Table of Contents

UNITED STATESSECURITIES AND
EXCHANGE COMMISSIONWashington, D.C. 20549

---

# FORM 10-Q

|                                              |   |  |                                                                                         
|--------------------------------------------- | - |  | ----------------------------------------------------------------------------------------
|                                              | þ |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|For the Quarterly Period Ended June 30, 2006 
|                                             
|                                              |  ̈ |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|For the Transition Period From _____ to _____

COMMISSION FILE NUMBER
0-24765

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

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

750 University Avenue,
Los Gatos, California 95032(Address of principal
executive offices and Zip Code)

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

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

YESþ
NO ̈



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

Large accelerated filer ̈
 Accelerated filerþ
Non-accelerated filer ̈

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

YES ̈
NOþ

The number of shares outstanding of
the Registrants Common Stock, par value $.001 per share, was 13,899,371 at
August 8, 2006.

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# TABLE OF CONTENTS

|                              |                                                                                               |                                                     
|----------------------------- | --------------------------------------------------------------------------------------------- | ----------------------------------------------------
|                              |                                                                                               |                                                     
|PART I. FINANCIAL INFORMATION
|                              | Item 1. Financial Statements (unaudited)                                                     
|                              |                                                                                               | Condensed Consolidated Balance Sheets               
|                              |                                                                                               | Condensed Consolidated Statements of Operations     
|                              |                                                                                               | Condensed Consolidated Statements of Cash Flows     
|                              |                                                                                               | Notes to Condensed Consolidated Financial Statements
|                              | Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
|                              | Item 3. Quantitative and Qualitative Disclosure About Market Risks                           
|                              | Item 4. Controls and Procedures                                                              
|PART II. OTHER INFORMATION   
|                              | Item 5. Other Information                                                                    
|                              | Item 6. Exhibits                                                                             
|Signatures                   
|Index to Exhibits            
|Exhibit 31.1                 
|Exhibit 31.2                 
|Exhibit 32.1                 
|Exhibit 32.2                 

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Table of Contents

# HIFN, INC.

# INDEX TO FORM 10-Q

|                  |  |                                                                                                                      |  |        
|----------------- |  | -------------------------------------------------------------------------------------------------------------------- |  | -------
|PART I.           |  | FINANCIAL INFORMATION                                                                                                |  |        
|Item 1.           |  | Financial Statements (unaudited)                                                                                     |  |        
|                  |  | Condensed Consolidated Balance Sheets as of June 30, 2006 and September 30, 2005                                     |  | 3      
|                  |  | Condensed Consolidated Statements of Operations for the three months and    nine months ended June 30, 2006 and 2005 |  | 4      
|                  |  | Condensed Consolidated Statements of Cash Flows for the nine months ended   June 30, 2006 and 2005                   |  | 5      
|                  |  | Notes to Condensed Consolidated Financial Statements                                                                 |  | 6 - 16 
|Item 2.           |  | Management's Discussion and Analysis of Financial Condition and Results of Operations                                |  | 17 - 37
|Item 3.           |  | Quantitative and Qualitative Disclosure About Market Risks                                                           |  | 37     
|Item 4.           |  | Controls and Procedures                                                                                              |  | 38     
|PART II.          |  | OTHER INFORMATION                                                                                                    |  | 39     
|Item 5.           |  | Other Information                                                                                                    |  | 39     
|Item 6.           |  | Exhibits                                                                                                             |  | 39     
|Signatures        |  | 40                                                                                                                  
|Index to Exhibits |  | 41                                                                                                                  

-2-

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Table of Contents

# PART 1  FINANCIAL
INFORMATION

# Item 1. Financial
Statements

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

|                                               | June 30,2006 |  | September 30,2005 |         
|---------------------------------------------- | ------------ |  | ----------------- | --------
|                                               |              |  |                   |         
|ASSETS                                        
|CURRENT ASSETS:                                |              | 
|Cash and cash equivalents                      |              |  | $                 | 24,848  
|Short-term investments                         |              |  |                   | 14,216  
|Accounts receivable, net                       |              |  |                   | 5,419   
|Inventories                                    |              |  |                   | 1,877   
|Prepaid expenses and other current assets      |              |  |                   | 1,470   
|                                               |              |  |                   |         
|Total current assets                           |              |  |                   | 47,830  
|Property and equipment, net                    |              |  |                   | 2,467   
|Intangible assets, net                         |              |  |                   | 7,664   
|Other assets                                   |              |  |                   | 1,359   
|                                               |              |  |                   |         
|                                               |              |  | $                 | 59,320  
|                                               |              |  |                   |         
|LIABILITIES AND STOCKHOLDERS EQUITY          
|CURRENT LIABILITIES:                          
|Accounts payable                               |              |  | $                 | 1,306   
|Accrued expenses and other current liabilities |              |  |                   | 5,313   
|                                               |              |  |                   |         
|Total current liabilities                      |              |  |                   | 6,619   
|                                               |              |  |                   |         
|STOCKHOLDERS EQUITY:                         
|Common stock                                   |              |  |                   | 14      
|Additional paid-in capital                     |              |  |                   | 165,792 
|Accumulated other comprehensive loss           |              |  |                   | (18     
|Accumulated deficit                            |              |  |                   | (108,834
|Treasury stock, at cost                        |              |  |                   | (4,253  
|                                               |              |  |                   |         
|Total stockholders equity                     |              |  |                   | 52,701  
|                                               |              |  |                   |         
|                                               |              |  | $                 | 59,320  
|                                               |              |  |                   |         
|                                               |              | 

See accompanying notes to condensed consolidated financial statements.

-3-

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Table of Contents

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

|                                                       | Three Months Ended
June 30, |  | Nine Months Ended
June 30, |       
|------------------------------------------------------ | --------------------------- |  | -------------------------- | ------
|
|Net revenues:                                          |                             |  |                            |       
|Processors                                             |                             |  | $                          | 10,917
|Software licenses and other                            |                             |  |                            | 1,335 
|                                                       |                             |  |                            |       
|Total net revenues                                     |                             |  |                            | 12,252
|                                                       |                             |  |                            |       
|Costs and operating expenses:                         
|Cost of revenues - processors                          |                             |  |                            | 3,992 
|Cost of revenues - software licenses and other         |                             |  |                            | 126   
|Research and development                               |                             |  |                            | 6,040 
|Sales and marketing                                    |                             |  |                            | 2,084 
|General and administrative                             |                             |  |                            | 1,841 
|Amortization of intangible assets                      |                             |  |                            | 784   
|                                                       |                             |  |                            |       
|Total costs and operating expenses                     |                             |  |                            | 14,867
|                                                       |                             |  |                            |       
|Loss from operations                                   |                             |  |                            | (2,615
|Interest and other income, net                         |                             |  |                            | 489   
|                                                       |                             |  |                            |       
|Loss before income taxes                               |                             |  |                            | (2,126
|Provision for income taxes                             |                             |  |                            | 85    
|                                                       |                             |  |                            |       
|Net loss                                               |                             |  | $                          | (2,211
|                                                       |                             |  |                            |       
|Net loss per share, basic and diluted                  |                             |  | $                          | (0.16 
|                                                       |                             |  |                            |       
|Weighted average shares outstanding, basic and diluted |                             |  |                            | 13,842
|                                                       |                             |  |                            |       

See accompanying notes
to condensed consolidated financial statements.

-4-

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Table of Contents

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

|                                                    | Nine Months Ended
June 30, | 
|--------------------------------------------------- | -------------------------- | 
|
|Cash flows from operating activities:               |                            | 
|Net loss                                            |                            | 
|Adjustments to reconcile net loss to net cash      
|used in operating activities:                      
|Depreciation and amortization                       |                            | 
|Amortization of intangible assets                   |                            | 
|Asset impairment                                    |                            | 
|Provision for excess and obsolete inventory         |                            | 
|Stock-based compensation expense                    |                            | 
|Allowance for doubtful accounts                     |                            | 
|Changes in assets and liabilities:                  |                            | 
|Accounts receivable                                 |                            | 
|Inventories                                         |                            | 
|Prepaid expenses and other current assets           |                            | 
|Other assets                                        |                            | 
|Accounts payable                                    |                            | 
|Accrued expenses and other current liabilities      |                            | 
|                                                    |                            | 
|Net cash used in operating activities               |                            | 
|                                                    |                            | 
|Cash flows from investing activities:               |                            | 
|Sales and maturities of short-term investments, net |                            | 
|Purchases of property and equipment                 |                            | 
|                                                    |                            | 
|Net cash provided by investing activities           |                            | 
|                                                    |                            | 
|Cash flows from financing activities:               |                            | 
|Proceeds from issuance of common stock              |                            | 
|Repurchase of common stock                          |                            | 
|Installment payments on acquired software licenses  |                            | 
|                                                    |                            | 
|Net cash provided by (used in) financing activities |                            | 
|                                                    |                            | 
|Net increase in cash and cash equivalents           |                            | 
|Cash and cash equivalents at beginning of period    |                            | 
|                                                    |                            | 
|Cash and cash equivalents at end of period          |                            | 
|                                                    |                            | 

See accompanying notes
to condensed consolidated financial statements.

-5-

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Table of Contents

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

# Note 1  Basis of Presentation

hi/fn,
inc., together with its subsidiaries, Hifn Limited, Hifn Netherlands B.V. and Hifn
International and its subsidiary, Saian (Hangzhou) Microsystems, Co., Ltd., together with
Hangzhou Ansai Information Technology Co., Ltd., a contractually controlled company of
Hifn International (collectively referred to as the Company or
Hifn) is a network- and storage-security market leader that supplies major
network original equipment manufacturers (OEMs) with patented technology to
accelerate, secure and compress data. Hifn designs, develops and markets both hardware and
software solutions to a targeted customer base of networking-, security- and storage-OEMs.
The Companys network- and security-processors, compression, flow classification and
content search solutions are used in networking, security and storage equipment such as
routers, remote access concentrators, virtual private networks (VPNs),
switches, broadband access equipment, network interface cards, firewalls and back-up
storage devices. The Companys operating activities are primarily in the
United States and revenues are generated from sales to customers in the
United States, Asia and Europe.

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 Annual Report on Form 10-K for the year ended September 30, 2005. In
the opinion of management, the accompanying condensed consolidated financial statements
contain all adjustments, consisting only of normal recurring adjustments, which the
Company believes are necessary for a fair statement of the Companys financial
position as of June 30, 2006 and its results of operations for the three and nine months
ended June 30, 2006 and 2005, 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 $108.8 million as of June 30, 2006, and has incurred
a net loss of $2.2 million and $6.4 million during the three and nine months ended June
30, 2006, respectively. The Company believes that its existing cash, cash equivalents and
short-term investments will fund any anticipated operating losses, purchases of capital
equipment and provide adequate working capital for the next twelve months. The
Companys liquidity is affected by many factors including, among others, the extent
to which the Company pursues additional capital expenditures, the level of the
Companys product development efforts, the risk of acceptance and pricing of the
Companys products and other factors related to the uncertainties of the industry,
global economies and general economic conditions. 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.

# Stock-Based Compensation
Expense

On
October 1, 2005, the Company adopted Statement of Financial Accounting Standards
No. 123 (revised 2004), Share-Based Payment, (SFAS 123(R))
which requires the measurement and recognition of compensation expense for all share-based
payment awards, including employee stock options and employee stock purchases, based on
estimated fair values. SFAS 123(R) supersedes the Companys previous accounting under
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees (APB 25) for periods beginning in fiscal 2006. In March 2005,
the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107
(SAB 107) relating to SFAS 123(R). The Company has applied the provisions of
SAB 107 in its adoption of SFAS 123(R). The Company adopted SFAS 123(R) using the modified
prospective transition method, which requires the application of the accounting standard
as of October 1, 2005, the first day of the Companys fiscal
year 2006. The Companys Consolidated Financial Statements as of and for the three
and nine months ended June 30, 2006, reflect the effect of SFAS 123(R).

-6-

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Table of Contents

Stock-based
compensation expense related to employee stock options and employee stock purchases and
recognized under SFAS 123(R) for the three and nine months ended June 30, 2006, was
$268,000 and $742,000, respectively. Under the modified prospective transition method, the
Companys Consolidated Financial Statements for prior periods need not be restated to
reflect or include the effect of SFAS 123(R). Accordingly, there was no stock-based
compensation expense related to employee stock options and employee stock purchases
recognized during the three and nine months ended June 30, 2005.

SFAS
123(R) requires companies to estimate the fair value of share-based payment awards on the
date of grant using an option-pricing model. The value of the portion of the award that is
ultimately expected to vest is recognized as expense over the requisite service periods in
the Companys Consolidated Statement of Operations. Prior to the adoption of SFAS
123(R), the Company accounted for stock-based awards using the intrinsic value method in
accordance with APB 25 as allowed under Statement of Financial Accounting Standards
No. 123, Accounting for Stock-Based Compensation (SFAS 123).
Under the intrinsic value method, no stock-based compensation expense had been recognized
in the Companys Consolidated Statement of Operations because the exercise price of
the Companys stock options granted to employees and directors equaled the fair
market value of the underlying stock at the date of grant.

Stock-based
compensation expense recognized during the period is based on the value of the portion of
share-based payment awards that is ultimately expected to vest during the period.
Stock-based compensation expense recognized in the Companys Consolidated Statement
of Operations for the first nine months of fiscal 2006 included compensation expense for
share-based payment awards granted prior to, but not yet vested as of September 30, 2005
based on the grant date fair value estimated in accordance with the pro forma provisions
of SFAS 123 and compensation expense for the share-based payment awards granted subsequent
to September 30, 2005 based on the grant date fair value estimated in accordance with the
provisions of SFAS 123(R). The Company attributes the value of stock-based compensation to
expense on a straight-line single option method, the same method used for share-based
payment awards granted on or prior to September 30, 2005. As stock-based compensation
expense recognized in the Consolidated Statement of Operations for the third quarter of
fiscal 2006 is based on awards ultimately expected to vest, it has been reduced for
estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of
grant and revised, if necessary, in subsequent periods if actual forfeitures differ from
those estimates. In the Companys pro forma information required under SFAS 123 for
the periods prior to fiscal 2006, the Company accounted for forfeitures as they occurred.

The
Company uses the Black-Scholes-Merton option-pricing model (Black-Scholes
model) as its method of valuation for share-based awards granted beginning in fiscal
2006, the same model used for the Companys pro forma information required under SFAS
123. The Companys determination of fair value of share-based payment awards on the
date of grant using an option-pricing model is affected by the Companys stock price
as well as assumptions regarding a number of subjective variables. These variables
include, but are not limited to, the Companys expected stock price volatility over
the term of the awards as well as actual and projected employee stock option exercise
behaviors. The Companys employee stock options have certain characteristics that may
differ from other options and changes in the subjective assumptions can materially affect
the estimated value. Accordingly, it is managements opinion that the existing
valuation models may not provide an accurate measure of the fair value of the
Companys employee stock options. Although the fair value of employee stock options
is determined in accordance with SFAS 123(R) and SAB 107 using an option-pricing model,
that value may not be indicative of the fair value in an actual market transaction.

On
November 10, 2005, the Financial Accounting Standards Board
(FASB) issued FASB Staff Position No. FAS 123(R)-3 (FSP 123(R)-3),
Transition Election Related to Accounting for Tax Effects of Share-Based Payment
Awards. The Company currently provides a full valuation allowance for its deferred
tax assets, accordingly, a valuation allowance is also provided for any tax effects of
stock-based compensation expense pursuant to SFAS 123(R). The Company is evaluating, and
has not yet determined, the transition method it will adopt under FSP 123(R)-3.

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Table of Contents

# Reclassifications

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

# Restructuring Charges

On
June 28, 2006, the company  implemented a  restructuring
plan to be more focused on the strategy in the  networking  and storage  markets and to take  advantage of
their  expanding  development  capacity in  China.  These actions were aimed to reduce the
companys  cost  structure,  including a reduction in its North America  workforce by 43 employees,  which
represents  about 21% of its  overall  workforce,  the impact of the  termination  of certain  engineering
projects and the planned closure of the facility in Carlsbad, California.

Involuntary Termination
Benefits

|                           | Expense
Accrued |  | Paid as of
June 30, 2006 |     | Balance
June 30, 2006 |  
|-------------------------- | --------------- |  | ------------------------ | --- | --------------------- | -
|
|Cost of revenues           |                 |  | $                        | 64  |                       | $
|Research and development   |                 |  |                          | 471 |                       |  
|Sales and marketing        |                 |  |                          | 59  |                       |  
|General and administrative |                 |  |                          | 24  |                       |  
|                           |                 |  |                          |     |                       |  
|Total                      |                 |  | $                        | 618 |                       | $
|                           |                 |  |                          |     |                       |  

Impairment of Long-lived Assets

The restructure
resulted in the impairment of certain software assets related to projects that were terminated
as part of the restructuring plan. The impairment of $292,000 was expensed to the research and development line
item on the Statement of Operations.

Non-recurring Engineering Expense
Recovery

The
cancellation of projects resulted in the reversal of previously accrued non-recurring
engineering costs of $516,000.  This reversal is reflected in the research and development line item on
the Statement of Operations.

Termination Of Operating Lease

As
part of the restructure,  the company plans to close its
facility in  Carlsbad,  California.  A liability related to the Carlsbad  facility
will be  reflected  in the  period  that the  Company  ceases  to use the  rights  conveyed  in the  lease
agreement as the fair value of the future lease  obligations net of sublease  income.  The  non-cancelable
lease  agreement  for this facility  terminates  in June 2010.  The facility will still be used during the
transition  period in the next  quarter and it is  managements  intention to cease use of the facility by
September  30, 2006.  At September  30,  2006,  the  remaining  lease  obligation  is estimated to be $1.5
million,  which will be paid monthly for the remainder of the lease contract  period.  At the current time
management  cannot  estimate the fair value of the liability and are  evaluating  sublease  opportunities.
Additional  cost will be incurred in the September  quarter for the relocation of operations and equipment
from the closing facility.  No estimate for the relocation cost is available at this time.

Net Restructuring Cost

Not
including the fair value of the lease obligation and relocation costs, the net expense at June 30, 2006 of the restructure
amounts to $394,000. The
actual payment of the restructuring cost, with the exception of the lease, is expected to be
completed by September 30, 2006. These payments will be funded by available cash on hand.

-8-

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Table of Contents

# Note 2  Balance
Sheet Details

|                                                                                                          |  | June 30,2006 |   | September 30,2005 | 
|--------------------------------------------------------------------------------------------------------- |  | ------------ | - | ----------------- | 
|
|Property and equipment:                                                                                   |  |              |   |                   | 
|Computer equipment                                                                                        |  |              |   |                   | 
|Furniture and fixtures                                                                                    |  |              |   |                   | 
|Leasehold improvements                                                                                    |  |              |   |                   | 
|Office equipment                                                                                          |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|Less: accumulated depreciation                                                                            |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|Intangible assets:                                                                                       
|Developed and core technology                                                                             |  |              |   |                   | 
|Workforce                                                                                                 |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|Less: accumulated amortization                                                                            |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|Goodwill                                                                                                  |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|The estimated future amortization expense related to intangible assets as of June 30, 2006 is as follows:
|Fiscal year ending September 30,                                                                         
|2006 (3 months ended)                                                                                     |  |              | $ | 782               | 
|2007                                                                                                      |  |              |   | 2,910             | 
|2008                                                                                                      |  |              |   | 2,354             | 
|2009                                                                                                      |  |              |   | 589               | 
|                                                                                                          |  |              |   |                  
|Total estimated amortization                                                                              |  |              | $ | 6,635             | 
|                                                                                                          |  |              |   |                  
|Other assets:                                                                                            
|Design tools and other licensed intellectual property                                                     |  |              |   |                   | 
|Refundable deposits                                                                                       |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|Accrued expenses and other current liabilities:                                                          
|Accrued vacant facility lease cost                                                                        |  |              |   |                   | 
|Accrued non-recurring engineering costs                                                                   |  |              |   |                   | 
|Compensation and employee benefits                                                                        |  |              |   |                   | 
|Deferred income and revenue                                                                               |  |              |   |                   | 
|Income taxes payable                                                                                      |  |              |   |                   | 
|Other                                                                                                     |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 
|                                                                                                          |  |              |   |                   | 

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Table of Contents

# Note 3  Net Loss
Per Share

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

|                                             | Three Months Ended
June 30, |  | Nine Months Ended
June 30, |          
|-------------------------------------------- | --------------------------- |  | -------------------------- | ---------
|
|Outstanding options to purchase common stock |                             |  |                            | 4,090,703

# Note 4 
Comprehensive Loss

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

|                                                | Three Months Ended
June 30, |  | Nine Months Ended
June 30, |       
|----------------------------------------------- | --------------------------- |  | -------------------------- | ------
|
|Net loss                                        |                             |  | $                          | (2,211
|Unrealized gain/(loss) on financial instruments |                             |  |                            | (6    
|                                                |                             |  |                            |       
|Comprehensive loss                              |                             |  | $                          | (2,217
|                                                |                             |  |                            |       
|                                                |                             | 

# Note 5  Employee
Stock Benefit Plans

# Employee Stock Option
Plan

As
of June 30, 2006, the Company had two employee stock option plans: the 1996 Equity
Incentive Plan (the 1996 Plan) and the 2001 Nonstatutory Stock Option Plan
(the 2001 Plan). Within the nine months ended June 30, 2006, the Company also
had a third stock option plan, the Apptitude Plan, which was assumed in connection with
the acquisition of Apptitude, Inc. in August 2000. The Apptitude Plan expired on
October 25, 2005. Options granted under the Apptitude Plan remain
outstanding until exercised or cancelled.

The
1996 Plan has 5,449,900 shares of the Companys Common Stock reserved for issuance
pursuant to nonqualified and incentive stock options and restricted stock awards. The 1996
Plan is administered by the Board of Directors of the Company or its designees and
provides generally that nonqualified stock options and restricted stock may be awarded at
a price not less than 85% of the fair market value of the stock at the date of the award.
Incentive stock options must be awarded at a price not less than 100% of the fair market
value of the stock at the date of the award, or 110% of fair market value for awards to
more than 10% stockholders. Options granted under the 1996 Plan may have a term of up to
10 years. Options typically vest at a rate of 25% of the total grant per year over a
four-year period. However, the Company may, at its discretion, implement a different
vesting schedule with respect to any new

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stock option grant. As a result of
early exercise features as provided for by the 1996 Plan, options granted are immediately
exercisable subject to the Companys repurchase rights which expire as options vest.

The
2001 Plan had 2,000,000 shares of the Companys Common Stock reserved for issuance
pursuant to nonqualified stock options. The 2001 Plan is administered by the
Companys Board of Directors or its designees and provides generally that
nonqualified stock options granted under the 2001 Plan may have a maximum life of 10
years. The terms and conditions of each stock option grant under the 2001 Plan are
determined by a committee of the Board of Directors and are set forth in agreements
between the recipient and the Company. Options granted under the 2001 Plan generally vest
over a period of four years.

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

|                                | Options
Available
for Grant |  | Outstanding
Options /
Quantity |           | Weighted
Average
Exercise
Price (per
share |  | Weighted
Average
Contractual
Term |   | Aggregate
Intrinsic
Value
(in
thousands) |      
|------------------------------- | --------------------------- |  | ------------------------------ | --------- | ------------------------------------------ |  | --------------------------------- | - | ---------------------------------------- | -----
|Balance at September 30, 2005   |                             |  |                                | 1,016,811 |                                            |  | 4,161,531                         |   | $                                        | 10.50
|Options granted                 |                             |  |                                | (10,000   | )                                          |  | 10,000                            |   |                                          | 5.49 
|Options exercised               |                             |  |                                | -         |                                            |  | (36,233                           | ) |                                          | 3.96 
|Options cancelled               |                             |  |                                | 102,282   |                                            |  | (102,282                          | ) |                                          | 11.17
|                                |                             |  |                                |           |                                            |  |                                  
|Balance at December 31, 2005    |                             |  |                                | 1,109,093 |                                            |  | 4,033,016                         |   |                                          | 10.53
|Additional shares authorized    |                             |  |                                | 500,000   |                                            |  | -                                 |   |                                          | -    
|Options granted                 |                             |  |                                | (358,500  | )                                          |  | 358,500                           |   |                                          | 6.79 
|Options exercised               |                             |  |                                | -         |                                            |  | (90,557                           | ) |                                          | 4.30 
|Options cancelled               |                             |  |                                | 36,967    |                                            |  | (36,967                           | ) |                                          | 8.72 
|                                |                             |  |                                |           |                                            |  |                                  
|Balance at March 31, 2006       |                             |  |                                | 1,287,560 |                                            |  | 4,263,992                         |   |                                          | 10.36
|                                |                             |  |                                |           |                                            |  |                                  
|Options granted                 |                             |  |                                | (29,500   | )                                          |  | 29,500                            |   |                                          | 6.55 
|Options exercised               |                             |  |                                | -         |                                            |  | (28,111                           | ) |                                          | 3.55 
|Options cancelled               |                             |  |                                | 157,856   |                                            |  | (174,678                          | ) |                                          | 11.38
|                                |                             |  |                                |           |                                            |  |                                  
|Balance at June 30, 2006        |                             |  |                                | 1,415,916 |                                            |  | 4,090,703                         |   |                                          | 10.33
|                                |                             |  |                                |           |                                            |  |                                  
|Fully vested and exercisable at |                             |  |                                |           |                                            |  |                                   |   |                                          |      
|June 30, 2006                   |                             |  |                                |           |                                            |  | 3,612,837                         |   |                                          | 10.81
|Expected to vest at             |                             |  |                                |           |                                            |  |                                   |   |                                          |      
|June 30, 2006                   |                             |  |                                |           |                                            |  | 417,177                           |   |                                          | 6.70 

Options
vested and exercisable as of June 30, 2006, include 172,400 shares, with a weighted
average exercise price of $10.88, related to options held by the Companys executive
officers for which vesting was accelerated as of August 2005 and for which a holding
period relating to the timing of the sale of exercised options, if any, was imposed. The
aggregate intrinsic value of options outstanding and exercisable as of June 30, 2006,
represents the total intrinsic value, based on the Companys closing stock price of
$6.18 as of such date, which would have been received by the option holders had the
options been exercised as of such date.

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# Employee Stock Purchase
Plan

The
Company has an employee stock purchase plan (the ESPP) through which qualified
employees of the Company may participate in stock ownership of the Company. The price of
shares purchased under the ESPP is the lower of 85% of the fair market value of the shares
on the first day of each semi-annual offering period, or 85% of the fair market value of
the shares on the last day of the semi-annual offering period. There were 109,406 shares
issued pursuant to the ESPP, at a weighted average price of $4.47, during the three months
ended June 30, 2006. During the nine months ended June 30, 2006, 208,039 shares were
issued pursuant to the ESPP, at a weighted average price of $4.49 per share. As of June
30, 2006, there were 580,444 shares available for future purchases under the ESPP.
Stock-based compensation expense relating to the ESPP was $58,000 and $198,000 for the
three and nine months ended June 30, 2006, respectively. Prior to the adoption of FAS
123(R) on October 1, 2005, the Company was not required to record compensation expense for
the ESPP.

# Stock-Based Compensation
under SFAS 123(R)

Effective
October 1, 2005, the Company adopted SFAS 123(R), on the modified prospective application
method, which requires the measurement and recognition of compensation expense for all
share-based awards made to the Companys employees and directors including employee
stock options and employee stock purchases outstanding as of and awarded after October 1,
2005. The total stock-based compensation expense recognized for the three months and nine
months ended June 30, 2006, were allocated as follows (in thousands):

|                                       | Three Months
Ended |  | Nine Months
Ended |    
|-------------------------------------- | ------------------ |  | ----------------- | ---
|Cost of revenues                       |                    |  | $                 | 3  
|Research and development               |                    |  |                   | 119
|Sales and marketing                    |                    |  |                   | 50 
|General and administrative             |                    |  |                   | 96 
|                                       |                    |  |                   |    
|Total stock-based compensation expense |                    |  | $                 | 268
|                                       |                    |  |                   |    
|                                       |                    | 

As
of June 30, 2006, there was approximately $1.7 million of total stock-based compensation
expense, after estimated forfeitures, related to unvested employee stock options, which is
expected to be recognized over an estimated weighted average amortization period of 2.33
years. The Company did not capitalize any stock-based compensation expense. The tax
benefit, and the resulting effect on cash flows from operations and financial activities,
related to stock-based compensation expense was not recognized as the Company currently
provides a full valuation allowance for its deferred tax assets. The effect of adoption of
SFAS 123(R) for the three and nine months ended June 30, 2006, was an increase in net loss
of $268,000 and $742,000, respectively, and an increase in net loss per share of $0.02 and
$0.05, respectively. This includes stock-based compensation expenses for ESPP of $58,000
and $198,000 for the three and nine months ended June 30, 2006, respectively.

The
method of valuation for share-based awards granted beginning in fiscal 2006 is the
Black-Scholes model which was also the method used for the Companys pro forma
information required under FAS 123. The expected term of the awards represents the
weighted-average period the stock options are expected to remain outstanding which assumes
that the employees exercise behavior is a function of the options remaining
contractual life and the extent to which the option is in-the-money (i.e., the average
stock price during the period is above the strike price of the stock option). The
Companys expected volatility assumption uses the historical volatility of the
Companys stock, as applicable for the expected term. The Company also used its
historical stock price to determine fair value of awards for purposes of its pro forma
information under FAS 123. Since the Company does not pay dividends, the expected dividend
yield is zero. The risk-free interest rate assumption is based upon observed interest
rates appropriate for the term of the Companys employee stock options. The
post-vesting forfeiture rate is based on the Companys historical option cancellation
and employee exercise information.

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The
fair value of employee stock options granted and employee stock purchased during the three
and nine months ended June 30, 2006, were estimated based on the following assumptions:

|                                      | Period Ended June 30, 2006
|------------------------------------- | --------------------------
|
|
|Weighted-average estimated fair value | $3.85                     
|Estimated life                        | 5.40 years                
|Risk-free interest rate               | 4.79%                     
|Expected stock price volatility       | 59.07%                    
|Dividend yield                        | 0.00%                     

# Pro Forma Information
under SFAS 123 for Periods Prior to Fiscal 2006

Prior
to adopting the provisions of SFAS 123(R), the Company recorded estimated compensation
expense for employee stock options based upon their intrinsic value on the date of grant
pursuant to APB 25, Accounting for Stock Issued to Employees and provided the
required pro forma disclosures of SFAS 123. Because the Company established the exercise
price based on the fair market value of the Companys stock at the date of grant, the
stock options had no intrinsic value upon grant, and therefore no estimated expense was
recorded prior to adopting SFAS 123(R). Each accounting period, the Company reported the
potential dilutive impact of stock options in its diluted earnings per common share using
the treasury-stock method. Out-of-the-money stock options (i.e., the average stock price
during the period was below the strike price of the stock option) were not included in
diluted earnings per common share as their effect was anti-dilutive.

For
purposes of pro forma disclosures under SFAS 123 for the three and nine months ended June
30, 2005, the estimated fair value of the stock options was assumed to be amortized to
expense over the stock options vesting periods. The pro forma effects of recognizing
estimated compensation expense under the fair value method on net loss and net loss per
share for the three and nine months ended June 30, 2005, were as follows (in thousands,
except per share data):

|                                                  | Period Ended
June 30, 2005 | 
|------------------------------------------------- | -------------------------- | 
|
|Net loss, as reported                             |                            | 
|Less: stock-based compensation expense            |                            | 
|                                                  |                            | 
|Pro forma net loss                                |                            | 
|                                                  |                            | 
|Basic and diluted net loss per share, as reported |                            | 
|Less: stock-based compensation expense per share  |                            | 
|                                                  |                            | 
|Pro forma basic and diluted net loss per share    |                            | 
|                                                  |                            | 

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The fair value of employee stock options granted and employee stock purchased during the
three and nine months ended June 30, 2005, was estimated using the Black-Scholes model
based on the following assumptions:

|                                      | Period Ended June 30, 2005
|------------------------------------- | --------------------------
|
|
|Weighted-average estimated fair value | $3.02                     
|Estimated life                        | 2.86 years                
|Risk-free interest rate               | 3.66%                     
|Expected stock price volatility       | 54.4%                     
|Dividend yield                        | 0.00%                     

# Stock Repurchase Program

On
April 25, 2005, the Companys Board of Directors authorized a
stock repurchase program whereby the Company may repurchase shares of the Companys
common stock with an aggregate fair market value of up to $10 million from time to time
through open market and privately negotiated transactions at prices determined by
management. The timing and amount of repurchases under this program is dependent upon
market conditions and corporate and regulatory considerations. The purchases are funded
from available working capital. The stock repurchase program expired on April 25, 2006.
The Company did not repurchase any shares during the three and nine months ended June 30,
2006, however, as of June 30, 2006, a total of 692,894 shares have been repurchased under
the program, which shares are held in treasury stock, at a cost of $4.3 million.

# Note 6  Segment
and Geographic Information

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

|                    | Three Months Ended
June 30, |  | Nine Months Ended
June 30, |       
|------------------- | --------------------------- |  | -------------------------- | ------
|
|
|North America:      |                             |  |                            |       
|United States       |                             |  | $                          | 4,776 
|Other               |                             |  |                            | 337   
|                    |                             |  |                            |       
|Total North America |                             |  |                            | 5,113 
|                    |                             |  |                            |       
|Asia:              
|Hong Kong           |                             |  |                            | 4,873 
|Malaysia            |                             |  |                            | 567   
|Singapore           |                             |  |                            | 487   
|Japan               |                             |  |                            | 558   
|Other               |                             |  |                            | 209   
|                    |                             |  |                            |       
|Total Asia          |                             |  |                            | 6,694 
|                    |                             |  |                            |       
|Europe and other    |                             |  |                            | 445   
|                    |                             |  |                            |       
|Total               |                             |  | $                          | 12,252
|                    |                             |  |                            |       

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# Major Customers

The
Companys major customers are generally original equipment manufacturers with
manufacturing subcontractors who purchase products directly from us. Our principal end
customers and their respective contribution to net revenues for the respective periods are
as follows:

|                          | Three Months Ended
June 30, |  | Nine Months Ended
June 30, |   
|------------------------- | --------------------------- |  | -------------------------- | --
|
|Cisco Systems, Inc.       |                             |  |                            | 52
|Huawei Technologies, Inc. |                             |  |                            | 10
|Quantum Corporation       |                             |  |                            | 8 
|                          |                             |  |                            |   
|                          |                             |  |                            | 70

# Property and Equipment

As
of June 30, 2006, the Company had net property and equipment of $1.5 million and $959,000
in the United States and China, respectively.

# Note 7  Income
Taxes

The
Company has a valuation allowance for its net deferred tax asset associated with its
U.S. operations.  Until such time as the Company utilizes its
U.S. net operating loss carryforwards and unused tax credits, a provision
for taxes on the Companys U.S. operations is expected to be
substantially offset by a reduction in the valuation allowance. The provision for
income taxes for the quarter ended June 30, 2006 and 2005, relates to taxes on the
Companys non-U.S. operations.

# Note 8  Guarantees
and Product Warranties

# Guarantees

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

As
permitted under Delaware law, the Company has agreements that provide
indemnification of officers and directors for certain events or occurrences while the
officer or director is, or was serving, at the Companys request in such capacity.
The indemnification period is effective for the officers or directors
lifetime. The maximum potential amount of future payments that the Company could be
required to make under these indemnification agreements is unlimited; however, the Company
has a Director and Officer insurance policy that limits its exposure and enables the
Company to recover a portion of any future amounts paid. All of the indemnification
agreements were grandfathered under the provisions of FIN 45 as they were in effect prior
to December 31, 2002. As a result of the insurance policy
coverage, the Company believes the estimated fair value of the potential liability under
these agreements is minimal. Accordingly,
the Company has not recorded any liabilities for these agreements as of June 30, 2006.

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The
Company enters into standard indemnification agreements in the ordinary course of
business. Pursuant to these agreements, the Company indemnifies, holds harmless, and
agrees to reimburse the indemnified party, generally business partners or customers, for
losses suffered or incurred in connection with patent, copyright or other intellectual
property infringement claims by any third party with respect to the Companys
products. The term of these indemnification agreements is generally perpetual, effective
after execution of the agreement. The maximum potential amount of future payments the
Company could be required to make under these indemnification agreements is unlimited. To
date, the Company has not incurred costs to defend lawsuits or settle claims related to
these indemnification agreements. Accordingly, the Company has not recorded any
liabilities for these agreements as of June 30, 2006. However, the Company may, in the
future, record charges related to indemnification obligations and, depending upon the
nature of any such lawsuit or claim, the estimated fair value of such indemnification
obligations may be material.

The
Company warrants that its hardware products are free from defects in material and
workmanship under normal use and service and that its hardware and software products will
perform in all material respects in accordance with the standard published specifications
in effect at the time of delivery of the licensed products to the customer. The warranty
periods generally range from three months to one year for software and one year for
hardware. Additionally, the Company warrants that its maintenance services will be
performed consistent with generally accepted industry standards through completion of the
agreed upon services. The Companys policy is to provide for the estimated cost of
product and service warranties based on specific warranty claims and claim history as a
charge to cost of revenues. To date, the Company has not incurred significant expense
under its product or service warranties. As a result, the Company has not recorded an
accrual related to product or warranty services as of June 30, 2006. The Company assesses
the need for a warranty accrual every quarter. There is no assurance that a warranty
accrual will not be necessary in the future.

# Note 9  Recent
Accounting Pronouncements

In
May 2005, as part of a broader attempt to eliminate differences with the
International Accounting Standards Board, the Financial Accounting Standards Board
(FASB) issued Statement of Financial Accounting Standards No. 154
(SFAS 154), Accounting Changes and Error Corrections, which
replaces Accounting Principles Board Opinion No. 20 (APB 20),
Accounting Changes, and FASB Statement of Financial Accounting Standards
No. 3, Reporting Accounting Changes in Interim Financial Statements.
APB 20 had required that changes in accounting principles be recognized by including
the cumulative effect of the change in the period in which the new accounting principle
was adopted. SFAS 154 requires retrospective application of the change to prior
periods financial statements, unless it is impracticable to determine the
period-specific effects of the change. The Statement is effective for fiscal years or
periods beginning after December 15, 2005. The adoption of this statement did not
have a material effect on the Companys financial statements.

In
July 2006, the FASB issued FASB  Interpretation 48, Accounting for Income Tax
Uncertainties  (FIN 48). FIN 48 defines the threshold for  recognizing  the benefits of
tax return  positions in the financial statements  as  more-likely-than-not  to  be
 sustained  by  the  tax  authority.  The  recently  issued literature  also  provides
 guidance on the  recognition,  measurement  and  classification  of income tax
uncertainties,  along with any related interest and penalties.  FIN 48 also includes
 guidance  concerning accounting  for income tax  uncertainties  in  interim  periods
 and  increases  the level of  disclosures associated  with  any  recorded  income  tax
 uncertainties.  FIN 48 is  effective  for the  fiscal  years beginning  after December
15, 2006. The  differences  between the amounts  recognized in the statements of
financial  position  prior to the  adoption  of FIN 48 and the amounts  reported  after
 adoption  will be accounted for as a  cumulative-effect  adjustment  recorded to the
beginning balance of retained earnings. We are evaluating the impact,  if any, of
adopting the provisions of FIN 48 on our financial  position and 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

This
Quarterly Report on Form 10-Q 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 and 10-Q. 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, Hifn Limited, Hifn Netherlands B.V. and Hifn
International and its subsidiary, Saian (Hangzhou) Microsystems, Co., Ltd., together with
Hangzhou Ansai Information Technology Co., Ltd., a contractually controlled company of
Hifn International (collectively referred to as the Company or
Hifn) is a network- and storage-security market leader that supplies
major network original equipment manufacturers (OEMs) with patented technology
to accelerate, secure and compress data. Hifn designs, develops and markets both hardware
and software solutions to a targeted customer base of networking-, security- and
storage-OEMs. Our solutions are attractive to customers because they feature
high-performance, including some of the fastest compression processing speeds available in
the market, multi-protocol capabilities and development tools that help reduce
time-to-market. Our processor solutions perform the computation-intensive tasks of
compression, encryption and authentication, providing our customers with high-performance,
interoperable implementations of a wide variety of industry-standard networking and
storage protocols. Our network- and security-processors, compression, flow classification
and content search solutions are used in networking, security and storage equipment such
as routers, remote access concentrators, virtual private networks (VPNs),
switches, broadband access equipment, network interface cards, firewalls and back-up
storage devices.

Our
encryption/compression and public key processors allow network equipment vendors to add
security functions to their products. Our encryption/compression and public key processors
provide industry-recognized algorithms that are used in products, such as 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 customers, partners and suppliers 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 a wide range of disk and tape back-up systems.

Hifns
flow classification technology enables network equipment vendors to add unique traffic
differentiation and recognition capabilities to their products. Our flow classification
solutions provide precise details about packets and data traversing a network and are used
in implementing and monitoring quality of service (QoS) and class of service
(CoS), which enables businesses to enhance the effectiveness of their systems.
Using QoS- or CoS-enabled network equipment, businesses can provide differentiated
services to their customers or build new revenue streams based on available services.
Hifns network processor technology, acquired from International Business Machines
Corporation (IBM), complements our security processor business and expands our
product offerings to include programmable, yet deterministic, devices that perform
computation-intensive, deep packet inspection for high-touch services. The architecture of
our network processor is unique and is an architecture used with applications that require
high-touch services. We are building upon this architecture to deliver the next generation
processors, which will continue to offer high-end performance and features, along with a
comprehensive software development toolkit.

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# Results for Third Fiscal
Quarter

During
the three months ended June 30, 2006, our net revenues of $12.3 million represented an
increase of 5 percent from the $11.7 million in net revenues reported in the previous
quarter and an increase of 2 percent from the $12.0 million in net revenues reported in
the third quarter of fiscal 2005. The increase from the prior quarter was a result of an
increase in software revenue.

We
have also brought to market two of our recent product initiatives, including the Virtual
Tape Library board, which replicates traditional tape libraries on disk storage, and a
pattern matching search software. These products accompany our next-generation network and
flow through security processors and we anticipate that these products will begin to
generate revenues during the last quarter of 2006.

Our
expense levels during the three months ended June 30, 2006, were higher than those of the
preceding quarter, mainly due to severance cost and software impairment as a result of
the restructuring. Some of the restructuring costs were offset by NRE recoveries
due to project cancellations.

# Restructuring Charges

On
June 28, 2006, the company  implemented a  restructuring
plan to be more focused on the strategy in the  networking  and storage  markets and to take  advantage of
their  expanding  development  capacity in  China.  These actions were aimed to reduce the
companys  cost  structure,  including a reduction in its North America  workforce by 43 employees,  which
represents  about 21% of its  overall  workforce,  the impact of the  termination  of certain  engineering
projects and the planned closure of the facility in Carlsbad, California.

Involuntary Termination
Benefits

|                           | Expense
Accrued |  | Paid as of
June 30, 2006 |     | Balance
June 30, 2006 |  
|-------------------------- | --------------- |  | ------------------------ | --- | --------------------- | -
|
|Cost of revenues           |                 |  | $                        | 64  |                       | $
|Research and development   |                 |  |                          | 471 |                       |  
|Sales and marketing        |                 |  |                          | 59  |                       |  
|General and administrative |                 |  |                          | 24  |                       |  
|                           |                 |  |                          |     |                       |  
|Total                      |                 |  | $                        | 618 |                       | $
|                           |                 |  |                          |     |                       |  

Impairment of Long-lived Assets

The restructure
resulted in the impairment of certain software assets related to projects that were terminated
as part of the restructuring plan. The impairment of $292,000 was expensed to the research and development line
item on the Statement of Operations.

Non-recurring Engineering Expense
Recovery

The
cancellation of projects resulted in the reversal of previously accrued non-recurring
engineering costs of $516,000.  This reversal is reflected in the research and development line item on
the Statement of Operations.

Termination Of Operating Lease

As
part of the restructure,  the company plans to close its
facility in  Carlsbad,  California.  A liability related to the Carlsbad  facility
will be  reflected  in the  period  that the  Company  ceases  to use the  rights  conveyed  in the  lease
agreement as the fair value of the future lease  obligations net of sublease  income.  The  non-cancelable
lease  agreement  for this facility  terminates  in June 2010.  The facility will still be used during the
transition  period in the  next  quarter and it is  managements  intention
to cease use of the facility by
September  30, 2006.  At September  30, 2006,  the  remaining  lease  obligation  is estimated to be $1.5
million,  which will be paid monthly for the remainder of

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the lease contract  period.  At the current time
management  cannot  estimate the fair value of the liability and are  evaluating  sublease  opportunities.
Additional  cost will be incurred in the September  quarter for the relocation of operations and equipment
from the closing facility.  No estimate for the relocation cost is available at this time.

Net Restructuring Cost

Not
including the fair value of the lease obligation and relocation costs, the net expense at June 30, 2006 of the restructure
amounts to $394,000. The
actual payment of the restructuring cost, with the exception of the lease, is expected to be
completed by September 30, 2006. These payments will be funded by available cash on hand.

# Critical Accounting
Policies

The
Companys critical accounting policies are disclosed in the Companys Form 10-K
for the year ended September 30, 2005, and have not changed materially as of June 30,
2006, with the exception of the following:

Stock-based
Compensation:We estimate the fair value of stock options using the Black-Scholes
model, consistent with the provisions of SFAS 123(R), SEC SAB No. 107 and our prior
period pro forma disclosures of net earnings, including stock-based compensation
(determined under a fair value method as prescribed by SFAS 123).  SFAS 123(R)
requires the use of option pricing models that were not developed for use in valuing
employee stock options. The Black-Scholes model was developed for use in estimating the
fair value of short-lived exchange traded options that have no vesting restrictions and
are fully transferable. In addition, option-pricing models require the input of highly
subjective assumptions, including the options expected life and the price volatility
of the underlying stock. The expected stock price volatility assumption was determined
using the historical volatility of the Companys common stock. Changes in the
subjective assumptions required in the valuation models may significantly affect the
estimated value of the awards, the related stock-based compensation expense and,
consequently, our results of operations.

# Results of Operations

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

Net
Revenues.

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

|                            | Three Months Ended
June 30, |  | Year-over-Year |        | Nine Months Ended
June 30, |   | Year-over-Year | 
|--------------------------- | --------------------------- |  | -------------- | ------ | -------------------------- | - | -------------- | 
|
|Processors                  |                             |  | $              | 10,917 |                            | $ | 10,885         | 
|Software licenses and other |                             |  |                | 1,335  |                            |   | 1,154          | 
|                            |                             |  |                |        |                            |   |                | 
|                            |                             |  | $              | 12,252 |                            | $ | 12,039         | 
|                            |                             |  |                |        |                            |   |                | 

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|                            | Three Months Ended
June 30, |  |  |      | Nine Months Ended
June 30, |  |      | 
|--------------------------- | --------------------------- |  |  | ---- | -------------------------- |  | ---- | 
|
|
|Processors                  |                             |  |  | 89%  |                            |  | 90%  | 
|Software licenses and other |                             |  |  | 11%  |                            |  | 10%  | 
|                            |                             |  |  |      |                            |  |      | 
|Total                       |                             |  |  | 100% |                            |  | 100% | 
|                            |                             |  |  |      |                            |  |      | 

Net
revenues increased by $213,000 for the quarter ended June 30, 2006, as compared to net
revenues for the quarter ended June 30, 2005. Our processor revenues increased $32,000
during the three months ended June 30, 2006 compared to the same period in the prior year.
The average selling price of these processors remained at relatively the same levels. The
increase in processor revenues between the comparative periods is attributable to the
increase in the volume of processor units sold during the period. The increase in revenues
from software license and royalties of $181,000 resulted from the variability in demand
for and timing of customers purchase of certain of the Companys licensed
software products.

Net
revenues decreased by $3.0 million for the nine months ended June 30, 2006, as compared to
the same period in the prior year. Our processor revenue decreased $2.3 million and was
primarily attributable to a decrease of $1.5 million and $114,000 in revenues from Quantum
and Huawei, respectively. The average selling price of these processors remained at
relatively the same levels. The decrease in processor revenues between the comparable
periods is attributable to decreases in volume. Our revenues from software license and
royalties decreased by $718,000 resulting from the variability in demand for and timing of
customers purchase of certain of the Companys licensed software products.

Semiconductor
and software  sales to Cisco,  an OEM producer of networking  equipment,  comprised 52%
and 53% of revenues for the three months ended June 30, 2006 and 2005,  respectively,  and 52% and 48% for
the nine  months  ended  June 30,  2006 and 2005,  respectively.  Semiconductor  sales to  Huawei,  an OEM
producer of  networking  equipment,  comprised 10% and 14% of revenues for the three months ended June 30,
2006  and  2005,  respectively,  and 13% and 12% for the  nine  months  ended  June  30,  2006  and  2005,
respectively.

Cost
of Revenues.

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

|                            | Three Months Ended
June 30, |  | Year-over-Year |       | Nine Months Ended
June 30, |   | Year-over-Year | 
|--------------------------- | --------------------------- |  | -------------- | ----- | -------------------------- | - | -------------- | 
|
|Processors                  |                             |  | $              | 3,992 |                            | $ | 3,731          | 
|Software licenses and other |                             |  |                | 126   |                            |   | 138            | 
|                            |                             |  |                |       |                            |   |                | 
|                            |                             |  | $              | 4,118 |                            | $ | 3,869          | 
|                            |                             |  |                |       |                            |   |                | 

|                            | % ofrevenuecategory |  | % ofrevenuecategory |     |  |  | % ofrevenuecategory |  | % ofrevenuecategory |  |  | 
|--------------------------- | ------------------- |  | ------------------- | --- |  |  | ------------------- |  | ------------------- |  |  | 
|Processors                  |                     |  |                     | 37% |  |  | 34%                 |  |                     |  |  | 
|Software licenses and other |                     |  |                     | 9%  |  |  | 12%                 |  |                     |  |  | 
|Total                       |                     |  |                     | 34% |  |  | 32%                 |  |                     |  |  | 

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Cost
of revenues consists primarily of semiconductors which were manufactured to our
specifications by third parties for resale by us. Cost of processor revenues as a
percentage of net processor revenues increased three percentage point for the three months
ended June 30, 2006, as compared to the same period in fiscal 2005. The change in cost is
the result of a net change in write down of $226,000 in inventory during the third quarter of fiscal
2006, as compared to fiscal 2005. During the three months ended June 30, 2006, we wrote
down inventories (net of recoveries) of $208,000. During the three months ended June 30,
2005, we sold inventories (net of write downs) of $18,000.

Cost
of processor revenues as a percentage of net processor revenues increased two percentage
points for the nine months ended June 30, 2006, as compared to the same period in fiscal
2005. The change in cost is the result a net change in write down of $300,000 in
inventory during fiscal 2006, as compared to fiscal 2005. During the nine months ended
June 30, 2006 and 2005, we wrote down inventories (net of recoveries) of $330,000 and
$30,000, respectively.

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

Operating
Expenses

Research
and Development.

|                                | Three Months Ended
June 30, |  | Year-over-
Year |       | Nine Months Ended
June 30, |   | Year-over-
Year | 
|------------------------------- | --------------------------- |  | --------------- | ----- | -------------------------- | - | --------------- | 
|
|                                |                             |  |                 |       |                            |   |                 | 
|Research & development expenses |                             |  | $               | 6,040 |                            | $ | 5,365           | 
|As a percentage of net revenues |                             |  |                 | 49%   |                            |   | 45%             | 

Research
and development costs consist primarily of salaries,  employee  benefits,  overhead,  outside
contractors  and  non-recurring  engineering  fees.  Such  research  and  development  expenses  increased
$675,000 for the three months  ended June 30, 2006,  over the same period in the prior year.  The increase
reflects  increases  of $1.1  million  in  expenses  related to  salaries  and  benefits  as a result of a
combination  of higher  average salary rates in connection  with employee  performance  reviews in October
2005,  involuntarily  termination  costs of  $471,000  and  $119,000  as a result of the  adoption of SFAS
123(R),  supplies  increased by $248,000 as a result of an increase in  development  activities,  of which
$227,000  relates  to China  and an increase in  depreciation and miscellaneous  expenses of $496,000,  which  includes  $292,000 for
the  impairment  of software  assets as a result of the  restructuring  and $109,000 for  increased  China
activities.  The increases were partially  offset by a decrease in  non-recurring  engineering  cost of $1.0
million  primarily  due to the timing of costs  associated  with ongoing R&D projects,  of which  $516,000
relates  to  the  reversal  of  previously  accrued  costs  related  to  terminated  projects  due  to the
restructuring, and a decrease of $169,000 in travel and entertainment, professional services and other expenses,
including building expenses due to the expiration of a lease.

Research
and  development  costs for the nine months ended June 30,  2006,  increased  $1.2 million
compared to the same period in the prior year.  The increase  reflects  increases  in expenses  related to
salaries and  benefits of $2.2  million as a result of a  combination  of higher  average  salary rates in
connection  with employee  performance  reviews in October  2005,  $365,000 as a result of the adoption of
SFAS 123(R),  involuntarily  termination costs of $471,000 and $484,000 due to an increase in headcount in
China,  supplies  increased  by $495,000 as a result of an increase in  development  activities,  of which
$376,000  relates to China, an increase in depreciation and  miscellaneous  expenses of $379,000,  which includes  $292,000
for the impairment of software  assets as a result of the  restructuring.  The increases were partially  offset
by a decrease in  non-recurring  engineering  cost of $1.4  million  primarily  due to the timing of costs
associated  with ongoing R&D projects,  of which  $516,000  relates to the reversal of previously  accrued
costs  related to  terminated projects, a decrease of $314,000 in travel and
entertainment and building

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expenses due to the expiration of a lease,
and a decrease in engineering and consulting  services of $207,000  primarily due to the
timing of costs associated with ongoing R&D projects.

Sales
and Marketing.

|                                | Three Months Ended
June 30, |  | Year-over-
Year |       | Nine Months Ended
June 30, |   | Year-over-
Year | 
|------------------------------- | --------------------------- |  | --------------- | ----- | -------------------------- | - | --------------- | 
|
|                                |                             |  |                 |       |                            |   |                 | 
|Sales & marketing expenses      |                             |  | $               | 2,084 |                            | $ | 1,910           | 
|As a percentage of net revenues |                             |  |                 | 17%   |                            |   | 16%             | 

Sales
and marketing expenses consist primarily of salaries, commissions and benefits of sales,
marketing and support personnel as well as consulting, advertising, promotion and overhead
expenses. Such expenses increased $174,000 for the three months ended June 30, 2006, over
the same period in the prior year. The increase primarily relates to an increase in
salaries and benefits of $95,000 due to a combination of higher average salary rates in connection with
employee performance reviews in October 2005 and $50,000 as a result of the adoption of
SFAS 123(R), an increase in travel and entertainment of $34,000 primarily due to the
change in travel schedules, an increase in sales representative commissions of $33,000 due
to a higher level of sales made through sales representatives and an increase of $12,000
in miscellaneous, building and other expenses.

Sales
and marketing expenses decreased $135,000 during the nine months ended June 30, 2006, as
compared to the same period in the prior year. The decrease primarily relates to a
decrease in sales representative commissions of $259,000 due to a lower level of sales
made through sales representatives, a decrease in travel and entertainment of $37,000
primarily due to the change in travel schedules and a reduction in building expenses of
$71,000 as a result of reduced allocation of rental and other costs due to the expiration
of a portion of the lease at our corporate facility. The decrease was partially offset by
increased salaries and benefits of $157,000 due to a combination of salary increases in connection with the
employee performance reviews in October 2005 and $129,000 as a result of the adoption of
SFAS 123(R), together with an increase in miscellaneous and other expense of $75,000.

General
and Administrative.

|                                  | Three Months Ended
June 30, |  | Year-over-
Year |       | Nine Months Ended
June 30, |   | Year-over-
Year | 
|--------------------------------- | --------------------------- |  | --------------- | ----- | -------------------------- | - | --------------- | 
|
|                                  |                             |  |                 |       |                            |   |                 | 
|General & administrative expenses |                             |  | $               | 1,841 |                            | $ | 1,214           | 
|As a percentage of net revenues   |                             |  |                 | 15%   |                            |   | 10%             | 

General
and  administrative  expenses are  comprised  primarily of salaries  for  administrative  and
corporate  services  personnel,  legal and other  professional  fees. Such expenses increased $627,000 for
the three  months  ended June 30, 2006,  over the same period in the prior year.  The  increase  primarily
relates to an increase in  salaries  and  benefits of  $250,000  due to a  combination  of higher  average
salary rates in connection  with employee  performance  reviews in October 2005 and $96,000 as a result of
the adoption of SFAS 123(R),  an increase in professional  services,  miscellaneous  and other expenses of
$415,000  primarily due to the release of general reserves in the June 30, 2005, quarter and the timing of
Sarbanes-Oxley  related  expenses.  These  increases  were  partially  offset by a  reduction  in building
expenses of $38,000 as a result of reduced  allocation of rental and other costs due to the  expiration of
a portion of the lease at our corporate facility.

General
and administrative expenses increased $990,000 during the nine months ended June 30, 2006,
as compared to the same period in the prior year. The increase primarily relates to an increase in
salaries and benefits of $511,000 due to a combination of higher average salary rates in connection with
employee performance reviews in October 2005 and $241,000 as a result of the adoption of SFAS 123(R), an
increase of $582,000 in professional services, miscellaneous and other expenses primarily due to the
release of general reserves in the June 30, 2005,

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quarter and the timing of Sarbanes-Oxley related expenses. These increases were offset by a
reduction in allocated building expense of $103,000 mainly as a result of reduced
allocation of rental and other costs due to the expiration of a portion of the lease at
our corporate facility.

Amortization
of Intangibles.

|                                | Three Months Ended
June 30, |  | Year-over-
Year |     | Nine Months Ended
June 30, |   | Year-over-
Year | 
|------------------------------- | --------------------------- |  | --------------- | --- | -------------------------- | - | --------------- | 
|
|                                |                             |  |                 |     |                            |   |                 | 
|Amortization of intangibles     |                             |  | $               | 784 |                            | $ | 828             | 
|As a percentage of net revenues |                             |  |                 | 6%  |                            |   | 7%              | 

Amortization
of intangibles relate to acquired technology, workforce and patents. Amortization of
intangibles decreased $44,000 for the three months ended June 30, 2006, over the same
period in the prior year mainly as a result of the full amortization of previously
capitalized intangible assets related to the Apptitude and C-Sky asset acquisitions.

Amortization
of intangibles decreased $106,000 for the nine months ended June 30, 2006, over the same
period in the prior year mainly as a result of the full amortization of previously
capitalized intangible assets related to the Apptitude and C-Sky asset acquisitions.

Interest
and Other Income, net.

|                                | Three Months Ended
June 30, |  | Year-over-
Year |     | Nine Months Ended
June 30, |   | Year-over-
Year | 
|------------------------------- | --------------------------- |  | --------------- | --- | -------------------------- | - | --------------- | 
|
|                                |                             |  |                 |     |                            |   |                 | 
|Interest & other income, net    |                             |  | $               | 489 |                            | $ | 345             | 
|As a percentage of net revenues |                             |  |                 | 4%  |                            |   | 3%              | 

Interest
and other income, net, increased $144,000 during the three months ended June 30, 2006, and
$557,000 during the nine months ended June 30, 2006, as compared to the same respective
periods in the prior fiscal year. The increase was primarily a result of the timing in
purchases of higher-average-yield instruments to take advantage of rising interest rates.

Income
Taxes.

|                                | Three Months Ended
June 30, |  | Year-over-
Year |    | Nine Months Ended
June 30, |   | Year-over-
Year | 
|------------------------------- | --------------------------- |  | --------------- | -- | -------------------------- | - | --------------- | 
|
|                                |                             |  |                 |    |                            |   |                 | 
|Provision for income taxes      |                             |  | $               | 85 |                            | $ | 69              | 
|As a percentage of net revenues |                             |  |                 | 1% |                            |   | 1%              | 

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We
recognize income tax expense based on an asset and liability approach that requires
recognition of deferred tax assets and liabilities related to future tax consequences of
events recognized in both our financial statements and income tax returns. Prior to fiscal
2003, we recorded a full valuation allowance for our deferred tax assets. In fiscal 2003,
we recognized a tax benefit of $1.8 million related to carry back of net operating losses
to prior years. We have not recognized tax benefits as a result of continuing losses over
a longer period than previously expected. The increase of $16,000 for the three months
ended June 30, 2006, over the same period in the prior year is the result of our new
entity, Hangzhou Ansai Information Technology Co., Ltd., in China. The
lower income taxes for the nine months ended June 30, 2006, reflects the reversal of
previously accrued tax liability for our non-U.S. operations. We continue to consider
future taxable income and ongoing prudent and feasible tax planning strategies in
assessing the valuation allowance.

# Liquidity and Capital
Resources

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

|                                                    | Nine Months Ended
June 30, | 
|--------------------------------------------------- | -------------------------- | 
|
|
|Net cash used in operating activities               |                            | 
|Net cash provided by investing activities           |                            | 
|Net cash provided by (used in) financing activities |                            | 
|                                                    |                            | 
|Net increase in cash and cash equivalents           |                            | 
|                                                    |                            | 
|                                                    |                            | 

Net
cash used in  operating  activities  of $5.3 million for the nine months ended June 30, 2006,  was
the  result of the net loss of $6.4  million,  which  includes  non-cash  expenses  for  depreciation  and
amortization  of $1.4 million  related to property and equipment and licensed  software,  an impairment of
certain  software  assets in the  amount  of  $292,000,  as part of the  restructuring,  additions  to the
provision for excess and obsolete  inventory in the amount of $455,000,  amortization  of  intangibles  of
$2.4 million in accordance with scheduled  amortization and stock-based  compensation expense of $742,000,
which was the effect of the  adoption  of SFAS 123(R)  during the period.  These  non-cash  expenses  were
offset by a  reduction  of $2.6  million  in accrued  liabilities,  a  reduction  in  accounts  payable of
$218,000  which was related to the timing of payments  made, an increase in prepaid  expenses of $667,000,
as a result of the  timing of  renewing  maintenance  contracts  and  additions  in our China  operations,
together with an increase in accounts  receivables  of $364,000 due to the timing of shipments,  additions
to other  assets of  $104,000  and an  increase  in  inventory  of  $196,000,  mainly due to the timing of
receipt of inventory purchases and the sale of previously reserved obsolete inventory.

Net

cash used in  operating  activities  of $1.3 million for the nine months ended June 30, 2005,  was
the result of net loss of $2.3 million as adjusted for non-cash  items,  which  include  depreciation  and
amortization costs of $1.2 million related to property and equipment and licensed  software,  amortization
of  intangibles  of $2.5 million in accordance  with  scheduled  amortization,  a provision for excess and
obsolete  inventory  in the  amount of  $132,000  together  with a  decreases  in  inventory  of  $262,000
resulting from the timing of purchase  receipts and customer  shipments,  partially  offset by the sale of
previously  reserved obsolete  inventory.  These non-cash expenses together with the decrease in inventory
were  offset by an increase  in other  assets of $251,000 as a result of an increase in software  licenses
and an  increase  in  prepaid  expenses  of  $98,000,  as a result of the timing of  renewing  maintenance
contracts,  together with an increase in accounts receivable of $1.1 million,  resulting from higher sales
levels at the end of the  quarter  and a decrease  in  accounts  payable  and  accrued  and other  current
liabilities  of $1.7  million,  reflecting  the timing in  payments  of trade  payables,  an  increase  in
deferred income and revenues  related to the timing of maintenance  contract  purchases  amortizable  over
the service term and distributor  sell-through of purchased  processors,  offset by a reduction in accrued
vacant facility lease cost in accordance with scheduled amortization.

Net
cash provided by investing activities was $5.6 million for the nine months ended June
30, 2006, and primarily reflects the net sales and maturities of short-term investments
of $7.1 million offset by the purchase of property and equipment of $1.5 million of
which $475,000 relates to our China operations.

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Net
cash provided by investing activities of $13.0 million for the nine months ended June
30, 2005, primarily reflects the net sale of short-term investments of $13.9 million,
as the Company shifted its portfolio mix from municipal bonds to higher interest-yielding
commercial paper, offset by the purchase of property and equipment of $895,000 to replace
older office equipment and acquire office equipment for headcount additions.

Net
cash provided by financing activities for the nine months ended June 30, 2006, of $1.3
million was comprised of cash proceeds from the issuance of common stock for stock option
exercises and employee stock purchase plan purchases which aggregated $1.6 million offset
by installment payments on acquired software licenses of $219,000.

Net
cash used in financing activities for the nine months ended June 30, 2005, was $1.2
million and was comprised of cash proceeds from the issuance of common stock for stock
option exercises and employee stock purchase plan purchases that totaled $1.8 million,
offset by the aggregate repurchase of 422,700 shares of the Companys outstanding
common stock for $2.5 million and installment payments on acquired software licenses of
$530,000.

The
Companys inventory balance decreased by $259,000 to $1.9 million at June
30, 2006, as compared to $2.1 million as of September 30, 2005. The decrease in inventory is a result of
additional provisions for obsolescence of $455,000, partially offset by an increase in inventory of
$196,000, mainly due to the timing of inventory purchases relative to manufacturer lead-time coupled
with anticipated shipment schedules to fill customer orders for the succeeding quarter and the sale of
previously reserved obsolete inventory. The Companys annualized inventory turns in the quarter ended
June 30, 2006, was 9.5 times as compared to 6.8 times in the quarter ended September 30, 2005. The
Companys accounts receivable balance, which is contingent upon the timing of product shipment within
the respective periods, increased $348,000, net of allowance for doubtful accounts of
$16,000, to $5.4 million as of June 30, 2006, reflecting higher sales
levels and revenues in June 2006 as compared to September 2005.

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

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

On
April 25, 2005, the Companys Board of Directors authorized a stock repurchase
program whereby the Company could repurchase shares of the Companys common stock
with an aggregate fair market value of up to $10 million from time to time through open
market and privately negotiated transactions at prices determined by management. The purchase was funded
from available working capital. The stock repurchase program expired on April 25, 2006.
During the quarter ended June 30, 2005, the Company repurchased 422,700 shares under the
program at a cost of $2.5 million. During the quarter ended September 30, 2005, the
Company repurchased 270,194 shares at a cost of $1.8 million. The Company did not
repurchase any shares during the nine months ended June 30, 2006, accordingly, as of June
30, 2006, the aggregate repurchase was a total of 692,894 shares at a cost of
approximately $4.3 million.

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The
Company occupies its facilities under several non-cancelable operating leases that expire
at various dates through June 2010, and which contain renewal options. Additionally,
contractual obligations were also entered into related to non-recurring engineering
services and inventory purchases. Payment obligations for such commitments as of June 30,
2006 are as follows:

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

# Off-Balance Sheet
Arrangements

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

# Guarantees

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

As
permitted under Delaware law, the Company has agreements that provide
indemnification of officers and directors for certain events or occurrences while the
officer or director is, or was serving, at the Companys request in such capacity.
The indemnification period is effective for the officers or directors
lifetime. The maximum potential amount of future payments that the Company could be
required to make under these indemnification agreements is unlimited; however, the Company
has a Director and Officer insurance policy that limits its exposure and enables the
Company to recover a portion of any future amounts paid. All of the indemnification
agreements were grandfathered under the provisions of FIN 45 as they were in effect prior
to December 31, 2002. As a result of the insurance policy
coverage, the Company believes the estimated fair value of the potential liability under
these agreements is minimal. Accordingly, the Company has not recorded any liabilities for
these agreements as of June 30, 2006.

The
Company enters into standard indemnification agreements in the ordinary course of
business. Pursuant to these agreements, the Company indemnifies, holds harmless, and
agrees to reimburse the indemnified party, generally business partners or customers, for losses suffered or
incurred in connection with patent, copyright or other intellectual property infringement
claims by any third party with respect to the Companys products. The term of these
indemnification agreements is generally perpetual, effective after execution of the
agreement. The maximum potential amount of future payments the Company could be required
to make under these indemnification agreements is unlimited. To date, the Company has not
incurred costs to defend lawsuits or settle claims related to these indemnification
agreements. Accordingly, the Company has not recorded any liabilities for these
agreements as of June 30, 2006. However, the Company may, in the future, record charges
related to indemnification obligations and,

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depending upon the nature of any such lawsuit
or claim, the estimated fair value of such indemnification obligations may be material.

The
Company warrants that its hardware products are free from defects in material and
workmanship under normal use and service and that its hardware and software products will
perform in all material respects in accordance with the standard published specifications
in effect at the time of delivery of the licensed products to the customer. The warranty
periods generally range from three months to one year for software and one year for
hardware. Additionally, the Company warrants that its maintenance services will be
performed consistent with generally accepted industry standards through completion of the
agreed upon services. The Companys policy is to provide for the estimated cost of
product and service warranties based on specific warranty claims and claim history as a
charge to cost of revenues. To date, the Company has not incurred significant expense
under its product or service warranties. As a result, the Company has not recorded an
accrual related to product or warranty services as of June 30, 2006. The Company assesses
the need for a warranty accrual every quarter. There is no assurance that a warranty
accrual will not be necessary in the future.

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:

Restructuring Activities May
Result In Unforeseen Negative Results To Operations And Customer Relations.

On
June 28, 2006 the Company announced a restructuring activity that reduced engineering
personnel and associated operating expenses in an effort to return to profitability.
Certain development projects were cancelled. The Company does not expect this to have an
adverse effect on customer relations but this cannot be assured.  With redirected
engineering effort, particularly in the area of network processing, customers may
accelerate their migration from existing designs to alternative solutions from our
competitors.

With
the closing of the Carlsbad, California facility the order fulfillment
function will be transferred to an alternate location during the last quarter of fiscal 2006. This move may affect the timely
shipments of product to the Companys customers.

The
restructuring significantly reduced the research and development resources in the
United States.  While the Company believes that the relations with
the employees still remains good, it is possible that unanticipated turnover may
accelerate from the remaining staff.

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

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

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

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

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

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

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

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

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

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

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

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

The
Companys major customers are generally original equipment manufacturers with
manufacturing subcontractors who purchase products directly from us. The end customers and
their respective contribution to net revenues for the respective periods are a follows:

|                          | Three Months Ended
June 30, |  | Nine Months Ended
June 30, |    | Year Ended
September 30, | 
|------------------------- | --------------------------- |  | -------------------------- | -- | ------------------------ | 
|
|Cisco Systems, Inc.       |                             |  |                            | 52 | %                        | 
|Huawei Technologies, Inc. |                             |  |                            | 10 | %                        | 
|Quantum Corporation       |                             |  |                            | 8  | %                        | 
|                          |                             |  |                            |    |                          | 
|                          |                             |  |                            | 70 | %                        | 

Cisco,
Quantum and Huawei are not under any binding obligation to order from us. If our sales to
Cisco, Quantum or Huawei decline, our business, financial condition and results of
operations could suffer. During the three months ended June 30, 2006, sales to
Cisco and Quantum increased 8% and 38%, respectively. Sales to Huawei decreased 40% as
compared to the previous quarter. Such fluctuations significantly affected the Companys
revenue levels and results of operations from quarter to quarter. It is possible 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, Nortel
Networks, Inc. and 3Com Corporation. As a result, our future success will depend upon our
ability to establish and maintain relationships with these companies. If these network
equipment vendors do not incorporate our packet processors into their products, our
business, financial condition and results of operations could suffer.

# Our Operating Results
May Fluctuate Significantly.

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

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

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

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

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

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

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

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

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

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

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

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

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

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# 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 Toshiba Corporation, Philips
Semiconductor and IBM. Since we depend upon independent manufacturers, we do not directly
control product delivery schedules or product quality. None of our products are
manufactured by more than one supplier. Since the semiconductor industry is highly
cyclical, foundry capacity has been very limited at times in the past and may become
limited in the future.

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

| |  | Adapting
  our   product   design,   if   necessary,   to  the  new          manufacturer's
process;
| | - | ----------------------------------------------------------------------------------------------------

| |  | Creating
a new mask set to manufacture the product;
| | - | ---------------------------------------------------

| |  | Having
 the new  manufacturer  prepare  sample  products  so we can          verify the product
specification; and
| | - | ------------------------------------------------------------------------------------------------------------------

| |  | Providing
sample products to customers for qualification.
| | - | ---------------------------------------------------------

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

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

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

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# 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 stockholder equity,
incur debt and contingent liabilities and amortize acquisition expenses related to
intangible assets, any of which could harm our operating results and/or the price of our
Common Stock. Acquisitions entail numerous risks, including:

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

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

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

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

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

# We Face Order And
Shipment Uncertainties, Which Makes It Difficult To Forecast Future Revenues Accurately
And May Cause Us To Hold Too Much Inventory.

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, by increasing our costs
without a commensurate increase in revenue, could harm our profit margins and restrict our
ability to fund our operations. Such variability in customer demand coupled with
customers ability to cancel orders on short notice also makes it more difficult to
forecast future revenue. For example, during fiscal 2001, we wrote off excess inventory of
$3.4 million as a result of a significant decrease in forecasted demand for our products.
We recognize revenue upon shipment of products to our customers. Revenue from products
sold to distributors is deferred until the distributor sells the products to a third
party. An unanticipated level of returns could harm our business, financial condition and
results of operations.

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

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

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

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

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

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

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

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

| |  | 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. During fiscal 2004, we acquired certain technology
for embedded processors, pattern matching and network processors. We may experience
substantial difficulty in introducing new products, such as new products containing the
acquired technologies and we may be unable to offer enhancements to existing products on a
timely or cost-effective basis, if at all. For instance, the performance of our
encryption/compression and public key processors depends upon the integrity of our
security technology. If any significant advances in overcoming cryptographic systems are
made, then the security of our encryption/compression and public key processors will be
reduced or eliminated unless we are able to develop further technical innovations that
adequately enhance the security of these products. Our inability to develop and introduce
new products or enhancements directed at new industry standards could harm our business,
financial condition and results of operations.

# Our Markets Are Highly
Competitive.

We
compete in markets that are intensely competitive and are expected to become increasingly
competitive as current competitors expand their product offerings and new competitors
enter the market. The markets that we compete in are subject to frequent product
introductions with improved price-performance characteristics, rapid technological change,
and the continued emergence of new industry standards. Our products compete with offerings
from companies such as SafeNet, Inc., Broadcom Corporation, Cavium Networks, Freescale
Technologies, Inc., Intel Corporation, Agere Systems and Applied Micro Circuits
Corporation. Hifn was a wholly-owned subsidiary of Stac, Inc. until Hifns spin-off
from Stac in 1996 upon which Stac assigned two license agreements entered into with IBM in
1994 in which Stac granted IBM the right to use, but not sublicense, our patented
compression technology in IBM hardware and software products. Stac also assigned to us its
license agreement with Microsoft Corporation (Microsoft) in 1994 whereby Stac
granted Microsoft the right to use, but not sublicense, our compression technology in
their software products. We expect significant future competition from major domestic and
international semiconductor suppliers. Several established electronics and semiconductor
suppliers have recently entered, or expressed an interest to enter, the network equipment
market. We also may face competition from suppliers of products based on new or emerging
technologies. Furthermore, many of our existing and potential customers internally develop
solutions which attempt to perform all or a portion of the functions performed by our
products.

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

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

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

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

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

| |  | Price;
| | - | ------

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

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

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

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

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

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

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

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

# Our Success Depends Upon
Protecting Our Intellectual Property.

Our
proprietary technology is critical to our future success. We rely in part on patent,
trade, trademark, mask work and copyright law to protect our intellectual property. We own
twenty-four (24) United States patents and nine foreign patents. Our
issued patents and patent applications primarily cover various aspects of our compression,
flow classification, bandwidth management, cryptographic packet processing, rate shaping
and pattern matching technologies and have expiration dates ranging from 2006 to 2022. We
also have three pending patent applications in the United States and a total
of fourteen (14) in Europe, Asia, China and Australia covering flow
classification, cryptographic packet processing, and pattern matching. Patents may not be
issued under our current or future patent applications, and the patents issued under such
patent applications could be invalidated, circumvented or challenged. In addition, third parties could
make infringement claims against us in the future. Such infringement claims could result
in costly litigation. We may not prevail in any such litigation or be able to license any
valid and infringed patents from third parties on commercially reasonable terms, if at
all. Regardless of the outcome, an infringement claim would likely result in substantial
cost and diversion of our resources. Any infringement claim or other litigation against
us or by us could harm our business, financial condition and results of operations. The
patents issued to us may not be adequate to protect our proprietary rights, to deter
misappropriation or to prevent an unauthorized third party from copying our technology,
designing around the patents we own or otherwise obtaining and using our products,
designs or other information. In addition, others could develop technologies that are
similar or superior to our technology.

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

# Network And Storage
Equipment Prices Typically Decrease.

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

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

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

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

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

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

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

# We Depend Upon Key
Personnel.

Our
success greatly depends on the continued contributions of our key management and other
personnel, many of whom would be difficult to replace. We do not have employment contracts
with any of our key personnel, nor do we maintain any key man life insurance on any of our
personnel. We have recently entered into severance and change of control agreements with
our executive and other officers, however, there can be no assurance that such personnel
will necessarily remain with the Company. 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.

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

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

# We Face Risks Associated
With Our International Business Activities.

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

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

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

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

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

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

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

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

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

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

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

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

Since
the Peoples Republic of China (PRC) regulations do not allow a wholly
foreign-owned enterprise to contract with the Chinese government, Hifn opted to create a
contractually controlled company called Hangzhou Ansai Information Technology Co., Ltd.
(Ansai), to expand our business in the PRC. Hifn International, one of the
subsidiaries of Hifn, controls Ansai by contractual arrangement only and does not have any
equity ownership in the company. These contractual arrangements should provide control
over Ansai similar to that of direct ownership.

As
of June 30, 2006, the aggregate amount of loans to the shareholders of Ansai was RMB 2.0
million (USD $250,000). Depending on future operational needs and profitability, Ansai may
require additional loans in the future.

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# 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.

# Our Stock Price May Be
Volatile.

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

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

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

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

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

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

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

# The Common Stock Sold In
Our Private Offering Increased, While The Common Stock Purchased Under Our Repurchase Program
Decreased, The Supply Of Our Common Stock On The Public Market, Which May Cause Our
Stock Price To Decline.

On
April 9, 2004, the Registration Statement on Form S-3 relating to
the sale of 2,200,000 shares of our Common Stock in a private equity offering on
February 6, 2004 was declared effective. The shares of Common Stock
becoming eligible for immediate and unrestricted resale into the public market at any time
could adversely affect the market price of our
Common Stock and the presence of these additional shares of Common Stock in the public
market may further depress our stock price.

On
April 25, 2005, our Board of Directors authorized a stock repurchase program for the
repurchase of shares of the Companys Common Stock with an aggregate fair market
value of up to $10.0 million from time to time through open market and privately
negotiated transactions at prices determined by management. The stock repurchase program
expired on April 25, 2006. Through June 30, 2006, the Company repurchased a total of
692,894 shares under the program, which shares have been held in treasury stock, at a cost
of $4.3 million. The increase or decrease in our levels of repurchase could affect the
market price of our Common Stock.

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

We
perform impairment analyses of goodwill and long-lived and intangible assets on an annual
basis. During fiscal 2003 and 2002, we determined that impairment had been realized on
certain developed technology and goodwill, resulting in recognition of impairment charges
of $3.9 million and $27.4 million, respectively. Pursuant to SFAS 142, Goodwill and
Other Intangible Assets, we will continue to perform an annual impairment test and
if, as a result of this analysis, we determine that there has been an impairment of our
goodwill and other long-lived and intangible assets, asset impairment charges will be
recognized. Approximately $1.0 million of goodwill remains as of June 30, 2006. 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.

# Recent Accounting
Pronouncements

In
May 2005, as part of a broader attempt to eliminate differences with the
International Accounting Standards Board, the Financial Accounting Standards Board
(FASB) issued Statement of Financial Accounting Standards No. 154
(SFAS 154), Accounting Changes and Error Corrections, which
replaces Accounting Principles Board Opinion No. 20 (APB 20),
Accounting Changes, and FASB Statement of Financial Accounting Standards
No. 3, Reporting Accounting Changes in Interim Financial Statements.
APB 20 had required that changes in accounting principles be recognized by
including the cumulative effect of the change in the period in which the new accounting
principle was adopted. SFAS 154 requires retrospective application of the change to prior
periods financial statements, unless it is impracticable to determine the
period-specific effects of the change. The Statement is effective for fiscal years or
periods beginning after December 15, 2005. The adoption of this statement did not
have a material effect on the Companys financial statements.

In
July 2006, the FASB issued FASB  Interpretation 48, Accounting for Income Tax
Uncertainties  (FIN 48). FIN 48 defines the threshold for  recognizing  the benefits of
tax return  positions in the financial statements  as  more-likely-than-not  to  be
 sustained  by  the  tax  authority.  The  recently  issued literature  also  provides
 guidance on the  recognition,  measurement  and  classification  of income tax
uncertainties,  along with any related interest and penalties.  FIN 48 also includes
 guidance  concerning accounting  for income tax  uncertainties  in  interim  periods
 and  increases  the level of  disclosures associated  with  any  recorded  income  tax
 uncertainties.  FIN 48 is  effective  for the  fiscal  years beginning  after December
15, 2006. The  differences  between the amounts  recognized in the statements of
financial  position  prior to the  adoption  of FIN 48 and the amounts  reported  after
 adoption  will be accounted for as a  cumulative-effect  adjustment  recorded to the
beginning balance of retained earnings. We are evaluating the impact,  if any, of
adopting the provisions of FIN 48 on our financial  position and results of operations.

# Item 3. Quantitative And
Qualitative Disclosures About Market Risk

Interest
Rate Risk  The Company does not use derivative financial instruments in its
investment portfolio. The Companys investment portfolio is generally comprised of
commercial paper. The Company places investments in instruments that meet high credit
quality standards. These securities are subject to interest rate risk, and could decline
in value if interest rates fluctuate. Due to the short duration and conservative nature of
the Companys investment portfolio, the Company does not expect any material loss
with respect to its investment portfolio. A 10% change in interest rates at June 30, 2006
would not have a material effect on the Companys pre-tax earnings and the fair value
of its investments.

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

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# Item 4. Controls And
Procedures

(a)Evaluation
of disclosure controls and procedures. We maintain disclosure           controls and
procedures that are designed to ensure that information required to           be
disclosed by us in reports that we file or submit under the Securities           Exchange
Act of 1934, as amended, is recorded, processed, summarized and           reported within
the time periods specified in Securities and Exchange Commission           rules and
forms and that such information is accumulated and communicated to our
          management, including our Chief Executive Officer and Chief Financial Officer,
          as appropriate to allow timely decisions regarding required disclosure.

Based
on their evaluation as of the end of the period covered by this Quarterly Report on Form
10-Q, our Chief Executive Officer and Chief Financial Officer have concluded that our
disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Act of 1934, as amended, are effective to ensure that information that is
required to be disclosed in this Quarterly Report on Form 10-Q is recorded, processed,
summarized and reported within the
time periods specified in SEC rules and forms and is accumulated and communicated to our
Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely
decisions regarding required disclosure.

(b)Changes
in internal controls over financial reporting. There was no change in our internal
control over financial reporting that was identified in connection with our evaluation of
disclosure controls and procedures that occurred during the quarter ended June 30, 2006
that has materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting.

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PART
II  OTHER INFORMATION

# Item 5. Other Information

In
accordance with Section 10A(i)(2) of the Securities Exchange Act of 1934, as added by
Section 202 of the Sarbanes-Oxley Act of 2002 (the Act), we are required to
disclose the non-audit services approved by our Audit Committee to be performed by
PricewaterhouseCoopers LLP, our external accountants. Non-audit services are defined in
the Act as services other than those provided in connection with an audit or a review of
the financial statements of a company. The Audit Committee approved the engagement of
PricewaterhouseCoopers LLP for work related to the Acts Section 404 certification
requirements.

# Item 6. Exhibits

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

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SIGNATURES

Pursuant to the requirements of the
Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned thereunto duly authorized.

|Date: August 9, 2006 |  | hi/fn, inc.(Registrant)BY: /s/ William R. Walker
William R. WalkerVice President, Finance, Chief Financial Officer and Secretary (duly authorized officer and principal financial and accounting officer)
|-------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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# INDEX TO EXHIBITS

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

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