  | ---------- |  | --------------
|                      |  | Votes for: |  | Votes against:
|Christopher G. Kenber |  | 7,755,106  |  | 1,938,787     
|David A. Norman       |  | 9,567,076  |  | 126,817       



| |                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Companys Board of Directors is currently comprised of seven
members who are divided into three classes with overlapping three-year
terms. The term for Class II directors (Dennis DeCoste, Taher Elgamal and
Robert W. Johnson) will expire at the meeting of stockholders to be held in
2004. The term for Class III directors (Albert E. Sisto and Douglas
L.Whiting) will expire at the meeting of stockholders to be held in 2005.
|
| | Proposal II:     Approval of an amendment to the Companys 1996 Amended and
Restated 1996 Equity Incentive Plan to provide for an increase in the number
of shares of common stock available for issuance thereunder by 500,000
shares to 4,949,900 shares.                                                                                                                                                                                

|                                       |  |  |                            | 
|-------------------------------------- |  |  | -------------------------- | 
|Votes for:
Votes against:
Abstentions: |  |  | 6,127,855
3,550,790
15,248 | 



| |                                                                                                                                                                                  
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Proposal III:     Approval of ratification of the appointment of
PricewaterhouseCoopers LLP as independent auditors of the Company for the
fiscal year ending September 30, 2003.

|                                       |  |  |                        | 
|-------------------------------------- |  |  | ---------------------- | 
|Votes for:
Votes against:
Abstentions: |  |  | 9,657,233
27,935
8,725 | 




Item 6.     Exhibits and Reports on Form 8-K



| | (a) |  | Exhibits     
| | --- |  | -------------
| |     |  | Exhibit Index

|               |  |                                                                                                                                                        |  |  |  | 
|-------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------ |  |  |  | 
|Exhibit Number |  | Description                                                                                                                                            |  |  |  | 
|               |  |                                                                                                                                                        |  |  |  | 
|3.1*           |  | Form of Third Amended and Restated Certificate of Incorporation of hi/fn, inc.                                                                        
|               |  |                                                                                                                                                        |  |  |  | 
|3.2*           |  | Amended and Restated Bylaws of hi/fn, inc.                                                                                                            
|               |  |                                                                                                                                                        |  |  |  | 
|99.1           |  | Certification of the Chief Executive Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
|               |  |                                                                                                                                                        |  |  |  | 
|99.2           |  | Certification of the Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.



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



---

|* |  | Incoporated 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.

|                     |  |                                                                                                                               |                      
|-------------------- |  | ----------------------------------------------------------------------------------------------------------------------------- | ---------------------
|                     |  | hi/fn, inc.
(Registrant)                                                                                                     
|                     |  |                                                                                                                               |                      
|Date: April 28, 2003 |  | By:                                                                                                                           | /s/ WILLIAM R. WALKER
|                     |  |                                                                                                                               |                      
|                     |  | William R. Walker
Vice President, Finance, Chief Financial Officer
and Secretary (principal financial and accounting
officer)

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CERTIFICATION PURSUANT TO
SECTION 302(a)
THE SARBANES-OXLEY ACT OF 2002

I, Christopher G. Kenber, certify that:



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



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



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



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



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

|                          |  |                                                                    
|------------------------- |  | -------------------------------------------------------------------
|Date:      April 28, 2003 |  |                                                                    
|                          |  |                                                                    
|                          |  | /s/ CHRISTOPHER G. KENBER                                          
|                          |  |                                                                    
|                          |  | Christopher G. Kenber
Chairman, President & Chief Executive Officer

32



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##### Table of Contents



CERTIFICATION PURSUANT TO
SECTION 302(a)
THE SARBANES-OXLEY ACT OF 2002

I, William R. Walker, certify that:



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



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



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



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



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

|                     |  |                                                                    
|-------------------- |  | -------------------------------------------------------------------
|Date: April 28, 2003 |  |                                                                    
|                     |  |                                                                    
|                     |  | /s/ WILLIAM R. WALKER                                              
|                     |  |                                                                    
|                     |  | William R. Walker
Vice President, Finance & Chief Financial Officer

33



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##### Table of Contents






INDEX TO EXHIBITS

|        |  |                                                                                                                                                        |  |  |  | 
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------ |  |  |  | 
|Exhibit |  |                                                                                                                                                        |  |  |  | 
|Number  |  | Exhibit                                                                                                                                                |  |  |  | 
|        |  |                                                                                                                                                        |  |  |  | 
|3.1*    |  | Form of Third Amended and Restated Certificate of Incorporation of hi/fn, inc.                                                                        
|        |  |                                                                                                                                                       
|3.2*    |  | Amended and Restated Bylaws of hi/fn, inc.                                                                                                            
|        |  |                                                                                                                                                       
|99.1    |  | Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
|        |  |                                                                                                                                                       
|99.2    |  | Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.



---

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