Table of Contents







**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 Washington,
        D.C. 20549
 
  **FORM
        10-Q**
  þQUARTERLY
        REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
        1934
 
 For
        the
        Quarterly Period Ended June 30, 2007
 
 oTRANSITION
        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
              (IRS
                  EmployerIncorporation
                  or Organization)
              Identification
                  Number)
 
 **750
        University Avenue, Los Gatos, California 95032**
 (Address
        of principal executive offices and Zip Code)
 
 Registrant’s
        telephone number, including area code: **(408)
        399-3500**
 
 Indicate
        by check mark if the Registrant is a well-known seasoned issuer, as defined
        in Rule
        405
        of the Securities Act.
 
 YES
o
        NO þ
 
 Indicate
        by check mark whether the Registrant (1) has filed all reports required to
        be
        filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
        the
        preceding 12 months (or for such shorter period that the Registrant was required
        to file such reports), and (2) has been subject to such filing requirements
        for
        the past 90 days.
 
 YES
þ
        NO o
 
 Indicate
        by check mark 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 o Accelerated
        filer þ Non-accelerated filer o
 
 Indicate
        by check mark whether the Registrant is a shell company (as defined in Rule
        12b-2 of the Act).
 
 YES
o
        NO þ


The
        number of shares outstanding of the Registrant’s Common Stock, par value $.001
        per share, was 14,215,475 at August 3, 2007.


Table
            of Contents
  **HIFN,
        INC.**
 
 **INDEX
        TO FORM 10-Q**
 
 PART
                  I.
              FINANCIAL
                  INFORMATIONItem
                  1.
              Financial
                  Statements (unaudited)Condensed
                  Consolidated Balance
                  Sheets
                as of June 30, 2007 and September 30,
                  2006
              3Condensed
                    Consolidated Statements of
                    Operations
                  for
                    the three months and nine months ended June 30,
                    2007 and June 30, 2006
              4Condensed
                    Consolidated Statements of Cash
                    Flows
                  for
                    the nine months ended June 30, 2007 and June 30,
                    2006
              5Notes
                  to Condensed Consolidated Financial
                  Statements
              6
                  -
                  15Item
                  2.
              Management’s
                  Discussion and Analysis of Financial Condition
                  and Results of Operations
              15
                  - 26Item
                  3.
              Quantitative
                  and Qualitative Disclosures About Market
                  Risks
              26Item
                  4.
              Controls
                  and Procedures
              26PART
                  II.
              OTHER
                  INFORMATIONItem
                  1A.
              Risk
                  Factors
              27
                  - 37Item
                2(c)
              Purchase
                of Equity Securities by the Issuer
              38Item
                  6.
              Exhibits
              38Signatures
              39Index
                  to ExhibitsExhibit
                31.1Exhibit
                31.2Exhibit
                32.1Exhibit
                32.2
 Table
              of Contents


**PART
      1– FINANCIAL INFORMATION**





**Item
      1.Financial Statements**







**HIFN,
                INC.****CONDENSED
                CONSOLIDATED BALANCE SHEETS**(in
                thousands)
              (unaudited)**June
                  30,**
                **2007**
            
            
            **September
                  30,**
                **2006****ASSETS**CURRENT
                ASSETS:Cash
                and cash equivalents
            
            $
            19,386
            
            
            $
            20,437Short-term
                investments
            
            18,077
            
            
            18,340Accounts
                receivable, net
            
            
            5,425
            
            
            
            4,614Inventories
            
            
            3,461
            
            
            
            2,028Prepaid
                expenses and other current assets
            
            
            1,461
            
            
            
            1,571Total
                current assets
            
            
            47,810
            
            
            
            46,990Property
                and equipment, net
            
            
            2,061
            
            
            
            2,356Goodwill
                and intangible assets, net
            
            
            4,669
            
            
            
            6,881Other
                assets
            
            
            1,551
            
            
            
            1,249$
            56,091
            
            
            $
            57,476**LIABILITIES
                AND STOCKHOLDERS’ EQUITY**CURRENT
                LIABILITIES:Accounts
                payable
            
            $
            2,150
            
            
            $
            1,672Accrued
                expenses and other current liabilities
            
            
            3,918
            
            
            
            5,119Total
                current liabilities
            
            
            6,068
            
            
            
            6,791STOCKHOLDERS’
                EQUITY:Common
                stock
            
            
            14
            
            
            
            14Additional
                paid-in capital
            
            
            168,736
            
            
            
            166,100Accumulated
                other comprehensive loss
            
            
            -
            
            
            
            (1
            )Accumulated
                deficit
            
            
            (114,300
            )
            
            
            (111,175
            )Treasury
                stock, at cost
            
            
            (4,427
            )
            
            
            (4,253
            )Total
                stockholders’ equity
            
            
            50,023
            
            
            
            50,685$
            56,091
            
            
            $
            57,476




See
      accompanying notes to condensed consolidated financial statements.


-3-
 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,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006**Net
                  revenues:Processors
              
              $
              11,046
              
              
              $
              10,917
              
              
              $
              29,819
              
              
              $
              31,765Software
                  licenses and other
              
              
              625
              
              
              
              1,335
              
              
              
              2,150
              
              
              
              2,878Total
                  net revenues
              
              
              11,671
              
              
              
              12,252
              
              
              
              31,969
              
              
              
              34,643Costs
                  and operating expenses:Cost
                  of revenues – processors
              
              
              3,882
              
              
              
              3,992
              
              
              
              10,517
              
              
              
              11,550Cost
                  of revenues – software licenses and other
              
              
              82
              
              
              
              126
              
              
              
              247
              
              
              
              379Research
                  and development
              
              
              2,916
              
              
              
              5,748
              
              
              
              10,336
              
              
              
              16,932Sales
                  and marketing
              
              
              2,097
              
              
              
              2,084
              
              
              
              6,036
              
              
              
              5,878General
                  and administrative
              
              
              1,940
              
              
              
              1,841
              
              
              
              7,040
              
              
              
              4,960Amortization
                  of intangible assets
              
              
              737
              
              
              
              1,076
              
              
              
              2,212
              
              
              
              2,670Total
                  costs and operating expenses
              
              
              11,654
              
              
              
              14,867
              
              
              
              36,388
              
              
              
              42,369Income
                  (loss) from operations
              
              
              17
              
              
              
              (2,615
              )
              
              
              (4,419
              )
              
              
              (7,726
              )Interest
                  and other income, net
              
              
              489
              
              
              
              489
              
              
              
              1,469
              
              
              
              1,358Income
                  (loss) before income taxes
              
              
              506
              
              
              
              (2,126
              )
              
              
              (2,950
              )
              
              
              (6,368
              )Provision
                  for income taxes
              
              
              222
              
              
              
              85
              
              
              
              175
              
              
              
              15Net
                  income (loss)
              
              $
              284
              
              
              $
              (2,211
              )
              
              $
              (3,125
              )
              
              $
              (6,383
              )Net
                  income (loss) per share-
                  Basic
              
              $
              0.02
              
              
              $
              (0.16
              )
              
              $
              (0.22
              )
              
              $
              (0.47
              )-
                  Diluted
              
              $
              0.02
              
              
              $
              (0.16
              )
              
              $
              (0.22
              )
              
              $
              (0.47
              )Weighted
                  average shares outstanding-
                  Basic
              
              
              14,109
              
              
              
              13,842
              
              
              
              14,010
              
              
              
              13,725-
                  Diluted
              
              
              14,398
              
              
              
              13,842
              
              
              
              14,212
              
              
              
              13,725




See
        accompanying notes to condensed consolidated financial statements.


-4-
 Table
          of Contents




**HIFN,
                INC.****CONDENSED
                CONSOLIDATED STATEMENTS OF CASH FLOWS**(in
                thousands)
              (unaudited)**Nine
                  Months Ended**
                **June
                  30,****2007**
            
            
            **2006**Cash
                flows from operating activities:Net
                loss
            
            $
            (3,125
            )
            
            $
            (6,383
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation and amortization
            
            
            1,342
            
            
            
            1,388Amortization of intangible assets
            
            
            2,212
            
            
            
            2,378Asset impairment
            
            
            -
            
            
            
            292Stock-based compensation expense
            
            
            1,749
            
            
            
            742Provision for (recovery of) excess and obsolete inventory
            
            
            (79
            )
            
            
            455Allowance for doubtful accounts
            
            
            7
            
            
            
            16Changes
                in assets and liabilities:Accounts receivable
            
            
            (818
            )
            
            
            (364
            )Inventories
            
            
            (1,354
            )
            
            
            (196
            )Prepaid expenses and other current assets
            
            
            110
            
            
            
            (667
            )Other assets
            
            
            (836
            )
            
            
            (104
            )Accounts payable
            
            
            478
            
            
            
            (218
            )Accrued expenses and other current liabilities
            
            
            (1,201
            )
            
            
            (2,639
            )Net cash used in operating activities
            
            
            (1,515
            )
            
            
            (5,300
            )Cash
                flows from investing activities:Sale
                and maturities of short-term investments
            
            
            28,691
            
            
            
            19,598Purchases
                of short-term investments
            
            
            (28,427
            )
            
            
            (12,533
            )Purchases
                of property and equipment
            
            
            (513
            )
            
            
            (1,443
            )Net cash (used in) provided by investment activities
            
            
            (249
            )
            
            
            5,622Cash
                flows from financing activities:Proceeds
                from issuance of common stock for stock option exercises and employee
                stock purchase plan, net
            
            
            887
            
            
            
            1,566Repurchase
                of common Stock
            
            
            (174
            )
            
            
            -Installment
                payments on acquired software licenses
            
            
            -
            
            
            
            (219
            )Net cash provided by financing activities
            
            
            713
            
            
            
            1,347Net
                (decrease) increase in cash and cash equivalents
            
            
            (1,051
            )
            
            
            1,669Cash
                and cash equivalents at beginning of period
            
            
            20,437
            
            
            
            23,179Cash
                and cash equivalents at end of period
            
            $
            19,386
            
            
            $
            24,848




See
      accompanying notes to condensed consolidated financial
      statements.


-5-
 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, Hifn (Hangzhou) Information Technologies Co., Ltd (previously known
      as 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,” “Hifn,” “we,” “us” or
“our”) is a network- and storage-security and data reduction market leader that
      supplies major network and storage original equipment manufacturers (“OEMs”)
      with patented technology for the continuous protection of information, whether
      it is in transit on a network or at rest on storage. 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 and encryption processing speeds available in the market,
      multi-protocol capabilities, development tools and board level products with
      high-levels of integration that help reduce their 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 and content search
      solutions are used in networking, security and storage equipment such as
      routers, remote access concentrators, Virtual Private Networks (“VPN”), Virtual
      Tape Libraries (“VTL”), Nearline storage systems, switches, broadband access
      equipment, network interface cards, firewalls and back-up storage
      devices.





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, 2006. In the opinion of
      management, the accompanying condensed consolidated financial statements contain
      all adjustments, consisting only of normal recurring adjustments, which the
      Company believes is necessary for a fair statement of the Company’s financial
      position as of June 30, 2007 and its results of operations for the three and
      nine months ended June 30, 2007 and June 30, 2006, respectively. These condensed
      consolidated financial statements are not necessarily indicative of the results
      to be expected for the entire year, or in any future period.





The
      Company has an accumulated
      deficit of $114.3 million as of June 30, 2007 with net income of $284,000 for
      the three months ended, and a net loss of $3.1 million for the nine months
      ended, June 30, 2007. The Company believes that its existing cash, cash equivalents
      and short-term investments will fund any anticipated operating losses and
      purchases of capital equipment and will provide adequate working capital for
      the
      next twelve months. The Company’s liquidity is affected by many factors
      including, among others, the extent to which the Company pursues additional
      capital expenditures, the level of the Company’s product development efforts,
      and other factors related to the uncertainties of the industry and global
      economies. Accordingly, there can be no assurance that events in the future
      will
      not require the Company to seek additional capital sooner or, if so required,
      that such capital will be available on terms acceptable to the Company, if
      at
      all.





**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.




-6-
 Table
          of Contents


**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 its
      expanding development capacity in China. The actions were aimed to reduce the
      Company’s cost structure, including a reduction in its North America workforce
      by 43 employees, which represented about 21% of its overall workforce at the
      time, the impact of the termination of certain engineering projects and the
      closure of the facility in Carlsbad, California.




*Involuntary
      Termination Cost*





**Expense**
              **Accrued**
              **June
                30, 2006**
            
            
            **Adjustments**
            
            
            **Paid
                as of**
              **September
                30,**
              **2006**
            
            
            **Balance**
              **September
                30,**
              **2006**(in
                thousands)Cost
                of revenues
            
            $
            64
            
            
            $
            (6
            )
            
            $
            53
            
            
            $
            5Research
                and development
            
            
            471
            
            
            
            (17
            )
            
            
            454
            
            
            
            -Sales
                and marketing
            
            
            59
            
            
            
            -
            
            
            
            59
            
            
            
            -General
                and administrative
            
            
            24
            
            
            
            -
            
            
            
            24
            
            
            
            -Total
            
            $
            618
            
            
            $
            (23
            )
            
            $
            590
            
            
            $
            5





The
      remaining balance was paid during the first quarter of fiscal 2007.





*Impairment
      Of Long-lived Assets*





The
      restructure resulted in a $292,000 impairment of certain software assets related
      to projects that were terminated.





*Non-recurring
      Engineering Expense Recovery*





The
      cancellation of engineering 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 condensed consolidated
      statement of operations.





*Termination
      Of Operating Lease*





As
      part
      of the restructure, the Company closed its facility in Carlsbad, California
      and
      ceased use of the facility as of September 30, 2006. A liability related to
      the
      Carlsbad facility of $550,000 was accrued during the last quarter of fiscal
      year
      2006, reflecting the fair value of the future lease obligations, net of sublease
      income at the time. During the second quarter of fiscal 2007, the estimated
      fair
      value of the future lease obligations, net of sublease income, was increased
      by
      $118,000, due to changes in market conditions. The non-cancelable lease
      agreement for this facility terminates in June 2010. At June 30, 2007, the
      remaining lease obligation is estimated to be $1.2 million, which will be paid
      monthly for the remainder of the lease contract period. Additional costs of
      approximately $74,000 were incurred in the fourth quarter of fiscal 2006 for
      the
      relocation of operations and equipment from the closing facility. As of June
      30,
      2007, $555,000 of the remaining lease cost was included in accrued expenses
      and
      other current liabilities in the accompanying condensed consolidated balance
      sheet.





*Net
      Restructuring Cost*





Including
      the fair value of the lease obligation and relocation costs, the net expense
      for
      the restructure as of June 30, 2007 amounted to $1.1 million. All remaining
      expenses, with the exception of the Carlsbad lease, were paid during the first
      quarter of fiscal year 2007.  These payments were funded by available
      cash on hand.




-7-
 Table
          of Contents


**Note
      2 -
      Balance Sheet Components**





**June
                  30,**
                **2007**
            
            
            **September
                  30, 2006**(in thousands)Property
                and equipment:Computer
                equipment
            
            $
            8,333
            
            
            $
            7,932Furniture
                and
                fixtures
            
            
            888
            
            
            
            1,068Leasehold
                improvements
            
            
            784
            
            
            
            778Office
                equipment
            
            
            903
            
            
            
            91110,908
            
            
            
            10,689Less:
                accumulated
                depreciation
            
            
            (8,847
            )
            
            
            (8,333
            )$
            2,061
            
            
            $
            2,356





Intangible
                assets:Developed
                and core technology
            
            
            $
            14,196
            
            
            $
            14,196Workforce
            
            
            
            159
            
            
            
            15914,355
            
            
            
            14,355Less: accumulated amortization
            
            
            
            (10,715
            )
            
            
            (8,503
            )3,640
            
            
            
            5,852Goodwill
            
            
            
            1,029
            
            
            
            1,029$
            4,669
            
            
            $
            6,881The
                estimated future amortization expense related to intangible assets
                as of
                June 30, 2007 is as follows:Fiscal
                year ending September 30,2007
                (3 months ended)
            
            $
            6982008
            
            
            2,3542009
            
            
            588Total
                estimated amortization
            
            $
            3,640Other
                assets:Design tools and other licensed intellectual property
            
            
            $
            1,200
            
            
            $
            916Refundable deposits
            
            
            
            351
            
            
            
            333$
            1,551
            
            
            $
            1,249Accrued
                expenses and other current liabilities:Compensation and employee benefits
            
            
            $
            1,530
            
            
            
            1,964Deferred income and revenue
            
            
            
            974
            
            
            
            641Accrued vacant facility lease cost
            
            
            
            962
            
            
            $
            1,560Accrued non-recurring engineering costs
            
            
            
            28
            
            
            
            510Income taxes payable
            
            
            
            -
            
            
            
            30Other
            
            
            
            424
            
            
            
            414$
            3,918
            
            
            $
            5,119




-8-
 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,****2007**
            
            
            **2006**
            
            
            **2007**
            
            
            **2006**Outstanding
                options to purchase common stock
            
            
            4,206,478
            
            
            
            4,090,703
            
            
            
            4,206,478
            
            
            
            4,090,703




**Note
      4 - Comprehensive Income (Loss)**





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





**Three
                  Months Ended**
                **June
                  30,**
            
            
            **Nine
                  Months Ended**
                **June
                  30,****2007**
            
            
            **2006**
            
            
            **2007**
            
            
            **2006**(in
                thousands)Net
                income
                (loss)
            
            $
            284
            
            
            $
            (2,211
            )
            
            $
            (3,125
            )
            
            $
            (6,383
            )Unrealized
                gain/(loss) on
                financial instruments
            
            
            (6
            )
            
            
            (6
            )
            
            
            1
            
            
            
            20Comprehensive
                income
                (loss)
            
            $
            278
            
            
            $
            (2,217
            )
            
            $
            (3,124
            )
            
            $
            (6,363
            )




**Note
      5 – Employee Stock Benefit Plans**





**Employee
      Stock Option Plan**





As
      of June 30, 2007, 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
      quarter ended December 31, 2005, 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. As of June 30, 2007, 66,558 options remained outstanding under the
      Apptitude Plan.





As
      of June 30, 2007, the 1996 Plan
      had 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 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.


-9-
 Table
          of Contents


As
      of June 30, 2007, 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 Apptitude Plan and the 2001 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, 2006
              
              
              1,920,859
              
              
              
              3,539,998
              
              
              $
              10.09Options
                    granted
              
              
              (904,550
              )
              
              
              904,550
              
              
              
              5.01Options
                    exercised
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              
              -Options
                    cancelled
              
              
              162,335
              
              
              
              (162,335
              )
              
              
              12.09Balance
                    at December 31, 2006
              
              
              1,178,644
              
              
              
              4,282,213
              
              
              
              8.94Options
                    granted
              
              
              (104,500
              )
              
              
              104,500
              
              
              
              6.07Options
                    exercised
              
              
              -
              
              
              
              (5,697
              )
              
              
              2.81
              
              
              
              
              15Options
                    cancelled
              
              
              163,295
              
              
              
              (163,295
              )
              
              
              8.41Balance
                    at March 31, 2007
              
              
              1,237,439
              
              
              
              4,217,721
              
              
              
              8.90Options
                    granted
              
              
              (318,850
              )
              
              
              318,850
              
              
              
              6.16Options
                    exercised / vested
              
              
              -
              
              
              
              (154,738
              )
              
              
              2.15
              
              
              
              
              666Options
                    cancelled
              
              
              175,355
              
              
              
              (175,355
              )
              
              
              6.92Balance
                    at June 30, 2007
              
              
              1,093,944
              
              
              
              4,206,478Fully
                    vested and expected to vest at June 30, 2007
              
              
              
              
              
              
              4,080,637
              
              
              $
              9.03
              
              5.96
              
              $
              1,513Fully
                    vested and exercisable at June 30, 2007
              
              
              
              
              
              
              3,029,294
              
              
              $
              10.20
              
              4.91
              
              $
              1,020
 
 Options
        granted in the December 31, 2007 quarter include 75,000 shares of restricted
        stock under the 1996 Plan with a weighted average grant date fair value of
        $4.85
        per share that vested over a six month period.  As of June 30, 2007, all
        shares were fully vested.




Options
      vested and exercisable as of June 30, 2007 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, 2007 represents the total intrinsic
      value, based on the Company’s closing stock price of $5.90 as of June 30, 2007
      (the last business day for the third fiscal quarter of 2007), which would have
      been received by the option holders had the options been exercised as of such
      date.





**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 lesser of 85% of the fair market value of the shares
      on
      the first day of each semi-annual offering period, or 85% of


-10-
 Table
          of Contents


the
      fair
      market value of the shares on the last day of the semi-annual offering period.
      There were 62,189 shares issued pursuant to the ESPP, at a weighted average
      price of $4.27, during the three months ended June 30, 2007. During the nine
      months ended June 30, 2007, 124,423 shares were issued pursuant to the ESPP,
      at
      a weighted average price of $4.31 per share. As of June 30, 2007, there were
      456,021 shares available for future purchases under the ESPP. Stock-based
      compensation expense relating to the ESPP was $32,000 and $112,000 for the
      three
      and nine months ended June 30, 2007, respectively.





**Stock-Based
      Compensation under SFAS 123(R)**





The
      total stock-based compensation
      expense recognized during the following periods was allocated as follows (in
      thousands):





**Three
                    Months Ended**
                  **June
                    30,**
            
            
            **Nine
                  Months Ended**
              **June
                  30,****2007**
            
            
            **2006**
            
            
            **2007**
            
            
            **2006**(in
                thousands)Cost
                of revenues
            
            $
            12
            
            
            $
            3
            
            
            $
            25
            
            
            $
            7Research
                and development
            
            
            397
            
            
            
            119
            
            
            
            688
            
            
            
            365Sales
                and marketing
            
            
            73
            
            
            
            50
            
            
            
            194
            
            
            
            129General
                and administrative
            
            
            280
            
            
            
            96
            
            
            
            842
            
            
            
            241Total
                stock-based compensation expense
            
            $
            762
            
            
            $
            268
            
            
            $
            1,749
            
            
            $
            742





As
      of June 30, 2007, there was
      approximately $3.7 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 2.68 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 SFAS 123(R) for the three months ended June
      30, 2007 was a decrease in net income of $762,000, or $0.05 per share and for
      the nine months ended June 30, 2007 was an increase in net loss of $1.7 million,
      or $0.12 per share.





The
      method of valuation for
      share-based awards granted beginning in fiscal 2006 is the Black-Scholes model.
      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. Because the Company has not in
      the
      past and does not currently expect to 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.





The
      fair
      value of employee stock options granted during the following periods was
      estimated based on the following assumptions:





**Three Months Ended**
              **June 30,**
            
            **Nine
                Months Ended**
              **June
                  30,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Weighted-average
                estimated fair value
            $3.17
            
            $3.85
            
            $3.10
            
            $4.07Estimated
                life
            5.66
                years
            
            5.40
                years
            
            5.79
                years
            
            5.45
                yearsRisk-free
                interest rate
            4.45%
            
            4.79%
            
            4.54%
            
            4.45%Expected
                stock price volatility
            49.56%
            
            59.07%
            
            53.72%
            
            64.05%Dividend
                yield
            0.00%
            
            0.00%
            
            0.00%
            
            0.00%




-11-
 Table
          of Contents


The
      fair
      value of employee stock purchased under the ESPP plan during the following
      periods was estimated based on the following assumptions:





**Three Months Ended**
                **June 30,**
            
            **Nine
                Months Ended**
              **June
                  30,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Weighted-average
                estimated fair value
            $1.42
            
            $1.31
            
            $1.52
            
            $1.37Estimated
                life
            0.49
                years
            
            0.49
                years
            
            0.50
                years
            
            0.49
                yearsRisk-free
                interest rate
            4.72%
            
            4.70%
            
            4.81%
            
            4.26%Expected
                stock price volatility
            34.79%
            
            32.67%
            
            35.77%
            
            32.27%Dividend
                yield
            0.00%
            
            0.00%
            
            0.00%
            
            0.00%





**Stock
      Repurchase**





On
      May 9,
      2007, the Company’s Board of Directors authorized a repurchase from Albert E.
      Sisto, the Company’s chairman and chief executive officer, of 26,812 shares of
      the Company’s common stock with an aggregate fair market value of $174,000, in
      order to satisfy certain tax withholding obligations arising out of the vesting
      of restricted stock held by Mr. Sisto.





**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, security
      protocol processors, compression processors, security boards, compression
      boards, 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 geographic location may be different
      from the geographic locations of our end customers.




**Three
                  Months Ended**
                **June
                  30,**
            
            
            **Nine
                  Months Ended**
                **June
                  30,****2007**
            
            
            **2006**
            
            
            **2007**
            
            
            **2006**(in
                thousands)North
                America:United
                States
            
            $
            4,643
            
            
            $
            4,776
            
            
            $
            12,720
            
            
            $
            12,551Other
            
            
            213
            
            
            
            337
            
            
            
            662
            
            
            
            896Total
                North America
            
            
            4,856
            
            
            
            5,113
            
            
            
            13,382
            
            
            
            13,447Asia:Hong
                Kong
            
            
            5,164
            
            
            
            4,873
            
            
            
            14,290
            
            
            
            15,454Malaysia
            
            
            206
            
            
            
            567
            
            
            
            1,263
            
            
            
            877Singapore
            
            
            90
            
            
            
            487
            
            
            
            224
            
            
            
            1,383Japan
            
            
            425
            
            
            
            558
            
            
            
            915
            
            
            
            1,351Thailand
            
            
            309
            
            
            
            177
            
            
            
            489
            
            
            
            591Taiwan
            
            
            15
            
            
            
            16
            
            
            
            45
            
            
            
            105Other
            
            
            13
            
            
            
            16
            
            
            
            13
            
            
            
            40Total
                Asia
            
            
            6,222
            
            
            
            6,694
            
            
            
            17,239
            
            
            
            19,801Europe
                and other
            
            
            593
            
            
            
            445
            
            
            
            1,348
            
            
            
            1,395Total
            
            $
            11,671
            
            
            $
            12,252
            
            
            $
            31,969
            
            
            $
            34,643




-12-
 Table
          of Contents


**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 periods indicated were as follows:





**Three
                  Months Ended**
                **June
                  30,**
            
            
            **Nine
                  Months Ended**
                **June
                  30,****2007**
            
            
            **2006**
            
            
            **2007**
            
            
            **2006**Cisco
                Systems, Inc.
            
            
            47%
            
            
            
            52%
            
            
            
            52%
            
            
            
            52%Huawei
                Technologies, Inc.
            
            
            12%
            
            
            
            10%
            
            
            
            13%
            
            
            
            13%59%
            
            
            
            62%
            
            
            
            65%
            
            
            
            65%





No
      other
      individual customer accounted for more than 10% of revenues in the periods
      presented.





**Property
      and Equipment**





As
      of
      June 30, 2007, the Company had net property and equipment of $1.3 million and
      $772,000 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 quarters ended June 30, 2006 and June 30, 2007 relates to accrued tax
      liabilities on the Company’s non-U.S. operations.





**Note
      8 – Guarantees and Product Warranties**





*Guarantees*





In
      November 2002, the Financial Accounting Standards Board (“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. 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, 2007.


-13-
 Table
            of Contents




The
      Company enters into standard indemnification agreements generally with business
      partners or customers in the ordinary course of business. Pursuant to these
      agreements, the Company indemnifies, holds harmless, and agrees to reimburse
      the
      indemnified party 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, 2007. 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.





*Product
      Warranties*





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.





**Note
      9 - Recent Accounting Pronouncements**





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 will be
      effective for the Company on October 1, 2007.  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.





In
      September 2006, the FASB issued SFAS
      No. 157, “Fair Value Measurements” (“SFAS 157”), which clarifies the definition
      of fair value, establishes guidelines for measuring fair value, and expands
      disclosures regarding fair value measurements.  SFAS 157 does not require
      any new fair value measurements and eliminates inconsistencies in guidance
      found
      in various prior accounting pronouncements.  SFAS 157 will be effective for
      the Company on October 1, 2008. The Company is currently evaluating the impact
      of adopting SFAS 157 on its financial position, cash flows, and results of
      operations.





In
      February 2007, the FASB issued SFAS
      No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”
(“SFAS 159”), which expands the standards under SFAS 157, Fair Value
      Measurement, to provide the one-time election (Fair Value Option) to measure
      financial instruments and certain other items at fair value and also includes
      an
      amendment of SFAS 115.  SFAS 159 will be effective for the Company on
      October 1, 2008. The Company is currently evaluating the impact of adopting
      SFAS
      159 on its financial position, cash flows, and results of
      operations.


-14-
 Table
          of Contents


**Note
      10 - Subsequent Events**





On
      July
      23, 2007, Hifn announced its acquisition of the business of Siafu Software,
      a
      providers of secure storage solutions. This acquisition extends Hifn's strategy
      of vertically integrating its data protection solutions to fill the gap in
      the
      convergence of storage, security and networking infrastructure. Siafu Software
      was already using Hifn's technology within their appliances prior to the
      acquisition.





**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 “Risk Factors” under Part II, Item 1A 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, Hifn (Hangzhou) Information Technologies Co., Ltd. (previously
      known
      as 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,” “Hifn,” “we,” “us” or
“our”) is a network- and storage-security and data reduction market leader that
      supplies major network and storage original equipment manufacturers (“OEMs”)
      with patented technology for the continuous protection of information, whether
      it is in transit on a network or at rest on storage. 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 and encryption processing speeds available in the market,
      multi-protocol capabilities, development tools and board level products with
      high-levels of integration that help reduce their 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 and content search
      solutions are used in networking, security and storage equipment such as
      routers, remote access concentrators, Virtual Private Networks (“VPN”), Virtual
      Tape Libraries (“VTL”), Nearline storage systems, switches, broadband access
      equipment, network interface cards, firewalls and back-up storage
      devices.





The
      Hifn
      encryption and compression processors allow network and storage equipment
      vendors to add security and data reduction functions to their products. Our
      encryption and compression 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 and Express
      VTL
      / Express Data Reduction (“DR”) boards to improve the performance and capacity
      of a wide range of disk and tape back-up systems. For example, storage OEMs
      who
      design in a Hifn Express VTL board can offer their customers a storage solution
      that more than doubles the storage capacity, saving them power, physical space,
      operational and capital expenses.


-15-
 Table
          of Contents





In
      addition to networking and storage OEMs, Hifn offers its new Express DR board
      and subsystem offerings via a partner channel consisting of solutions providers,
      value-added resellers (“VARs”) and system integrators. This channel initiative
      will enable the company to target new customer sales, as well as target the
      upgrade market for data reduction and data security. For example, existing
      customers of Hifn partner FalconStor may choose to upgrade their existing VTL
      or
      Nearline storage systems with the Hifn Express DR 1000 board designed
      to accelerate FalconStor backup/recovery operations while more than doubling
      existing storage capacity using Hifn’s patented compression
      technologies.





Additionally,
      Hifn announced in 2006 the Hifn Pattern Matching (“HPM”) technology which
      accelerates regular expression pattern matching, a key search function in
      security systems such as Anti-Virus and Intrusion
      Detection/Prevention.   HPM contains “rule compression”
technology that creates a highly compact rules database format. The database,
      along with HPM’s small code footprint, can reside in a microprocessor cache
      enabling the search function to run at the speed of the processor. Network
      edge
      security devices and Unified Threat Management (“UTM”) appliances all have the
      same fundamental limitation: they can only process packets at the speed at
      which
      they can detect signatures.





Hifn’s
      network processor technology, acquired from International Business Machines
      Corporation (“IBM”), complements our security processor business and expands our
      product offerings to include a programmable, yet deterministic, device that
      performs 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.





**Results
      for Third Fiscal Quarter**





Revenues
      for the third quarter of
      fiscal 2007 were $11.7 million, an increase of six percent from the $11.0
      million in revenues reported in the previous quarter and a decrease of five
      percent from the $12.3 million in revenues reported in the third quarter of
      fiscal 2006. Fluctuation in ordering patterns from Cisco and Huawei have
      significantly affected our revenue levels during these periods. Such fluctuation
      is notable between the second and third quarters of fiscal 2007 with net
      revenues from orders placed by Cisco and Huawei decreasing by 10%.





In
      November 2006 we embarked on a
      strategy to significantly improve our execution and our operating performance.
      The quarter ended June 30, 2007 represents our second sequential quarter of
      top-line growth. Orders from long standing customers continued at expected
      levels while we continued to improve our execution and operating performance
      at
      every level of our business. This was a quarter of significant financial
      improvement across the board, returning to profitability, sequential growth,
      cash generation and improved working capital.





**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 its
      expanding development capacity in China. The actions were aimed to reduce the
      Company’s cost structure, including a reduction in its North America workforce
      by 43 employees, which represented about 21% of its overall workforce at the
      time, the impact of the termination of certain engineering projects and the
      closure of the facility in Carlsbad, California.





*Involuntary
      Termination Cost*





**Expense**
                **Accrued**
                **June
                  30, 2006**
              
              
              **Adjustments**
              
              
              **Paid
                  as of**
                **September
                  30,**
                **2006**
              
              
              **Balance**
                **September
                  30,**
                **2006**(in
                  thousands)Cost of revenues
              
              $
              64
              
              
              $
              (6
              )
              
              $
              53
              
              
              $
              5Research and development
              
              
              471
              
              
              
              (17
              )
              
              
              454
              
              
              
              -Sales and marketing
              
              
              59
              
              
              
              -
              
              
              
              59
              
              
              
              -General and administrative
              
              
              24
              
              
              
              -
              
              
              
              24
              
              
              
              -Total
              
              $
              618
              
              
              $
              (23
              )
              
              $
              590
              
              
              $
              5
 
 -16-
 Table
              of Contents
  The
        remaining balance was paid during the first quarter of fiscal
        2007.





*Impairment
      Of Long-lived Assets*





The
      restructure resulted in a $292,000 impairment of certain software assets related
      to projects that were terminated.





*Non-recurring
      Engineering Expense Recovery*





The
      cancellation of engineering 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 condensed consolidated
      statement of operations.





*Termination
      Of Operating Lease*





As
      part
      of the restructure, the Company closed its facility in Carlsbad, California
      and
      ceased use of the facility as of September 30, 2006. A liability related to
      the
      Carlsbad facility of $550,000 was accrued during the last quarter of fiscal
      year
      2006, reflecting the fair value of the future lease obligations, net of sublease
      income at the time. During the second quarter of fiscal 2007, the estimated
      fair
      value of the future lease obligations, net of sublease income, was increased
      by
      $118,000, due to changes in market conditions. The non-cancelable lease
      agreement for this facility terminates in June 2010. At June 30, 2007, the
      remaining lease obligation is estimated to be $1.2 million, which will be paid
      monthly for the remainder of the lease contract period. Additional costs of
      approximately $74,000 were incurred in the fourth quarter of fiscal 2006 for
      the
      relocation of operations and equipment from the closing facility. As of June
      30,
      2007, $555,000 of the remaining lease cost was included in accrued expenses
      and
      other current liabilities in the accompanying condensed consolidated balance
      sheet.





*Net
      Restructuring Cost*





Including
      the fair value of the lease obligation and relocation costs, the net expense
      for
      the restructure as of June 30, 2007 amounted to $1.1 million. All remaining
      expenses, with the exception of the Carlsbad lease, were paid during the first
      quarter of fiscal year 2007.  These payments were 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, 2006 and have not changed materially as of
      June
      30, 2007.




-17-
 Table
          of Contents


**Results
      of Operations**




*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**(dollars in thousands)
            
            **2007**
            
            
            **2006**
            
            
            **Change**
            
            
            **2007**
            
            
            **2006**
            
            
            **Change**Processors
            
            $
            11,046
            
            
            $
            10,917
            
            
            
            1%
            
            
            $
            29,819
            
            
            $
            31,765
            
            
            
            (6)%Software licenses and other
            
            
            625
            
            
            
            1,335
            
            
            
            (53)%
            
            
            
            2,150
            
            
            
            2,878
            
            
            
            (25)%$
            11,671
            
            
            $
            12,252
            
            
            
            (5)%
            
            
            $
            31,969
            
            
            $
            34,643
            
            
            
            (8)%








**%
                  of net revenues**
            
            
            **%
                  of net revenues**
            
            
            
            
            
            **%
                  of net revenues**
            
            
            **%
                  of net revenues**Processors
            
            
            95%
            
            
            
            89%
            
            
            
            
            
            
            
            93%
            
            
            
            92%Software licenses and other
            
            
            5%
            
            
            
            11%
            
            
            
            
            
            
            
            7%
            
            
            
            8%Total
            
            
            100%
            
            
            
            100%
            
            
            
            
            
            
            
            100%
            
            
            
            100%





Net
      revenues decreased by $581,000 for the quarter ended June 30, 2007 as compared
      to net revenues for the quarter ended June 30, 2006. Our processor revenues
      increased $129,000 during the three months ended June 30, 2007 compared to
      the
      same period in the prior year. The average selling price of processors remained
      at relatively the same levels. The increase in processor revenues between the
      comparative periods is attributable to increasing board sales, partially offset
      by a decrease in the volume of processor units sold during the period. The
      decrease in revenues from software license and royalties of $710,000 resulted
      from the variability in demand for and timing of customers’ purchases of certain
      of the Company’s licensed software products.





Net
      revenues decreased by $2.7 million for the nine months ended June 30, 2007
      as
      compared to the same period in the prior year. Our processor revenue decreased
      $1.9 million and was attributable to a decrease in revenues from Quantum and
      Huawei of $1.8 million and $319,000, 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 processor sales volume. Our revenues from software license and royalties
      decreased by $728,000 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 our principal end customers and their respective
      contribution to net revenue for the respective periods were as
      follows:




**Three
                    Months Ended**
                  **June
                    30,**
              
              
              **Nine
                    Months Ended**
                  **June
                    30,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006**Cisco Systems, Inc.
              
              
              47%
              
              
              
              52%
              
              
              
              52%
              
              
              
              52%Huawei Technologies, Inc.
              
              
              12%
              
              
              
              10%
              
              
              
              13%
              
              
              
              13%59%
              
              
              
              62%
              
              
              
              65%
              
              
              
              65%
 -18-
 Table
              of Contents


*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
                  Change**
              
              **Six
                  Months Ended June 30,**
              
              **Year-over-**
                **Year
                  Change**(dollars
                  in thousands)
              
              **2007**
              
              **2006**
              
              
              **2007**
              
              **2006**Processors
              
              $
              3,882
              
              $
              3,992
              
              
              (3)%
              
              $
              10,517
              
              $
              11,550
              
              
              (9)%Software
                  licenses and other
              
              
              82
              
              
              126
              
              
              (35)%
              
              
              247
              
              
              379
              
              
              (35)%$
              3,964
              
              $
              4,118
              
              
              (4)%
              
              $
              10,764
              
              $
              11,929
              
              
              (10)%
 **%
                    of revenue category**
                
                **%
                    of revenue catagory**
                
                
                **%
                    of****revenue
                    catagory**
                
                **%
                    of****revenue
                    catagory**Processors
                
                
                35%
                
                
                37%
                
                
                
                
                
                35%
                
                
                36%Software licenses and other
                
                
                13%
                
                
                9%
                
                
                
                
                
                11%
                
                
                13%Total
                
                
                34%
                
                
                34%
                
                
                
                
                
                34%
                
                
                34%




Cost of revenues consists primarily of semiconductors and boards which were
      manufactured to our specifications by third parties for resale by us. Cost
      of
      processor revenues as a percentage of net processor revenues decreased two
      percentage points for the three months ended June 30, 2007 as compared to the
      same period in fiscal 2006. The Company’s product offerings in the three months
      ended June 30, 2007 include a higher proportion of security processors, which
      carry a lower cost of revenues as compared to all other processors. As a result,
      processor cost of revenues as a percentage of net revenues decreased. This
      decrease was partially offset by increased board sales, which in turn carry
      a
      higher cost of revenue. During the three months ended June 30, 2007, we
      recovered inventories (net of write downs) of $5,000. During the three months
      ended June 30, 2006, we wrote down inventories (net of recoveries) of $208,000,
      which also contributed to the higher cost of revenue for the three months ended
      June 30, 2006 as compared to the current period.





Cost
      of
      processor revenues as a percentage of net processor revenues decreased one
      percentage point for the nine months ended June 30, 2007 as compared to the
      same
      period in fiscal 2006. The Company’s product offerings in the nine months ended
      June 30, 2007 include a higher proportion of security processors, which carry
      a
      lower cost of revenues as compared to all other processors. As a result,
      processor cost of revenues as a percentage of net revenues decreased. This
      decrease was partially offset by increased board sales, which in turn carry
      a
      higher cost of revenue. During the nine months ended June 30, 2007, we recovered
      inventories (net of write downs) of $80,000. During the nine months ended June
      30, 2006, we wrote down inventories (net of recoveries) of $330,000, which
      also
      contributed to the higher cost of revenue for the nine months ended June 30,
      2006 as compared to the current period.





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.





-19-
 Table
          of Contents


*Operating
      Expenses*





*Research
      and Development.*





**Three
                  Months Ended June 30,**
            
            
            **Year-over-Year**
            
            
            **Nine
                  Months Ended June 30,**
            
            
            **Year-over-Year***(dollars in thousands)*
            
            **2007**
            
            
            **2006**
            
            
            **Change**
            
            
            **2007**
            
            
            **2006**
            
            
            **Change**Research &development
                expenses
            
            $
            2,916
            
            
            $
            5,748
            
            
            
            (49)%
            
            
            $
            10,336
            
            
            $
            16,932
            
            
            
            (39)%As a percentage of net revenues
            
            
            25%
            
            
            
            47%
            
            
            
            
            
            
            
            32%
            
            
            
            49%





Research
      and development costs consist primarily of salaries, employee benefits,
      overhead, outside contractors and non-recurring engineering fees. Such research
      and development expenses decreased $2.8 million for the three months ended
      June
      30, 2007 over the same period in the prior year. The decrease reflects decreases
      in expenses related to salaries and benefits of $1.9 million as a result of
      the
      reduction in headcount implemented in June 2006, partially offset by higher
      average salary rates in connection with employee performance reviews in October
      2006 and an increase in SFAS 123(R) expenses, a $185,000 reduction in NRE and
      related costs due to the reimbursement of certain costs under an R&D
      contract, supplies decreased $357,000 due to the different stages of projects
      completion, a $130,000 reduction in lease expenses mainly as a result of closing
      the Carlsbad, CA facility, a decrease in depreciation of $56,000 as a result
      of
      fully depreciated fixed assets, a $6,000 decrease in software maintenance cost
      and a $186,000 decrease in telephone, travel and miscellaneous expenses
      resulting from the reduced headcount. These decreases were partially offset
      by a
      $41,000 increase in professional services.





Research
      and development costs for the nine months ended June 30, 2007 decreased $6.6
      million compared to the same period in the prior year. The decrease reflects
      decreases in expenses related to salaries and benefits of $4.1 million as a
      result of the reduction in headcount implemented in June 2006, partially offset
      by higher average salary rates in connection with employee performance reviews
      in October 2006 and an increase in SFAS 123(R) expenses, a $1.4 million
      reduction in NRE and related costs due to the reimbursement of certain costs
      under an R&D contract, supplies decreased $707,000 due to the different
      stages of projects completion, a $367,000 reduction in lease expenses mainly
      as
      a result of closing the Carlsbad, CA facility, a decrease of $322,000 in travel
      and miscellaneous expenses resulting from the reduced headcount and a decrease
      in depreciation of $69,000 as a result of fully depreciated fixed assets. These
      decreases were partially offset by a $309,000 increase in software maintenance
      costs primarily due to costs associated with ongoing R&D projects and an
      increase in professional services and other expenses of $73,000.





*Sales
      and Marketing.*




**Three
                  Months Ended June 30,**
            
            
            **Year-over-Year**
            
            
            **Nine
                  Months Ended June 30,**
            
            
            **Year-over-Year***(dollars
                in
                thousands)*
            
            **2007**
            
            
            **2006**
            
            
            **Change**
            
            
            **2007**
            
            
            **2006**
            
            
            **Change**Sales
                & marketingexpenses
            
            $
            2,097
            
            
            $
            2,084
            
            
            
            1%
            
            
            $
            6,036
            
            
            $
            5,878
            
            
            
            3%As
                a
                percentage of net revenues
            
            
            18%
            
            
            
            17%
            
            
            
            
            
            
            
            19%
            
            
            
            17%


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 $13,000 for the three
      months ended June 30, 2007 over the same period in the prior year. The increase
      primarily relates to an increase in professional services of $132,000 relating
      to company branding, and an increase in telephone, building and miscellaneous
      expenses of $30,000. These increases were partially offset by a reduction in
      traveling expenses of $87,000 as a result of reduced travel and the timing
      of
      sales and marketing conferences and a reduction in salaries and benefits of
      $62,000 primarily due to an average lower headcount for the period and the
      restructuring cost incurred in the June 30, 2006 quarter.





Sales
      and
      marketing expenses increased $158,000 during the nine months ended June 30,
      2007
      as compared to the same period in the prior year. The increase primarily relates
      to a $279,000 increase in professional services


-20-
 Table
          of Contents


relating
      to a new website and company branding, an increase in sales conference expenses
      of $28,000 due to the timing of conferences and increased sales representative
      commissions of $21,000 due to a higher level of sales made through sales
      representatives. The increase was partially offset by a reduction in salaries
      and benefits of $83,000 due to a average lower headcount partially offset by
      higher average salary rates in connection with employee performance reviews
      in
      October 2006 and an increase in SFAS 123(R) expenses, a decrease in traveling
      and other expenses of $77,000 due to the timing of events and a decrease in
      miscellaneous expenses of $10,000.





*General
      and Administrative.*




**Three
                  Months Ended June 30,**
            
            
            **Year-over-Year**
            
            
            **Nine
                  Months Ended June 30,**
            
            
            **Year-over-Year***(dollars
                in
                thousands)*
            
            **2007**
            
            
            **2006**
            
            
            **Change**
            
            
            **2007**
            
            
            **2006**
            
            
            **Change**General
                & administrativeexpenses
            
            $
            1,940
            
            
            $
            1,841
            
            
            
            5%
            
            
            $
            7,040
            
            
            $
            4,960
            
            
            
            42%As
                a
                percentage of net revenues
            
            
            17%
            
            
            
            15%
            
            
            
            
            
            
            
            22%
            
            
            
            14%


General
      and administrative expenses are comprised primarily of salaries for
      administrative and corporate services personnel, legal and other professional
      fees. Such expenses increased $99,000 for the three months ended June 30, 2007
      over the same period in the prior year. The increase
      primarily relates to increases in salaries and benefits expense of
      $150,000 in connection with the employee performance reviews in October 2006
      together with costs associated with the transition in leadership, an increase
      in
      building expenses of $102,000 mainly due to the closure of our Carlsbad, CA
      facility, an increase in miscellaneous expenses of $23,000 mainly due to
      recruitment costs associated with the leadership transition together with an
      increase in travel and depreciation expenses of $27,000. These increases were
      partially offset by a decrease of $164,000 in professional services, legal
      counsel costs associated with strategic planning and audit and other SEC
      compliance related costs and a reduction in telephone and miscellaneous
      expenses of $39,000.





General
      and administrative expenses increased $2.1 million during the nine months ended
      June 30, 2007 as compared to the same period in the prior year. The increase
      primarily relates to increases in salaries and benefits expense of
      $938,000 mainly due to costs associated with the transition in leadership and
      the employee performance reviews in October 2006, an increase of $361,000 in
      professional services mainly associated with strategic planning and legal
      counsel costs, an increase in audit and other SEC compliance related costs
      of
      $187,000 of which $100,000 relates to Sarbanes-Oxley expenses in China, an
      increase in building expenses of $366,000 mainly due to the closure of our
      Carlsbad, CA facility, an increase in miscellaneous expenses of $257,000
      primarily due to recruitment cost associated with the leadership transition,
      a
      $42,000 increase in other taxes relating to our non-U.S. locations together
      with
      an increase in travel and depreciation expenses of $105,000. These increases
      were partially offset by a reduction in telephone and supplies expenses
      of
      $176,000.





*Amortization
      of Intangibles.*




**Three
                  Months Ended June 30,**
            
            
            **Year-over-Year**
            
            
            **Nine
                  Months Ended June 30,**
            
            
            **Year-over-Year***(dollars
                in
                thousands)*
            
            **2007**
            
            
            **2006**
            
            
            **Change**
            
            
            **2007**
            
            
            **2006**
            
            
            **Change**Amortization
                of
                intangibles
            
            $
            737
            
            
            $
            1,076
            
            
            
            (32)%
            
            
            $
            2,212
            
            
            $
            2,670
            
            
            
            (17)%As
                a
                percentage of net revenues
            
            
            6%
            
            
            
            9%
            
            
            
            
            
            
            
            7%
            
            
            
            8%


Amortization
      of intangibles relate to acquired technology, workforce and patents.
      Amortization of intangibles decreased $339,000 for the three months ended June
      30, 2007 over the same period in the prior year mainly as a result of the full
      amortization of previously capitalized intangible assets and a software
      impairment expense of $292,000 relating to the June 28, 2006
      restructure.





Amortization
      of intangibles decreased $458,000 for the nine months ended June 30, 2007 over
      the same period in the prior year mainly as a result of the full amortization
      of
      previously capitalized intangible assets and a software impairment expense
      of
      $292,000 relating to the June 28, 2006 restructure.


-21-
 Table
          of Contents




*Interest
      and Other Income, net.*




**Three
                  Months Ended June 30,**
            
            
            **Year-over-Year**
            
            
            **Nine
                  Months Ended June 30,**
            
            
            **Year-over-Year***(dollars
                in
                thousands)*
            
            **2007**
            
            
            **2006**
            
            
            **Change**
            
            
            **2007**
            
            
            **2006**
            
            
            **Change**Interest
&
                other income, net
            
            $
            489
            
            
            $
            489
            
            
            
            0%
            
            
            $
            1,469
            
            
            $
            1,358
            
            
            
            8%As
                a
                percentage of net revenues
            
            
            4%
            
            
            
            4%
            
            
            
            
            
            
            
            5%
            
            
            
            4%


Interest
      and other income, net, remained unchanged during the three months ended June
      30,
      2007 and increased $111,000 during the nine months ended June 30, 2007 as
      compared to the same respective periods in the prior fiscal year. The increase
      was primarily a result of the timing in sales and 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***(dollars
                in
                thousands)*
            
            **2007**
            
            
            **2006**
            
            
            **Change**
            
            
            **2007**
            
            
            **2006**
            
            
            **Change**Provision
                for
                income taxes
            
            $
            222
            
            
            $
            85
            
            
            
            161%
            
            
            $
            175
            
            
            $
            15
            
            
            
            1067%As
                a
                percentage of net revenues
            
            
            2%
            
            
            
            1%
            
            
            
            
            
            
            
            1%
            
            
            
            0% 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 provision for income taxes increased
        $137,000 during the three months and $160,000 during the nine months ended
        June
        30, 2007. These taxes relates to our non-U.S. operations and the increases
        are
        primarily due to increased activities at our China location. 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,****2007**
            
            
            **2006**(in
                thousands)Net
                cash used
                in operating activities
            
            $
            (1,515
            )
            
            $
            (5,300
            )Net
                cash
                (used in) provided by investing activities
            
            
            (249
            )
            
            
            5,622Net
                cash
                provided by financing activities
            
            
            713
            
            
            
            1,347Net  (decrease) increase in cash and cash equivalents
            
            $
            (1,051
            )
            
            $
            1,669





*Operating
      Activities.*Net
      cash
      used in operating activities was $1.5 million for the nine months ended June
      30,
      2007 resulting from a net loss during the period of $3.1 million, adjusted
      for
      non-cash items including depreciation and amortization of fixed assets of $1.3
      million, amortization of intangibles related to acquired technologies of $2.2
      million, stock-based compensation expenses of $1.8 million and an increase
      in
      the allowance for bad debts of $7,000. These non-cash expenses were offset
      by an
      increase in accounts receivable of $818,000, reflecting higher sales and a
      shift
      in the timing of shipments and collections during the third quarter of fiscal
      2007,


-22-
 Table
          of Contents


and
      an
      increase in inventories of $1.4 million, net of $79,000 in reserve recoveries
      for excess and obsolete inventory, mainly due to the timing of receipt of
      inventory purchases and higher sales volumes, an increase in other current
      assets of $836,000, primarily due to the addition of  short-term
      software license agreements in China, together with a reduction in accrued
      liabilities of $1.2 million. Contributing to cash provided by operations was
      a
      reduction in prepaid expenses of $110,000 as well as an increase in accounts
      payable of $478,000, which was related to the timing of payments
      made.





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.





*Investing
      Activities.* Net
      cash used in investing activities was $249,000 for the nine months ended June
      30, 2007, which primarily reflects the purchase of property and equipment of
      $513,000, offset by the net sale of short-term investments of
      $264,000.





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.





*Financing
      Activities.* Net
      cash provided by financing activities for the nine months ended June 30, 2007
      of
      $713,000 was comprised of cash proceeds from the issuance of common stock for
      stock option exercises and employee stock purchase plan purchases which
      aggregated to $887,000, partially offset by the repurchase of common stock
      of
      $174,000.





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.





The
      Company’s inventory balance
      increased by $1.5 million to $3.5 million at June 30, 2007 as compared to $2.0
      million as of September 30, 2006. The increase in inventory is a result of
      the
      timing of inventory purchases relative to manufacturer lead-time, coupled with
      anticipated shipment schedules to fill customer orders for the succeeding
      quarter. The continued growth in the VTL board business also requires higher
      inventory levels which in turn carries a much higher unit cost than other
      products. The Company’s annualized inventory turns for the quarter ended June
      30, 2007 were 5.4 times as compared to 7.2 times for the year ended September
      30, 2006. The Company’s accounts receivable balance, which is contingent upon
      the timing of product shipment within the respective periods, increased $818,000
      from September 30, 2006 to June 30, 2007.





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.


-23-
 Table
          of Contents


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.




*Stock**Repurchase**.*****On May 9, 2007,
      the Company’s Board of Directors authorized a repurchase from Albert E.
      Sisto, the Company’s chairman and chief executive officer, of 26,812 shares of
      the Company’s common stock with an aggregate fair market value of $174,000, in
      order to satisfy certain tax withholding obligations arising out of the vesting
      of restricted stock held by Mr. Sisto.





**Contractual
      Obligations**





The
      Company occupies its facilities under several non-cancelable operating leases
      that expire at various dates through November 2011, 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, 2007 are as follows:





**Payments
                  Due By Period****Contractual
                  Obligations**
            
            **Total**
            
            
            **Less
                  than**
                **1
                  year**
            
            
            **1
                  – 3**
                **years**
            
            
            **3
                  – 5**
                **years**
            
            
            **More
                  than**
                **5
                  years**(in
                thousands)Operating
                lease
                commitments
            
            $
            3,755
            
            
            $
            1,719
            
            
            $
            1,872
            
            
            $
            164
            
            
            $
            -Inventory
                purchases
            
            
            2,325
            
            
            
            2,325
            
            
            
            -
            
            
            
            -
            
            
            
            -Non-recurring
                engineering
                expense
            
            
            28
            
            
            
            28
            
            
            
            -
            
            
            
            -
            
            
            
            -Totals
            
            $
            6,108
            
            
            $
            4,072
            
            
            $
            1,872
            
            
            $
            164
            
            
            $
            -





**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
      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.


-24-
 Table
          of Contents




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. 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, 2007.





The
      Company enters into standard indemnification agreements generally with business
      partners or customers in the ordinary course of business. Pursuant to these
      agreements, the Company indemnifies, holds harmless, and agrees to reimburse
      the
      indemnified party 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, 2007. 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.





*Product
      Warranties*





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.





**Recent
      Accounting Pronouncements**





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 will be
      effective for the Company on October 1, 2007.  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.





In
      September 2006, the FASB issued SFAS
      No. 157, “Fair Value Measurements” (“SFAS 157”), which clarifies the definition
      of fair value, establishes guidelines for measuring fair value, and expands
      disclosures regarding fair value measurements.  SFAS 157 does not require
      any new fair value measurements and eliminates inconsistencies in guidance
      found
      in various prior accounting pronouncements.  SFAS 157 will be effective for
      the Company on October 1, 2008. The Company is currently evaluating the impact
      of adopting SFAS 157 on its financial position, cash flows, and results of
      operations.


-25-
 Table
          of Contents





In
      February 2007, the FASB issued SFAS
      No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”
(“SFAS 159”), which expands the standards under SFAS 157, Fair Value
      Measurement, to provide the one-time election (Fair Value Option) to measure
      financial instruments and certain other items at fair value and also includes
      an
      amendment of SFAS 115.  SFAS 159 will be effective for the Company on
      October 1, 2008. The Company is currently evaluating the impact of adopting
      SFAS
      159 on its financial position, cash flows, 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, 2007 would have an
      immaterial 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. To date, we have not incurred any significant gains or losses
      from
      such fluctuations.




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
      (“SEC”) 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, as of the end of such period, our disclosure controls and
      procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
      Exchange Act of 1934, as amended, were 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, 2007 that has materially affected, or is reasonably
      likely to materially affect, our internal control over financial
      reporting.


-26-
 Table
          of Contents





**PART
      II- OTHER INFORMATION**





**Item
      1A.*Risk Factors***





The
      risk
      factors included herein include any material changes to and supersedes the
      description of the risk factors associated with our business previously
      disclosed in Item 1A to Part I of our 2006 Annual Report on Form
      10-K.  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 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 the cancellation of these projects 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.
      The restructure may not achieve the expected benefits, and future restructuring
      may be necessary.





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





**The
      Company May Have Difficulty Establishing Adequate Management, Legal, and
      Financial Controls in the People’s Republic of China.**





The
      People's Republic of China (“PRC”) historically has been deficient in Western
      style management and financial reporting concepts and practices, as well as
      in
      modern banking, computer and other control systems. In addition, the Company
      may
      have difficulty in hiring and retaining a sufficient number of qualified
      employees to work in the PRC. As a result of these factors, the Company may
      experience difficulty in establishing management, legal and financial controls,
      collecting financial data, books of account and records and instituting business
      practices that meet Western standards.





**If
      We Are Unable to Protect Our Proprietary Technology, Our Ability to Succeed
      Will
      be Harmed.**





Our
      ability to compete successfully and achieve future growth will depend, in part,
      on our ability to protect our proprietary technology. We rely on a combination
      of patent, copyright, trademark, and trade secret laws and restrictions on
      disclosure to protect our intellectual property rights. However, the steps
      we
      have taken may not prevent the misappropriation of our intellectual property,
      particularly in foreign countries, such as the PRC, where the laws may not
      protect our proprietary rights as fully as in the United States. If we are
      unable to protect our proprietary technology, our ability to succeed will be
      harmed. Moreover, we may in the future initiate claims or litigation against
      third parties for infringement of our proprietary rights. These claims could
      result in costly litigation and the diversion of the attention of our technical
      and management personnel.





**Our
      Contractual Arrangement with Hangzhou Ansai Information Technology May Not
      Be As
      Effective as Direct Ownership.**





Becausea wholly
      foreign-owned enterprise is precluded by regulation or otherwise from conducting
      activities in certain industry sectors and participating in certain research
      projects inthe PRC, 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 may not provide control over Ansai similar to that of direct
      ownership,
      making it more difficult for Hifn to ensure effective oversight of operations
      in
      the PRC.


-27-
 Table
          of Contents




**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 if 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, Storage
      Networking, Network Processor and Virtual Tape Library And Nearline Storage
      Markets.**





Our
      success is largely dependent upon continued growth in the market for network
      security and compression 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 compression security products into their
      systems. The virtual tape library and Nearline products from storage system
      vendors incorporate our compression products and our goal is to become a leading
      supplier for compression in those markets. We also 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 fulfill the need for security in the storage networking
      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 these markets. Our ability to generate significant revenue
      in
      the network and storage equipment, virtual private network, network processor,
      storage networking, virtual tape library and Nearline 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;




·
            The
                    adoption of security as a necessary feature in storage
                    networking;




·
            The
                  adoption of compression as a necessary feature in virtual tape
                  library
                  products; and




·
            The
                  adoption of compression as a necessary feature in Nearline storage
                  products..





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, storage networking,
      virtual tape library or Nearline markets, or if these markets fail to develop,
      our business, financial


-28-
 Table
          of Contents


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. Our
      principal end customers and their respective contribution to net revenues for
      the periods indicated are as follows:




**Three
                  Months Ended**
                **June
                  30,**
            
            
            **Nine
                  Months Ended**
                **June
                  30,****2007**
            
            
            **2006**
            
            
            **2007**
            
            
            **2006**Cisco
                Systems, Inc.
            
            
            47%
            
            
            
            52%
            
            
            
            52%
            
            
            
            52%Huawei
                Technologies, Inc.
            
            
            12%
            
            
            
            10%
            
            
            
            13%
            
            
            
            13%59%
            
            
            
            62%
            
            
            
            65%
            
            
            
            65%




Cisco
      and
      Huawei are not under any binding obligation to order from us. If our sales
      to
      Cisco or Huawei decline, our business, financial condition and results of
      operations could suffer. During the three months ended June 30, 2007, sales
      to
      Cisco decreased 14 percent while sales to Huawei increased 14 percent, over
      revenues generated from each respective customer in the preceding quarter,
      significantly affecting the Company’s revenue levels and results of operations
      for the 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.





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, Huawei Datacomm, Nortel Networks, Inc. and
      Alcatel-Lucent. 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.





**We
      Face Risks Associated With Our Business Expansion Into The Solutions, VAR And
      System Integrator Channels.**





The
      success of our business expansion initiatives in the area of board and subsystem
      products (Hifn Express DR family) is dependent on the successful recruitment,
      training, activation, management and competitive defense of channel partners
      in
      the North American and global markets. Our channel partner initiatives are
      being
      launched from a standing start, and Hifn must invest management time, attention
      and resources in order for these activities to have a substantive positive
      impact on our revenues over time. The steps required for our business expansion
      initiatives in the channel include:





·
            The
                creation and launch of the Hifn “PartnerExpress” program designed to
                enable a Partner Relationship Management (“PRM”) portal for our partners
                to securely interact with Hifn.





·
            Promotional
                and outbound marketing activities designed to identify, screen and
                qualify
                prospective partners.





·
            Technical
                and sales training of partners relative to the Hifn Express family
                boards
                and subsystems.





·
            Sales
                cycle and time-to-revenue issues relative to a partner-based (vs.
                our
                historical OEM-direct) sales
                model.


-29-
 Table
          of Contents





·
            Partner
                incentive activities that promote the sale of a Hifn product vs.
                a
                competitive offering.




Our
      business, financial condition and results of operations could suffer based
      on
      the execution risk contained in one or more of these activities.





**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;




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




·
            Partner
                incentive activities that promote the sale of a Hifn product vs.
                a
                competitive offering.




·
            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. 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 related
      revenues, if any, on the other hand. In addition, the delays inherent in such
      a
      lengthy sales cycle raise additional risks of customer decisions to cancel
      or
      change product plans, which could result in the loss of anticipated sales.
      Our
      business, financial condition and results of operations could suffer if
      customers reduce or delay orders or choose not to release products using our
      technology.





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





We
      rely
      on subcontractors to manufacture, assemble and test our packet processors.
      We
      currently subcontract our semiconductor manufacturing to Atmel Corporation,
      Toshiba Corporation, Open Silicon and IBM. Because 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.
      Because 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 products to us
      in
      a timely manner. Because 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


-30-
 Table
          of Contents


result,
      we switched production of the product to a new manufacturer, which 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 and our cost of
      revenues could increase. This could harm our business, financial condition
      and
      results of operations.





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





**We
      Face Risks Associated With Acquisitions.**





We
      have
      acquired business and technologies in the past, 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 shareholder approval, and could cause us to dilute shareholder
      equity, incur debt and contingent liabilities and amortize acquisition expenses
      related to intangible assets, any of which could harm our operating results
      and/or the price of our Common Stock. Acquisitions entail numerous risks,
      including:




·
            Difficulties
                      in assimilating acquired operations, technologies and
                      products;




·
            Diversion
                      of management’s attention from other business
                      concerns;




·
            Risks
                      of entering markets in which we have little or no prior experience;
                      and





-31-
 Table
          of Contents


·
            Loss
                      of key employees of acquired
                      organizations.




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





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





On
      December 31, 2003, we acquired
      certain assets and intellectual property related to the IBM network processor
      product line. Prior to our acquisition of these assets, we understand IBM
      informed its customers that it was discontinuing selected research and
      development activities in connection with the assets and would not be developing
      any related follow-on products with respect to the products associated with
      the
      acquired assets. While the Company has, to date, been able to retain the
      customers in existence for the network processors as of the time of the
      acquisition, there can be no assurance that the established customer base will
      continue to purchase the products based on the acquired assets from us or
      maintain their relationship with us in the future for follow-on products. If
      we
      fail to maintain the established customer base, we may not be able to maintain
      the revenue and profit performance levels that IBM established with respect
      to
      these products. Loss of the established customer base could negatively impact
      our results of operations, business and financial condition.





**We
      Face Order And Shipment Uncertainties, Which Make 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 cancelled
      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. 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




·
            Respond
                      effectively to new technological changes or new product announcements
                      by
                      others.


-32-
 Table
          of Contents


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, Applied Micro Circuits Corporation, AHA and Indra
      Networks. Hifn was a wholly-owned subsidiary of Stac, Inc. until Hifn’s spin-off
      from Stac in 1996 upon which Stac assigned two license agreements entered into
      with IBM in 1994 in which Stac granted IBM the right to use, but not sublicense,
      our patented compression technology in IBM hardware and software products.
      Stac
      also assigned 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., 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


-33-
 Table
          of Contents


consolidate,
      lower the prices of their products or bundle their products with other products.
      Any of the above would significantly and negatively impact our ability to
      compete and obtain or maintain market share. If we are unable to successfully
      compete against our competitors, our business, results of operations and
      financial condition will suffer.





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


·
            Performance;




·
            Price;




·
            The
                        time that is required to develop a new product or enhancements
                        to existing
                        products;




·
            The
                      ability to achieve product acceptance with major network and
                      storage
                      equipment
                      vendors;




·
            The
                        support that exists for new network and storage
                        standards;




·
            Features
                        and
                        functionality;




·
            Adaptability
                        of products to specific
                        applications;




·
            Reliability;
                        and




·
            Technical
                      service and support as well as effective intellectual property
                      protection.




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





**Our
      Success Depends Upon Protecting Our Intellectual Property.**





Our
      proprietary technology is critical to our future success. We rely in part on
      patent, trade, trademark, mask work and copyright law to protect our
      intellectual property. We own twenty-two (22) United States patents and fourteen
      (14) 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 2007 to 2024. Of our issued United States
      patents we have nine (9) in renewal litigation which is expected to complete
      before the end of Fiscal Year 2007. We also have seven (7) pending patent
      applications in the United States and a total of twenty six (26) in Europe,
      Asia
      and Australia covering flow classification, cryptographic packet processing,
      and
      pattern matching. Patents may not be issued under our current or future patent
      applications, and the patents issued under such patent applications could be
      invalidated, circumvented or challenged. In addition, third parties could make
      infringement claims against us in the future. Such infringement claims could
      result in costly litigation. We may not prevail in any such litigation or be
      able to license any valid and infringed patents from third parties on
      commercially reasonable terms, if at all. Regardless of the outcome, an
      infringement claim would likely result in substantial cost and diversion of
      our
      resources. Any infringement claim or other litigation against us or by us could
      harm our business, financial condition and results of operations. The patents
      issued to us may not be adequate to protect our proprietary rights, to deter
      misappropriation or to prevent an unauthorized third party from copying our
      technology, designing around the patents we own or otherwise obtaining and
      using
      our products, designs or other information. In addition, others could develop
      technologies that are similar or superior to our technology.




-34-
 Table
          of Contents


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.





**Declines
      In Network And Storage Equipment Prices Could Harm Our Operating
      Results.**





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.





-35-
 Table
          of Contents


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 could
      harm 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.





As
      of
      June 30, 2007, 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.





**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


-36-
 Table
          of Contents


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.





**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 or
      other long-lived and intangible assets, asset impairment charges will be
      recognized. Approximately $1.0 million of goodwill remains as of June 30, 2007.
      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.





-37-
 Table
          of Contents


**Item
      2(c).   Purchase of Equity Securities by the
      Issuer**





In
      compliance with Item 703 of
      Regulation S-K, the Company provides the following summary of its purchases
      of
      Common Stock during the third quarter of fiscal 2007.




On May 9, 2007, the Company’s Board of Directors authorized a repurchase from
      Albert E. Sisto, the Company’s chairman and chief executive officer, of 26,812
      shares of the Company’s common stock at an average price of $6.48 and an
      aggregate fair market value of $174,000, in order to satisfy certain tax
      withholding obligations arising out of the vesting of restricted stock held
      by
      Mr. Sisto. No additional shares were approved for repurchase by the Company’s
      Board of Directors.


Table
          of Contents





**Item
      6.   Exhibits**


**Exhibit**
                **Number**
              ****
              **Exhibit**31.1
              
              Certification
                  of Chief Executive Officer pursuant to Section 302(a) of the
                  Sarbanes-Oxley Act of 2002.31.2
              
              Certification
                  of Chief Financial Officer pursuant to Section 302(a) of the
                  Sarbanes-Oxley Act of 2002.32.1
              
              Certification
                  of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350,
                  as
                  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002.32.2
              
              Certification
                  of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350,
                  as
                  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002.







-38-
 Table
          of Contents


**SIGNATURES**





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




hi/fn,
                inc.(Registrant)Date: August
                8,
                2007
              
              By:
                /s/ William R.
                WalkerWilliam
                  R. WalkerVice President,
                Finance, Chief Financial Officer and Secretary (principal financial
                and
                accounting officer)




-39-
 Table
          of Contents


**INDEX
      TO EXHIBITS**







**Exhibit**
                  **Number**
                ****
                **Exhibit**31.1
                
                Certification
                    of Chief Executive Officer pursuant to Section 302(a) of the
                    Sarbanes-Oxley Act of 2002.31.2
                
                Certification
                    of Chief Financial Officer pursuant to Section 302(a) of the
                    Sarbanes-Oxley Act of 2002.32.1
                
                Certification
                    of the Chief Executive Officer pursuant to 18 U.S.C. Section
                    1350, as
                    adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                    2002.32.2
                
                Certification
                    of the Chief Financial Officer pursuant to 18 U.S.C. Section
                    1350, as
                    adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                    2002.