##### Table of Contents



U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


---

FORM 10-Q


|                                             |  |                                                                                          
|-------------------------------------------- |  | -----------------------------------------------------------------------------------------
|(X Box)                                      |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934  
|                                            
|
|For the Quarterly Period Ended June 30, 2002
|                                            
|
|(Box)                                        |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the Transition Period From _____ to _____

COMMISSION FILE NUMBER 0-24765

hi/fn, inc.

(Exact Name of Registrant as specified in its Charter)


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

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

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

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

Yes (X Box) No (Box)

The number of shares outstanding of the Registrants Common Stock, par value
$.001 per share, was 10,491,808 as of July 30, 2002.

1



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TABLE OF CONTENTS



|                               |                                                                                               |                                                      |  |  |  |  |  | 
|------------------------------ | --------------------------------------------------------------------------------------------- | ---------------------------------------------------- |  |  |  |  |  | 
|PART 1  FINANCIAL INFORMATION
|                               | Item 1. Financial Statements                                                                 
|                               |                                                                                               | CONDENSED CONSOLIDATED BALANCE SHEETS               
|                               |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS     
|                               |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                               |                                                                                               | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
|                               | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                               | Item 3. Quantitative and Qualitative Disclosures About Market Risk                           
|PART II  OTHER INFORMATION   
|                               | Item 1. Legal Proceedings                                                                    
|                               | Item 2. Changes in Securities                                                                
|                               | Item 3. Defaults Upon Senior Securities                                                      
|                               | Item 4. Submission of Matters to a Vote of Security Holders                                  
|                               | Item 5. Other Information                                                                    
|                               | Item 6. Exhibits and Reports on Form 8-K                                                     
|SIGNATURES                    
|EXHIBIT 99.1                  



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##### Table of Contents



HIFN, INC.

INDEX TO FORM 10-Q

|           |  |                                                                                       |  |                                                                                                           |       |  |     | 
|---------- |  | ------------------------------------------------------------------------------------- |  | --------------------------------------------------------------------------------------------------------- | ----- |  | --- | 
|PART I.    |  | FINANCIAL INFORMATION                                                                 |  |                                                                                                           |       | 
|          
|          
|          
|          
|Item 1.    |  | Financial Statements                                                                  |  |                                                                                                           |       | 
|          
|          
|          
|          
|           |  |                                                                                       |  | Condensed Consolidated Balance Sheets
as of June 30, 2002 and September 30, 2001                          |       |  | 3   | 
|          
|          
|          
|          
|           |  |                                                                                       |  | Condensed Consolidated Statements of Operations for
the three and nine months endedJune 30, 2002 and 2001 |       |  | 4   | 
|          
|          
|          
|          
|           |  |                                                                                       |  | Condensed Consolidated Statements of Cash Flows for
the nine months endedJune 30, 2002 and 2001           |       |  | 5   | 
|          
|          
|          
|          
|           |  |                                                                                       |  | Notes to Condensed Consolidated Financial Statements                                                      |       |  | 6-9 | 
|          
|          
|          
|          
|Item 2.    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  |                                                                                                           | 10-25 | 
|          
|          
|          
|          
|Item 3.    |  | Quantitative and Qualitative Disclosures about Market Risk                            |  |                                                                                                           | 25    | 
|          
|          
|          
|          
|PART II.   |  | OTHER INFORMATION                                                                     |  |                                                                                                           |       | 
|          
|          
|          
|          
|Item 1.    |  | Legal Proceedings                                                                     |  |                                                                                                           | 26    | 
|          
|          
|          
|          
|Item 6.    |  | Exhibits and Reports on Form 8-K                                                      |  |                                                                                                           | 27    | 
|          
|          
|          
|          
|Signatures |  |                                                                                       |  |                                                                                                           | 28    | 

2



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##### Table of Contents



PART 1  FINANCIAL INFORMATION







Item 1. Financial Statements




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

|                                     |                                                |                            |         |             |        |               |         |         |         | 
|------------------------------------ | ---------------------------------------------- | -------------------------- | ------- | ----------- | ------ | ------------- | ------- | ------- | ------- | 
|                                     |                                                |                            |         |             |        |               |        
|                                     |                                                |                            |         | June 30,    |        | September 30,
|                                     |                                                |                            |         | 2002        |        | 2001         
|                                     |                                                |                            |         |             |        |              
|                                     |                                                |                            |         | (unaudited) |        |               |         |        
|ASSETS                               |                                                |                            |         |             |        |               |         |        
|                                    
|                                    
|                                    
|                                    
|CURRENT ASSETS:                      |                                                |                            |         |             |        |               |         |        
|                                    
|                                    
|                                    
|                                    
|                                     | Cash and cash equivalents                      |                            | $       | 53,979      |        |               | $       | 54,600  |        
|                                    
|                                    
|                                    
|                                    
|                                     | Short-term investments                         |                            |         | 3,423       |        |               |         | 10,151  |        
|                                    
|                                    
|                                    
|                                    
|                                     | Accounts receivable, net                       |                            |         | 3,583       |        |               |         | 3,814   |        
|                                    
|                                    
|                                    
|                                    
|                                     | Inventories                                    |                            |         | 418         |        |               |         | 1,685   |        
|                                    
|                                    
|                                    
|                                    
|                                     | Deferred income taxes                          |                            |         | 2,188       |        |               |         | 3,424   |        
|                                    
|                                    
|                                    
|                                    
|                                     | Prepaid expenses and other current assets      |                            |         | 2,678       |        |               |         | 3,598   |        
|                                     |                                                |                            |         |             |        |               |         |        
|                                     |                                                | Total current assets       |         |             | 66,269 |               |         |         | 77,272  | 
|                                    
|                                    
|                                    
|                                    
|Property and equipment, net          |                                                |                            | 2,825   |             |        |               | 4,111   |        
|                                    
|                                    
|                                    
|                                    
|Deferred income taxes                |                                                |                            |        |             |        |               | 3,836   |        
|                                    
|                                    
|                                    
|                                    
|Intangibles and other assets, net    |                                                |                            | 38,099  |             |        |               | 41,591  |        
|                                     |                                                |                            |         |             |        |               |         |        
|                                     |                                                | $                          | 107,193 |             |        | $             | 126,810 |        
|                                     |                                                |                            |         |             |        |               |         |        
|LIABILITIES AND STOCKHOLDERS EQUITY |                                                |                            |         |             |        |               |         |        
|                                    
|                                    
|                                    
|                                    
|CURRENT LIABILITIES:                 |                                                |                            |         |             |        |               |         |        
|                                    
|                                    
|                                    
|                                    
|                                     | Accounts payable                               |                            | $       | 2,966       |        |               | $       | 2,404   |        
|                                    
|                                    
|                                    
|                                    
|                                     | Accrued expenses and other current liabilities |                            |         | 8,109       |        |               |         | 4,571   |        
|                                     |                                                |                            |         |             |        |               |         |        
|                                     |                                                | Total current liabilities  |         |             | 11,075 |               |         |         | 6,975   | 
|                                     |                                                |                            |         |             |        |               |         |        
|STOCKHOLDERS EQUITY:                |                                                |                            |         |             |        |               |         |        
|                                    
|                                    
|                                    
|                                    
|                                     | Common stock                                   |                            |         | 10          |        |               |         | 10      |        
|                                    
|                                    
|                                    
|                                    
|                                     | Additional paid-in capital                     |                            |         | 124,354     |        |               |         | 118,252 |        
|                                    
|                                    
|                                    
|                                    
|                                     | Retained earnings                              |                            |         | (28,246     | )      |               |         | 1,573   |        
|                                     |                                                |                            |         |             |        |               |         |        
|                                     |                                                | Total stockholders equity |         |             | 96,118 |               |         |         | 119,835 | 
|                                     |                                                |                            |         |             |        |               |         |        
|                                     |                                                | $                          | 107,193 |             |        | $             | 126,810 |        
|                                     |                                                |                            |         |             |        |               |         |        

See accompanying notes to condensed consolidated financial statements.

3



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##### Table of Contents



HIFN, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS




(in thousands, except per share data)
(unaudited)

|                                                       |                                          |                                    |         |                    |        |                   |         |       |        |      |         |        |        |   |         |        |        | 
|------------------------------------------------------ | ---------------------------------------- | ---------------------------------- | ------- | ------------------ | ------ | ----------------- | ------- | ----- | ------ | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | 
|                                                       |                                          |                                    |         | Three Months Ended |        | Nine Months Ended
|                                                       |                                          |                                    |         | June 30,           |        | June 30,         
|                                                       |                                          |                                    |         |                    |        |                  
|                                                       |                                          |                                    |         | 2002               |        | 2001              |         | 2002  |        | 2001
|                                                       |                                          |                                    |         |                    |        |                   |         |       |        |     
|Net revenues                                           |                                          | $                                  | 5,485   |                    |        | $                 | 6,575   |       |        | $    | 17,615  |        |        | $ | 36,512  |       
|                                                       |                                          |                                    |         |                    |        |                   |         |       |        |      |         |        |        |   |         |       
|Costs and operating expenses:                          |                                          |                                    |         |                    |        |                   |         |       |        |      |         |        |        |   |         |       
|                                                      
|                                                      
|                                                      
|                                                      
|                                                       | Cost of revenues                         |                                    |         | 1,606              |        |                   |         | 5,098 |        |      |         | 5,337  |        |   |         | 12,026 |       
|                                                      
|                                                      
|                                                      
|                                                      
|                                                       | Research and development                 |                                    |         | 4,225              |        |                   |         | 5,075 |        |      |         | 13,683 |        |   |         | 14,218 |       
|                                                      
|                                                      
|                                                      
|                                                      
|                                                       | Sales and marketing                      |                                    |         | 2,080              |        |                   |         | 2,092 |        |      |         | 6,439  |        |   |         | 7,470  |       
|                                                      
|                                                      
|                                                      
|                                                      
|                                                       | General and administrative               |                                    |         | 3,804              |        |                   |         | 1,797 |        |      |         | 8,221  |        |   |         | 6,145  |       
|                                                      
|                                                      
|                                                      
|                                                      
|                                                       | Amortization of intangibles and goodwill |                                    |         | 2,819              |        |                   |         | 2,768 |        |      |         | 8,564  |        |   |         | 8,337  |       
|                                                       |                                          |                                    |         |                    |        |                   |         |       |        |      |         |        |        |   |         |       
|                                                       |                                          | Total costs and operating expenses |         |                    | 14,534 |                   |         |       | 16,830 |      |         |        | 42,244 |   |         |        | 48,196 | 
|                                                       |                                          |                                    |         |                    |        |                   |         |       |        |      |         |        |        |   |         |       
|Loss from operations                                   |                                          |                                    | (9,049  | )                  |        |                   | (10,255 | )     |        |      | (24,629 | )      |        |   | (11,684 | )     
|                                                      
|                                                      
|                                                      
|                                                      
|Interest and other income, net                         |                                          |                                    | 211     |                    |        |                   | 592     |       |        |      | 824     |        |        |   | 2,180   |       
|                                                       |                                          |                                    |         |                    |        |                   |         |       |        |      |         |        |        |   |         |       
|Loss before income taxes                               |                                          |                                    | (8,838  | )                  |        |                   | (9,663  | )     |        |      | (23,805 | )      |        |   | (9,504  | )     
|                                                      
|                                                      
|                                                      
|                                                      
|Provision for (benefit from) income taxes              |                                          |                                    | 9,828   |                    |        |                   | (2,779  | )     |        |      | 6,014   |        |        |   | (542    | )     
|                                                       |                                          |                                    |         |                    |        |                   |         |       |        |      |         |        |        |   |         |       
|Net loss                                               |                                          | $                                  | (18,666 | )                  |        | $                 | (6,884  | )     |        | $    | (29,819 | )      |        | $ | (8,962  | )     
|                                                       |                                          |                                    |         |                    |        |                   |         |       |        |      |         |        |        |   |         |       
|Net loss per share, basic and diluted                  |                                          | $                                  | (1.78   | )                  |        | $                 | (0.68   | )     |        | $    | (2.87   | )      |        | $ | (0.88   | )     
|                                                       |                                          |                                    |         |                    |        |                   |         |       |        |      |         |        |        |   |         |       
|Weighted average shares outstanding,
basic and diluted |                                          |                                    | 10,476  |                    |        |                   | 10,168  |       |        |      | 10,392  |        |        |   | 10,128  |       
|                                                       |                                          |                                    |         |                    |        |                   |         |       |        |      |         |        |        |   |         |       

See accompanying notes to condensed consolidated financial statements.

4



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##### Table of Contents



HIFN, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS




(in thousands)
(unaudited)

|                                                 |                                                                                 |                                                |                                                     |         |                   |        |        |        |        |        |  
|------------------------------------------------ | ------------------------------------------------------------------------------- | ---------------------------------------------- | --------------------------------------------------- | ------- | ----------------- | ------ | ------ | ------ | ------ | ------ | -
|                                                 |                                                                                 |                                                |                                                     |         | Nine Months Ended
|                                                 |                                                                                 |                                                |                                                     |         | June 30,         
|                                                 |                                                                                 |                                                |                                                     |         |                  
|                                                 |                                                                                 |                                                |                                                     |         | 2002              |        | 2001  
|                                                 |                                                                                 |                                                |                                                     |         |                   |        |       
|Cash flows from operating activities:            |                                                                                 |                                                |                                                     |         |                   |        |        |       
|                                                
|                                                
|                                                
|                                                
|                                                 | Net loss                                                                        |                                                | $                                                   | (29,819 | )                 |        | $      | (8,962 | )     
|                                                
|                                                
|                                                
|                                                
|                                                 | Adjustments to reconcile net loss to
net cash provided by operating activities: |                                                |                                                     |         |                   |        |        |        |       
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                 | Depreciation and amortization                  |                                                     |         | 1,426             |        |        |        | 1,182  |       
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                 | Amortization of intangibles and goodwill       |                                                     |         | 8,564             |        |        |        | 8,337  |       
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                 | Amortization of deferred stock compensation    |                                                     |         | 2,677             |        |        |        | 3,356  |       
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                 | Deferred income taxes                          |                                                     |         | 5,072             |        |        |        |       |       
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                 | Tax benefit from employee stock plans          |                                                     |         | 281               |        |        |        | 3,870  |       
|                                                
|                                                
|                                                
|                                                
|                                                 | Changes in assets and liabilities:                                              |                                                |                                                     |         |                   |        |        |        |       
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                 | Accounts receivable                            |                                                     |         | 231               |        |        |        | 2,843  |       
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                 | Inventories                                    |                                                     |         | 1,267             |        |        |        | (718   | )     
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                 | Prepaid expenses and other current assets      |                                                     |         | 920               |        |        |        | (6,387 | )     
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                 | Intangibles and other assets                   |                                                     |         | (2,870            | )      |        |        | (160   | )     
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                 | Accounts payable                               |                                                     |         | 562               |        |        |        | (1,437 | )     
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                 | Accrued expenses and other current liabilities |                                                     |         | 3,564             |        |        |        | 139    |       
|                                                 |                                                                                 |                                                |                                                     |         |                   |        |        |       
|                                                 |                                                                                 |                                                | Net cash provided by (used in) operating activities |         |                   | (8,125 | )      |        |        | 2,063  |  
|                                                 |                                                                                 |                                                |                                                     |         |                   |        |        |       
|Cash flows from investing activities:            |                                                                                 |                                                |                                                     |         |                   |        |        |       
|                                                
|                                                
|                                                
|                                                
|                                                 | Sale (purchase) of short-term investments, net                                  |                                                |                                                     | 6,728   |                   |        |        | (7,309 | )     
|                                                
|                                                
|                                                
|                                                
|                                                 | Purchases of property and equipment                                             |                                                |                                                     | (140    | )                 |        |        | (2,445 | )     
|                                                 |                                                                                 |                                                |                                                     |         |                   |        |        |       
|                                                 |                                                                                 |                                                | Net cash provided by (used in) investing activities |         |                   | 6,588  |        |        |        | (9,754 | )
|                                                 |                                                                                 |                                                |                                                     |         |                   |        |        |       
|Cash flows from financing activities:            |                                                                                 |                                                |                                                     |         |                   |        |        |       
|                                                
|                                                
|                                                
|                                                
|                                                 | Proceeds from issuance of common stock, net                                     |                                                |                                                     | 942     |                   |        |        | 1,121  |       
|                                                
|                                                
|                                                
|                                                
|                                                 | Payment on capital lease obligations                                            |                                                |                                                     | (26     | )                 |        |        | (51    | )     
|                                                 |                                                                                 |                                                |                                                     |         |                   |        |        |       
|                                                 |                                                                                 |                                                | Net cash provided by financing activities           |         |                   | 916    |        |        |        | 1,070  |  
|                                                 |                                                                                 |                                                |                                                     |         |                   |        |        |       
|Net decrease in cash and cash equivalents        |                                                                                 |                                                | (621                                                | )       |                   |        | (6,621 | )     
|                                                
|                                                
|                                                
|                                                
|Cash and cash equivalents at beginning of period |                                                                                 |                                                | 54,600                                              |         |                   |        | 59,688 |       
|                                                 |                                                                                 |                                                |                                                     |         |                   |        |        |       
|Cash and cash equivalents at end of period       |                                                                                 | $                                              | 53,979                                              |         |                   | $      | 53,067 |       
|                                                 |                                                                                 |                                                |                                                     |         |                   |        |        |       

See accompanying notes to condensed consolidated financial statements.

5



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##### Table of Contents






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

Note 1  Basis of Presentation

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

The accompanying condensed consolidated financial statements have been
prepared pursuant to the rules and regulations of the Securities and Exchange
Commission regarding interim financial reporting. Accordingly, they do not
include all of the information and footnotes required by generally accepted
accounting principles for complete financial statements and should be read in
conjunction with the Financial Statements and notes thereto included in the
Companys Form 10-K for the period ending September 30, 2001. In the opinion of
management, the accompanying condensed consolidated financial statements
contain all adjustments, consisting only of normal recurring items, which the
Company believes is necessary for a fair statement of the Companys financial
position as of June 30, 2002 and its results of operations for the three and
nine month periods ended June 30, 2002 and 2001, respectively. These condensed
consolidated financial statements are not necessarily indicative of the results
to be expected for the entire year.

Note 2  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 3,442,083 shares of common stock, or 278,382 weighted average
shares, for the three months ended June 30, 2002 and 4,956,601 shares of common
stock, or 336,254 weighted average shares, for the nine months ended June 30,
2002 were not included in the computation of diluted earnings per share because
their impact would be anti-dilutive. Outstanding options to purchase 3,923,024
shares of common stock, or 464,605 weighted average shares, for the three
months ended June 30, 2001 and 3,605,769 shares of common stock, or 640,972
weighted average shares, for the nine months ended June 30, 2001 were not
included in the computation of diluted earnings per share because their impact
would be anti-dilutive.

Note 3  Detailed Balance Sheet:

|                                           |                                       |      |             |       |               |   |       |       |  
|------------------------------------------ | ------------------------------------- | ---- | ----------- | ----- | ------------- | - | ----- | ----- | -
|                                           |                                       |      | June
30,    |       | September 30,
|(in thousands)                             |                                       | 2002 |             | 2001 
|                                           |                                       |      |             |       |              
|                                           |                                       |      | (unaudited) |       |               |   |      
|Accounts receivable:                       |                                       |      |             |       |               |   |       |      
|                                          
|                                          
|                                          
|                                          
|                                           | Trade receivables                     |      | $           | 3,728 |               |   | $     | 3,985 |  
|                                          
|                                          
|                                          
|                                          
|                                           | Less: allowance for doubtful accounts |      |             | (145  | )             |   |       | (171  | )
|                                           |                                       |      |             |       |               |   |       |      
|                                           |                                       | $    | 3,583       |       |               | $ | 3,814 |      
|                                           |                                       |      |             |       |               |   |       |      
|Prepaid expenses and other current assets: |                                       |      |             |       |               |   |       |      
|                                          
|                                          
|                                          
|                                          
|                                           | Prepaid taxes                         |      | $           | 958   |               |   | $     | 2,420 |  
|                                          
|                                          
|                                          
|                                          
|                                           | Rent                                  |      |             | 254   |               |   |       | 252   |  
|                                          
|                                          
|                                          
|                                          
|                                           | Insurance                             |      |             | 246   |               |   |       | 296   |  
|                                          
|                                          
|                                          
|                                          
|                                           | License fees                          |      |             | 400   |               |   |       |      |  
|                                          
|                                          
|                                          
|                                          
|                                           | Other                                 |      |             | 820   |               |   |       | 630   |  
|                                           |                                       |      |             |       |               |   |       |      
|                                           |                                       | $    | 2,678       |       |               | $ | 3,598 |      
|                                           |                                       |      |             |       |               |   |       |      

6



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##### Table of Contents



|                                                |                                    |      |             |         |               |   |        |         |  
|----------------------------------------------- | ---------------------------------- | ---- | ----------- | ------- | ------------- | - | ------ | ------- | -
|                                                |                                    |      | June 30,    |         | September 30,
|(in thousands)                                  |                                    | 2002 |             | 2001   
|                                                |                                    |      |             |         |              
|                                                |                                    |      | (unaudited) |         |               |   |       
|Property and equipment:                         |                                    |      |             |         |               |   |        |        
|                                               
|                                               
|                                               
|                                               
|                                                | Computer equipment                 |      | $           | 4,964   |               |   | $      | 4,833   |  
|                                               
|                                               
|                                               
|                                               
|                                                | Furniture and fixtures             |      |             | 1,158   |               |   |        | 1,158   |  
|                                               
|                                               
|                                               
|                                               
|                                                | Leasehold improvements             |      |             | 1,196   |               |   |        | 1,188   |  
|                                               
|                                               
|                                               
|                                               
|                                                | Office equipment                   |      |             | 581     |               |   |        | 580     |  
|                                                |                                    |      |             |         |               |   |        |        
|                                                |                                    |      | 7,899       |         |               |   | 7,759  |        
|                                               
|                                               
|                                               
|                                               
|                                                | Less: accumulated depreciation     |      |             | (5,074  | )             |   |        | (3,648  | )
|                                                |                                    |      |             |         |               |   |        |        
|                                                |                                    | $    | 2,825       |         |               | $ | 4,111  |        
|                                                |                                    |      |             |         |               |   |        |        
|Intangibles and other assets:                   |                                    |      |             |         |               |   |        |        
|                                               
|                                               
|                                               
|                                               
|                                                | Developed and core technology      |      | $           | 3,263   |               |   | $      | 3,263   |  
|                                               
|                                               
|                                               
|                                               
|                                                | Workforce                          |      |             | 599     |               |   |        | 599     |  
|                                               
|                                               
|                                               
|                                               
|                                                | Patents                            |      |             | 600     |               |   |        | 600     |  
|                                               
|                                               
|                                               
|                                               
|                                                | Goodwill                           |      |             | 47,121  |               |   |        | 47,121  |  
|                                               
|                                               
|                                               
|                                               
|                                                | Purchased intellectual property    |      |             | 6,017   |               |   |        | 1,049   |  
|                                               
|                                               
|                                               
|                                               
|                                                | Other                              |      |             | 1,897   |               |   |        | 1,542   |  
|                                                |                                    |      |             |         |               |   |        |        
|                                                |                                    |      | 59,497      |         |               |   | 54,174 |        
|                                               
|                                               
|                                               
|                                               
|                                                | Less: accumulated amortization     |      |             | (21,398 | )             |   |        | (12,583 | )
|                                                |                                    |      |             |         |               |   |        |        
|                                                |                                    | $    | 38,099      |         |               | $ | 41,591 |        
|                                                |                                    |      |             |         |               |   |        |        
|Accrued expenses and other current liabilities: |                                    |      |             |         |               |   |        |        
|                                               
|                                               
|                                               
|                                               
|                                                | Deferred revenue                   |      | $           | 2,218   |               |   | $      | 2,433   |  
|                                               
|                                               
|                                               
|                                               
|                                                | Compensation and employee benefits |      |             | 1,100   |               |   |        | 1,005   |  
|                                               
|                                               
|                                               
|                                               
|                                                | Facility sublease accrual          |      |             | 1,325   |               |   |        | 329     |  
|                                               
|                                               
|                                               
|                                               
|                                                | Accrued litigation settlement      |      |             | 2,700   |               |   |        |        |  
|                                               
|                                               
|                                               
|                                               
|                                                | Other                              |      |             | 766     |               |   |        | 804     |  
|                                                |                                    |      |             |         |               |   |        |        
|                                                |                                    | $    | 8,109       |         |               | $ | 4,571  |        
|                                                |                                    |      |             |         |               |   |        |        

Note 4  Voluntary Stock Option Exchange

On November 15, 2001, the Company extended a voluntary stock option
exchange offer (the Exchange Program) to its eligible employees whereby
employees had the opportunity to cancel options granted from January 29, 1999
through January 8, 2001 in exchange for new options. On December 17, 2001, a
total of 1,278,406 shares were tendered for exchange. The Company was required
to accelerate the amortization of previously recorded deferred compensation
related to options tendered for exchange and, accordingly, recognized
approximately $1.7 million in accelerated deferred compensation expense during
the period ended December 31, 2001. The number of shares granted in exchange
for the old options was subject to the applicable exchange ratio: (i) for every
old option to buy three shares of common stock that was granted between January
29, 1999 and January 14, 2000, a new option was granted to buy two shares of
common stock and (ii) for every old option to buy four shares of common stock
that was granted between January 15, 2000 and January 8, 2001, a new option was
granted to buy three shares of common stock. Additionally, participating
employees who were required to cancel all stock options granted during the six
month period prior to the Exchange Program offer were entitled to receive an
equal number of shares subject to the new options. On June 18, 2002, the
Company granted new options to purchase 910,278 shares of the Companys common
stock in exchange for the options surrendered under the Exchange Program at an
exercise price of $6.66, the fair market value of the Companys common stock on
the new grant date. The new options have the same vesting schedule as if the
old options continued to vest through the new grant date.

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Note 5  Employee Stock Option Plan

In June 2002, the Board of Directors of the Company authorized an increase
in the number of shares reserved for issuance under the 2001 Nonstatutory Stock
Options Plan (the 2001 Plan) of 500,000 shares resulting in a total of 2
million shares reserved for issuance under the 2001 Plan. As of June 30, 2002,
options to purchase an aggregate of 784,405 were granted under the 2001 Plan.

Note 6  Taxation

During the quarter ended June 30, 2002, the
Company recorded $9.8 million of provision for income taxes to
establish valuation allowances against deferred tax assets. Continuing
losses in recent reporting periods increase the uncertainties
regarding realizability of deferred tax assets. After the
establishment of the valuation allowance, the Company has $2.2
million in remaining deferred tax assets as of June 30, 2002,
which is expected to be realized as refunds of prior taxes paid in
accordance with taxation carryback provisions.

Note 7  Legal Matters

In October and November 1999, six purported class action complaints were
filed in the United States District Court for the Northern District of
California (the District Court) against the Company and certain of its
officers and directors. On March 17, 2000, these complaints were consolidated
into In re Hi/fn, Inc. Securities Litigation No. 99-04531 SI. The consolidated
complaint was filed on behalf of persons who purchased the Companys stock
between July 26, 1999 and October 7, 1999 (the class period). The complaint
sought unspecified money damages and alleged that the Company and certain of
its officers and directors violated federal securities laws in connection with
various public statements made during the class period. In August 2000, the
Court dismissed the complaint as to all defendants, other than Raymond J.
Farnham and the Company. In February 2001, the District Court certified the
purported class. On May 15, 2002, the parties entered into a Memorandum of
Understanding to settle all claims in the consolidated securities class action.
The settlement amount is $9.5 million, comprised of $6.8 million in cash that
was contributed by the Companys insurers and $2.7 million to be settled by the
Company. The Company will issue a minimum of 270,000 shares of Hifn common
stock and make up any shortfall to the extent that the trading price falls
below $10.00 at the time of settlement by issuing additional common stock or
cash. On June 10, 2002, the District Court entered an order preliminarily
approving the Stipulation of Settlement and providing for notice and an
opportunity to object to the shareholder class. The settlement is subject to
final court approval, which is scheduled for August 30, 2002. During the three
months ended June 30, 2002, the Company recorded a liability of $2.7 million
representing its portion of the settlement obligation. Should the fair market
value of the Companys common stock exceed $10, the Company would recognize an
additional charge equal to the aggregate fair market value of the 270,000
shares of common stock less the $2.7 million already recognized. If the
settlement is disapproved or terminated and the action proceeds, the Company
intends to defend the action vigorously.

In March 2002, two purported shareholder derivative actions were filed,
one in the United States District Court for the Northern District of California
and one in the Superior Court of California for the County of Santa Clara (the
federal derivative action and the state derivative action, respectively).
These complaints were filed against Hifn, Inc. and certain of its current and
former officers and directors. The derivative complaints alleged violations of
California Corporations Code Section 25402, breach of fiduciary duty and waste
of corporate assets, based on the same facts and events alleged in the class
action. On June 7, 2002, the federal court entered an order granting
plaintiffs motion to voluntarily dismiss the federal derivative action without
prejudice. On June 26, 2002, the state court sustained Hifns demurrer, with
leave to amend, on the ground that plaintiff had failed to plead facts showing
that he was excused from making demand on the Companys board of directors. The
court also ordered limited discovery relating solely to the issue whether
demand is excused. The court did not rule upon the demurrer to the derivative
complaint filed by the individual director defendants. The Company did not
accrue for loss contingencies associated with this action because the Company
believes that an unfavorable settlement is not probable. The Company and the
individual director defendants believe the allegations contained in the
complaint are without merit and intend to defend the action vigorously.

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Note 8  Recent Accounting Pronouncements

In June 2001, the FASB issued SFAS No. 141, Business Combinations (SFAS
141) and SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142).
SFAS 141 will apply to all business combinations that the Company enters into
after June 30, 2001, and eliminates the pooling-of-interests method of
accounting. SFAS 142 is effective for fiscal years beginning after December 15,
2001. Under the new Statements, goodwill and intangible assets deemed to have
indefinite lives will no longer be amortized but will be subject to annual
impairment tests in accordance with the Statements. Other intangible assets
will continue to be amortized over their useful lives. In addition, the
Statements include provisions upon adoption for the reclassification of certain
existing recognized intangibles as goodwill, reassessment of the useful lives
of existing recognized intangibles, reclassification of certain intangibles out
of previously reported goodwill and the testing for impairment of existing
goodwill and other intangibles. The Company is required to adopt these
Statements for accounting for goodwill and other intangible assets beginning
October 1, 2002 at which time the Company will cease amortization of goodwill
and reclassify the unamortized balance of workforce to goodwill. Goodwill
amortization expense aggregated $2.4 million during each of the three months
ended June 30, 2002 and 2001 and $7.1 million during each of the nine months
ended June 30, 2002 and 2001. As of June 30, 2002, the net book value of
goodwill and workforce was approximately $29.4 million. Upon adoption on
October 1, 2002, the Company will perform the required impairment tests of
goodwill and has not yet determined the effect of these tests on the earnings
and financial position of the Company. If as a result of the analysis we
determine that there has been an impairment of the Companys goodwill, asset
impairment charges will be recognized in the first quarter of fiscal 2003.

In August 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets (SFAS 144). SFAS 144 supersedes
SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of, and provides further guidance regarding
the accounting and disclosure of long-lived assets. The Company is required to
adopt SFAS 144 effective October 1, 2002, and has not yet determined the
impact, if any, of adoption.

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

Cautionary Statement Regarding Forward-Looking Statements

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

Overview

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

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

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

Critical Accounting Policies

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

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

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

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

The Company receives software license revenue from OEMs that sublicense
Company software shipped with their products. The OEM sublicense agreements are
generally valid for a term of one year and include rights to unspecified future
upgrades and maintenance during the term of the agreement. License fees under
these agreements are recognized ratably over the term of the agreement.
Revenues from sublicenses sold in excess of the specified volume in the
original license agreement are recognized when they are reported as sold to end
customers by the OEM. The Companys deferred revenue balance as of June 30,
2002 was $2.2 million and included approximately $182,000 in estimated returns.

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

Inventories.We value our inventory at the lower of cost (determined on a
first-in, first-out cost method) or market. Inventories are comprised solely of
finished goods, which are manufactured by third party foundries for resale by
the Company. The Company provides for obsolete, slow moving or excess
inventories, based on forecasts prepared by management, in the period when
obsolescence or inventory in excess of expected demand is first identified.
Reserves are established to reduce the cost basis of inventory for excess and
obsolete inventory. As of June 30, 2002, the remaining portion of a write-down
in excess inventory was $3.8 million. Subsequent increases in projected demand
will not result in a reversal of these reserves until the sale of the related
inventory.

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

Valuation of long-lived and intangible assets and goodwill.We evaluate
the recovery of goodwill, other intangible assets and other long-lived assets
on a periodic basis and whenever events or changes in circumstances indicate
that their carrying value may not be recoverable through the estimated
undiscounted future cash flows resulting from the use of the assets. If we
determine that the carrying value of goodwill, other intangible assets and
other long-lived assets may not be recoverable we measure impairment by using
the projected discounted cash-flow method.

Our judgments regarding the existence of impairment indicators are based
on market conditions and operational performance of our business. Future events
could cause us to conclude that impairment indicators exist and that goodwill
is impaired. Any resulting impairment loss could have a material adverse impact
on our financial condition and results of operations.

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In accordance with Financial Accounting Standards Board Statement of
Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible
Assets, goodwill and intangible assets deemed to have indefinite lives will no
longer be amortized but instead will be subject to annual impairment tests. We
will adopt SFAS No. 142 during the first quarter of fiscal 2003. Other
intangible assets will continue to be amortized over their useful lives.
Certain existing recognized intangibles will be reclassified as goodwill.
Goodwill amortization expense aggregated $2.4 million, $7.1 million and $9.4
million during the three and nine months ended June 30, 2002 and in fiscal
2001, respectively. As of June 30, 2002, the net book value of goodwill and
workforce was approximately $29.4 million. Upon adoption on October 1, 2002,
the Company will perform the required impairment tests of goodwill and has not
yet determined the effect of these tests on the earnings and financial position
of the Company. If as a result of the analysis we determine that there has been
an impairment of the Companys goodwill, asset impairment charges will be
recognized in the first quarter of fiscal 2003. Asset impairment charges could
have a material effect on the Companys consolidated financial position and
results of operations.

Accounting for income taxes.As part of the process of preparing our
consolidated financial statements we are required to estimate our income taxes,
which involves estimating our actual current tax exposure together with
assessing temporary differences resulting from differing treatment of items for
tax and accounting purposes. These differences result in deferred tax assets
and liabilities.

Significant management judgment is required to assess the likelihood that
our deferred tax assets will be recovered from future taxable income. During
the quarter ended June 30, 2002, the Company recorded $9.8
million of provision for income taxes to establish valuation
allowances against deferred tax assets. Continuing losses in recent
reporting periods increase the uncertainties regarding realizability
of deferred tax assets. After the establishment of the valuation
allowance, the Company has $2.2 million in remaining deferred tax
assets as of June 30, 2002, which is expected to be realized as
refunds of prior taxes paid in accordance with taxation carryback
provisions. While we have considered future taxable income and
ongoing prudent and feasible tax planning strategies in assessing the need for
the valuation allowance, in the event we were to determine that we would be
able to realize our deferred tax assets in the future in excess of its net
recorded amount, an adjustment to the deferred tax asset would increase income
in the period such determination was made. Likewise, should we determine that
we will not be able to realize all or part of our net deferred tax asset in the
future, an adjustment to the deferred tax asset would be charged to income in
the period such determination is made.

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

During the three months ended June 30, 2002, in relation to the class
action suit against the Company, the court preliminarily approved a settlement
of all claims and the Company recognized approximately $2.7 million in accrued
litigation settlement charges, which represent the Companys portion of the
settlement amount. Should the fair market value of the Companys common stock
exceed $10 prior to finalization of the settlement, the Company would recognize
an additional charge equal to the aggregate fair market value of the 270,000
shares of common stock less the $2.7 million already recognized. Future
increases in the value of common stock above $10 prior to finalization of the
settlement or disapproval and termination of the settlement may require us to
revise reserves and may materially affect our results of operations, financial
condition and future cash flows.

12



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Results of Operations

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

|                                          |                                          |  |                    |    |                   |  |      |    |      |  |      |    |  |  |     |    | 
|----------------------------------------- | ---------------------------------------- |  | ------------------ | -- | ----------------- |  | ---- | -- | ---- |  | ---- | -- |  |  | --- | -- | 
|                                          |                                          |  | Three Months Ended |    | Nine Months Ended
|                                          |                                          |  | June 30,           |    | June 30,         
|                                          |                                          |  |                    |    |                  
|                                          |                                          |  | 2002               |    | 2001              |  | 2002 |    | 2001
|                                          |                                          |  |                    |    |                   |  |      |    |     
|Net revenues                              |                                          |  | 100                | %  |                   |  | 100  | %  |      |  | 100  | %  |  |  | 100 | % 
|                                          |                                          |  |                    |    |                   |  |      |    |      |  |      |    |  |  |     |   
|Costs and operating expenses:             |                                          |  |                    |    |                   |  |      |    |      |  |      |    |  |  |     |   
|                                         
|                                         
|                                         
|                                         
|                                          | Cost of revenues                         |  |                    | 29 |                   |  |      | 78 |      |  |      | 30 |  |  |     | 33 | 
|                                         
|                                         
|                                         
|                                         
|                                          | Research and development                 |  |                    | 77 |                   |  |      | 77 |      |  |      | 78 |  |  |     | 39 | 
|                                         
|                                         
|                                         
|                                         
|                                          | Sales and marketing                      |  |                    | 38 |                   |  |      | 32 |      |  |      | 36 |  |  |     | 21 | 
|                                         
|                                         
|                                         
|                                         
|                                          | General and administrative               |  |                    | 69 |                   |  |      | 27 |      |  |      | 47 |  |  |     | 17 | 
|                                         
|                                         
|                                         
|                                         
|                                          | Amortization of intangibles and goodwill |  |                    | 52 |                   |  |      | 42 |      |  |      | 49 |  |  |     | 22 | 
|                                          |                                          |  |                    |    |                   |  |      |    |      |  |      |    |  |  |     |   
|Total costs and operating expenses        |                                          |  | 265                |    |                   |  | 256  |    |      |  | 240  |    |  |  | 132 |   
|                                          |                                          |  |                    |    |                   |  |      |    |      |  |      |    |  |  |     |   
|Loss from operations                      |                                          |  | (165               | )  |                   |  | (156 | )  |      |  | (140 | )  |  |  | (32 | ) 
|                                         
|                                         
|                                         
|                                         
|Interest and other income, net            |                                          |  | 4                  |    |                   |  | 9    |    |      |  | 5    |    |  |  | 6   |   
|                                          |                                          |  |                    |    |                   |  |      |    |      |  |      |    |  |  |     |   
|Loss before income taxes                  |                                          |  | (161               | )  |                   |  | (147 | )  |      |  | (135 | )  |  |  | (26 | ) 
|                                         
|                                         
|                                         
|                                         
|Provision
for (benefit from) income taxes |                                          |  | 179                |    |                   |  | (42  | )  |      |  | 34   |    |  |  | (1  | ) 
|                                          |                                          |  |                    |    |                   |  |      |    |      |  |      |    |  |  |     |   
|Net loss                                  |                                          |  | (340               | )% |                   |  | (105 | )% |      |  | (169 | )% |  |  | (25 | )%
|                                          |                                          |  |                    |    |                   |  |      |    |      |  |      |    |  |  |     |   

Net Revenues.Net revenues decreased 17% to $5.5 million for the quarter
ended June 30, 2002 from $6.6 million for the quarter ended June 30, 2001. Net
revenues for the first nine months of fiscal 2002 was $17.6 million, a decrease
of 52% from the $36.5 million reported for the first nine months of fiscal
2001. The decrease in net revenues for the three and nine months ended June 30,
2002 over the same periods in the prior year was primarily due to decreased
sales of Hifns data compression and encryption processors to network equipment
manufacturers coupled with a decrease in revenues from software license and
royalties. Semiconductor sales to Quantum, an OEM producer of high-performance
tape storage devices, through its manufacturing subcontractor, comprised 35%
and 40% of revenues for the three and nine months ended June 30, 2002,
respectively. Semiconductor sales to Benchmark, an OEM producer of networking
equipment, comprised 16% and 10% of revenues for the three and nine months
ended June 30, 2002, respectively.

Cost of Revenues.Cost of revenues consists primarily of semiconductors
which were manufactured to our specifications by third parties for resale by
us. Cost of revenues as a percentage of net revenues decreased to 29.3% for the
three months ended June 30, 2002 from 77.5% for the same period in fiscal 2001.
Cost of revenues as a percentage of net revenues decreased to 30.3% for the
nine months ended June 30, 2002 from 32.9% for the same period in fiscal 2001.
During the three month period ended June 30, 2001, the Company recognized a
charge for excess inventory of $3.4 million. Exclusive of this charge, cost of
revenues for the three and nine months ended June 30, 2001 were 25.8% and
23.6%, respectively. The fluctuation in cost of revenues as a percentage of net
revenues for both periods, exclusive of the inventory write-down, is
attributable to the sale of certain processors at lower prices, a shift in the
processor revenue mix, lower levels of software revenue and the impact of a
consistent level of overhead expenses spread over a lower revenue base.

Research and Development.The cost of product development consists
primarily of salaries, employee benefits, overhead, outside contractors and
nonrecurring engineering fees. Such research and development expenses were
approximately $4.2 million and $5.1 million for the quarters ended June 30,
2002 and 2001, respectively. The decrease is primarily attributable to
reductions in wages and benefits as a result of lower headcount, outside
consulting and non-recurring engineering costs as a result of the timing and
stage of product development, as well as a reduction in deferred compensation
amortization. Research and development costs were $13.7 million and $14.2
million for the nine months ended June 30, 2002 and 2001, respectively. The
decrease primarily reflects the net effect of a decrease in salaries, benefits
and outside consulting services. The decrease is partially offset by increases
in engineering development costs and deferred compensation expense. The
deferred compensation expense increased as a result of options tendered for
exchange in the first quarter of 2002.

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Sales and Marketing.Sales and marketing expenses consist primarily of
the salaries, commissions and benefits of sales, marketing and support
personnel, and consulting, advertising, promotion and overhead expenses. Such
expenses were approximately $2.1 million for both the three months ended June
30, 2002 and 2001. Sales and marketing expense for the nine months ended June
30, 2002 and 2001 were approximately $6.4 million and $7.5 million,
respectively. The decrease primarily reflects lower commission costs associated
with lower revenues as well as lower marketing collateral and recruiting costs.

General and Administrative.General and administrative expenses are
comprised primarily of salaries for administrative and corporate services
personnel, legal and other professional fees. Such expenses were $3.8 million
and $1.8 million for the three months ended June 30, 2002 and 2001,
respectively. The increase is primarily attributable to a charge of $2.7
million for litigation settlement related to the class action lawsuit offset by
reductions in salaries and benefits, building expenses, lower equipment
purchases and recruiting costs as well as a decrease in doubtful accounts
expenditure. General and administrative expenses for the nine months ended June
30, 2002 and 2001 were $8.2 million and $6.1 million, respectively. The
increase is the effect of $2.7 million in charges for litigation settlement and
an increase of $635,000 in facility sublease costs, as well as increased legal
costs. The increase was offset by reductions in deferred compensation
amortization, salaries and benefits and lower equipment purchases and
recruiting costs.

Amortization of Intangibles and Goodwill.Amortization of intangibles and
goodwill relate primarily to the acquisition of Apptitude as well as other
intellectual property. Amortization of intangibles and goodwill was $2.8
million for each of the three months ended June 30, 2002 and 2001 and $8.6
million and $8.3 million for the nine months ended June 30, 2002 and 2001,
respectively.

Interest and Other Income, Net.Net interest and other income was $211,000
and $592,000 for the three months ended June 30, 2002 and 2001, respectively,
and $824,000 and $2.2 million for the nine months ended June 30, 2002 and 2001,
respectively. The decrease in interest and other income for the periods
presented was mainly due to lower average cash balances, a shift in the
investment mix and lower overall interest rates.

Income Taxes.The effective income tax rate was (111)% and 29% for three
months ended June 30, 2002 and 2001, respectively, and (25)% and 6% for the
nine months ended June 30, 2002 and 2001, respectively. During the three months
ended June 30, 2002, the Company recorded a provision for income taxes of
approximately $9.8 million to establish valuation allowances against deferred
tax assets in accordance with FASB No. 109, Accounting for Income Taxes. Net
of the valuation allowance, the remaining deferred tax assets at June 30, 2002
was approximately $2.2 million and represents expected refunds of prior taxes
paid in the carry-back period. The remaining variability in the effective tax
rates is reflective of the effect of the non-deductibility of certain
acquisition related charges on the respective operating results for the period.

Liquidity and Capital Resources

Net cash used in operating activities was $8.1 million for the nine months
ended June 30, 2002. Net cash provided by operating activities was $2.1 million
for the nine months ended June 30, 2001. During the nine months ended June 30,
2002, net cash used in operating activities was attributed to net loss as
adjusted for non-cash items including amortization of intangibles and deferred
stock compensation of $11.2 million, tax benefit from employee stock plans of
$281,000, depreciation and amortization costs of $1.4 million, a decrease in
deferred tax assets of $5.1 million, as well as a decrease in accounts
receivable, inventories and prepaid expenses and other current assets of
$231,000, $1.3 million and $920,000, respectively, and an increase in accounts
payable and accrued and other current liabilities of $4.1 million. These
adjustments were offset mainly by an increase in intangibles and other assets
of $2.9 million. During the nine months ended June 30, 2001, net cash provided
by operating activities was attributed to net loss as adjusted for non-cash
items including amortization of intangibles and deferred stock compensation of
$11.7 million, tax benefit from employee stock plans of $3.9 million,
depreciation and amortization costs of $1.2 million, as well as a decrease in
accounts receivable of $2.8 million and an increase in accrued expenses and
other current liabilities of $139,000. These adjustments were offset by
increases in inventory and prepaid expenses and other assets of $718,000 and
$6.5 million, respectively, as well as a decrease in accounts payable of $1.4
million.

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Net cash provided by investing activities was $6.6 million for the nine
months ended June 30, 2002 and related to the sale of short-term investments.
Net cash used in investing activities was $9.8 million for the nine months
ended June 30, 2001 and related to the purchase of $7.3 million in short-term
investments and $2.4 million in property and equipment.

Net cash provided by financing activities was $916,000 and $1.1 million
for the nine month periods ended June 30, 2002 and 2001, respectively. Net cash
provided by financing activities for both periods was attributable to proceeds
from issuance of common stock slightly offset by payments on capital lease
obligations.

We use a number of independent suppliers to manufacture substantially all
of our products. As a result, we rely on these suppliers to allocate to us a
sufficient portion of foundry capacity to meet our needs and deliver sufficient
quantities of our products on a timely basis. These arrangements allow us to
avoid utilizing our capital resources for manufacturing facilities and
work-in-process inventory and to focus substantially all of our resources on
the design, development and marketing of our products. Additionally, orders
with our suppliers require substantial lead times and require, from time to
time, adjustments in our ordering patterns based on anticipated customer
demand. As of June 30, 2002, our inventory balance decreased to $418,000 as
compared to $1.7 million as of fiscal year ended September 30, 2001 resulting
mainly from the sale of existing inventory coupled with a reduction in orders
as a result of reduced customer demand. We will continue to monitor shifts in
customer demand and will adjust our order levels accordingly.

We require substantial working capital to fund our business, particularly
to finance accounts receivable and inventory, and for investments in property
and equipment. Our need to raise capital in the future will depend on many
factors including the rate of sales growth, market acceptance of our 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 current cash and cash
equivalents, short-term investments and cash generated from operations will
satisfy our expected working capital, capital expenditure and investment
requirements through at least the next twelve months.

The Company occupies its facilities under several non-cancelable operating
leases that expire at various dates through December 2007, and which contain
renewal options. Future minimum lease payments for operating leases as of June
30, 2002 are as follows (in thousands):

|                                 |            |                              |   |                 |        | 
|-------------------------------- | ---------- | ---------------------------- | - | --------------- | ------ | 
|                                 |            |                              |   | Operating Lease
|                                 |            |                              |   | Commitments    
|                                 |            |                              |   |                
|Fiscal year ending September 30, |            |                              |   |                
|                                
|                                
|                                
|                                
|                                 | 2002       |                              | $ | 761             |       
|                                
|                                
|                                
|                                
|                                 | 2003       |                              |   | 3,058           |       
|                                
|                                
|                                
|                                
|                                 | 2004       |                              |   | 2,685           |       
|                                
|                                
|                                
|                                
|                                 | 2005       |                              |   | 2,146           |       
|                                
|                                
|                                
|                                
|                                 | Thereafter |                              |   | 2,005           |       
|                                 |            |                              |   |                
|                                 |            | Total minimum lease payments |   | $               | 10,655 | 
|                                 |            |                              |   |                

Recent Accounting Pronouncements

In June 2001, the FASB issued SFAS No. 141, Business Combinations (SFAS
141) and SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142).
SFAS 141 will apply to all business combinations that the Company enters into
after June 30, 2001, and eliminates the pooling-of-interests method of
accounting. SFAS 142 is effective for fiscal years beginning after December 15,
2001. Under the new Statements, goodwill and intangible assets deemed to have
indefinite lives will no longer be amortized but will be subject to annual
impairment tests in accordance with the Statements. Other intangible assets
will continue to be amortized over their useful lives. In addition, the
Statements include provisions upon adoption for the reclassification of certain
existing recognized intangibles as goodwill, reassessment of the useful lives
of existing recognized intangibles, reclassification of certain intangibles out
of previously reported goodwill and the testing for impairment of existing
goodwill and other intangibles. The Company is required to adopt these
Statements for accounting for goodwill and other intangible assets beginning
October 1, 2002 at which time the Company will cease amortization of goodwill
and reclassify the unamortized balance of workforce to goodwill. Goodwill
amortization expense aggregated $2.4 million, $7.1 million

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and $9.4 million during the three and nine months ended June 30, 2002 and
in fiscal 2001, respectively. As of June 30, 2002, the net book value of
goodwill and workforce was approximately $29.4 million. Upon adoption on
October 1, 2002, the Company will perform the required impairment tests of
goodwill and has not yet determined the effect of these tests on the earnings
and financial position of the Company. If as a result of the analysis we
determine that there has been an impairment of the Companys goodwill, asset
impairment charges will be recognized in the first quarter of fiscal 2003.
Asset impairment charges could have a material effect on the Companys
consolidated financial position and results of operations.

In August 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets (SFAS 144). SFAS 144 supersedes
SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of, and provides further guidance regarding
the accounting and disclosure of long-lived assets. The Company is required to
adopt SFAS 144 effective October 1, 2002, and has not yet determined the
impact, if any, of adoption.

Trends and Uncertainties

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, but not limited to, the following:



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

If We Determine That Our Goodwill Has Been Impaired Our Financial Condition and
Results of Operations May Suffer.

At June 30, 2002, we had approximately $29.4 million of goodwill. Pursuant
to SFAS 142, Goodwill and Other Intangible Assets, we
will adopt SFAS 142 beginning October 1, 2002 and will perform our annual
goodwill impairment test upon adoption. If as a result of this analysis we
determine that there has been an impairment of our goodwill, asset impairment
charges will be recognized in the first quarter of fiscal 2003. Asset
impairment charges could have a material adverse effect on our consolidated
financial position and results of operations.

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We Depend Upon A Small Number Of Customers.

Quantum Corporation (Quantum), through its manufacturing subcontractor,
accounted for approximately 35%, 40% and 36% of our revenues during the three
and nine months ended June 30, 2002 and in fiscal year 2001, respectively.
Lucent, through its manufacturing subcontractors, accounted for approximately
17% of our revenues during fiscal year 2001 and less than 10% of our revenues
for the three and nine months ended June 30, 2002, respectively. Linksys accounted for 13% of
our revenues for the three months ended March 31, 2002 and less than 10% of our
revenues for the nine months ended June 30, 2002 and Benchmark accounted for
16% and 10% of our revenues for the three and nine months ended June 30, 2002.
Quantum, Lucent, Linksys and Benchmark do not have any binding obligations to
order from us. If our sales to and of these customers decline, our business,
financial condition and results of operations could suffer. We expect that our
most significant customers in the future could be different from our largest
customers today for a number of reasons, including customers deployment
schedules and budget considerations. As a result, we believe we may experience
significant fluctuations in our results of operations on a quarterly and an
annual basis.

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

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

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

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

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



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

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

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

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



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

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

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

Our Markets Are Highly Competitive.

We compete in markets that are intensely competitive and are expected to
become more competitive as current competitors expand their product offerings
and new competitors enter the market. The markets that we compete in are
subject to frequent product introductions with improved price-performance
characteristics, rapid technological change, and the continued emergence of new
industry standards. Our products compete with offerings from companies such as
Analog Devices, Inc., Safenet, Inc., IBM, Broadcom Corporation, Motorola, Inc.
and Philips Corporation. We operated as a division of Stac, Inc., our previous
parent company, and was spun-off from Stac on December 16, 1998. In connection
with the spin-off, we assumed certain license agreements entered into by Stac
including two license agreements 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 entered into a license agreement with
Microsoft Corporation (Microsoft) in 1994 whereby Stac granted Microsoft the
right to use, but not sublicense, our compression technology in their software
products. We expect significant future competition from major domestic and
international semiconductor suppliers. Several established electronics and
semiconductor suppliers have recently entered, or expressed an interest to
enter, the network equipment market. We also may face competition from
suppliers of products based on new or emerging technologies. Furthermore, many
of our existing and potential customers internally develop solutions which
attempt to perform all or a portion of the functions performed by our products.

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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 had an advantage
over us in their ability to establish existing markets for their products and
rapidly respond to the requests of customers in the global market. Although
the export restriction has been liberalized, we may not be successful in
entering or competing in the foreign encryption markets. See Our Products Are
Subject To Export Restrictions.

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

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



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

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

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

Our success is largely dependent upon continued growth in the market for
network security equipment, such as routers, remote access concentrators,
switches, broadband access equipment, security gateways, firewalls and network
interface cards. In addition, our success depends upon storage equipment
vendors incorporating our packet processors into their systems. The network
security equipment market has in the past, and may in the future, fluctuate
significantly based upon numerous factors, including the lack of industry
standards, adoption of alternative technologies, capital spending levels and
general economic conditions. We are unable to determine the rate or extent

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to which these markets will grow, if at all. Any decrease in the growth of
the network or storage equipment market or a decline in demand for our products
could harm our business, financial condition and results of operations.

Our Success Depends Upon Protecting Our Intellectual Property.

Our proprietary technology is critical to our future success. We rely in
part on patent, trade, trademark, maskwork and copyright law to protect our
intellectual property. We own 12 United States patents and four foreign
patents. We also have 2 pending patent applications in Japan. Our issued
patents and patent applications primarily cover various aspects of our
compression technology and have expiration dates ranging from 2006 to 2013. In
addition to compression, we have six pending patent applications in the United
States, four in Europe and Asia (Japan) covering our flow classification
technology. There are 2 pending patent applications in the United States
covering our bandwidth management and rate shaping technology. Patents may not
be issued under our current or future patent applications, and the patents
issued under such patent applications could be invalidated, circumvented or
challenged. In addition, third parties could make infringement claims against
us in the future. Such infringement claims could result in costly litigation.
We may not prevail in any such litigation or be able to license any valid and
infringed patents from third parties on commercially reasonable terms, if at
all. Regardless of the outcome, an infringement claim would likely result in
substantial cost and diversion of our resources. Any infringement claim or
other litigation against us or by us could harm our business, financial
condition and results of operations. The patents issued to us may not be
adequate to protect our proprietary rights, to deter misappropriation or to
prevent an unauthorized third party from copying our technology, designing
around the patents we own or otherwise obtaining and using our products,
designs or other information. In addition, others could develop technologies
that are similar or superior to our technology.

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

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

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

We Depend Upon Independent Manufacturers And Limited Sources Of Supply.

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

We depend on our suppliers to deliver sufficient quantities of finished
product to us in a timely manner. Since we place orders on a purchase order
basis and do not have long-term volume purchase agreements with any of our
suppliers, our suppliers may allocate production capacity to other products
while reducing deliveries to us on short notice. For example, in June 1995, one
of our suppliers delayed the delivery of one of our products. As a result, we
switched production of the product to a new manufacturer. This caused a 3-month
delay in shipments to customers. We 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

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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.

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

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

Network And Storage Equipment Prices Typically Decrease.

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



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

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

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

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

We Face Order And Shipment Uncertainties.

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

We Depend Upon Key Personnel.

Our success greatly depends on the continued contributions of our key
management and other personnel, many of whom would be difficult to replace. We
do not have employment contracts with any of our key personnel, nor do we
maintain any key man life insurance on any of our personnel. Several members of
our management team have joined us in the last 18 months. It may be difficult
for us to integrate new members of our management team. We must also attract
and retain experienced and highly skilled engineering, sales and marketing and
managerial personnel. Competition for such personnel is intense in the
geographic areas and market segments in which we compete, and we may not be
successful in hiring and retaining such people. If we lose the services of any
key personnel, or cannot attract or retain qualified personnel, particularly
engineers, our business, financial condition and results of operations could
suffer. In addition, companies in technology industries whose employees accept
positions with competitors have in the past claimed that their competitors have
engaged in unfair competition or hiring practices. We could receive such claims
in the future as we seek to hire qualified personnel. These claims could result
in material litigation. We could incur substantial costs in defending against
any such claims, regardless of their merits.

Our Products Are Subject To Export Restrictions.

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

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We Face Risks Associated With Our International Business Activities.

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



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

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

We Face Risks Associated With Acquisitions.

We continually evaluate strategic acquisitions of businesses and
technologies that would complement our product offerings or enhance our market
coverage or technological capabilities. While we are not currently negotiating
any acquisitions, we may make additional acquisitions in the future. Future
acquisitions could be effected without stockholder approval, and could cause us
to dilute shareholder equity, incur debt and contingent liabilities and
amortize acquisition expenses related to goodwill and other intangible assets,
any of which could harm our operating results and/or the price of our Common
Stock. Acquisitions entail numerous risks, including:



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

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

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The Cyclicality Of The Semiconductor Industry May Harm Our Business.

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

Our Stock Price May Be Volatile.

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



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

We Are Currently Engaged in Several Securities Class-Action Lawsuits.

In October and November 1999, six purported class action complaints were
filed in the United States District Court for the Northern District of
California (the District Court) against the Company and certain of its
officers and directors. On March 17, 2000, these complaints were consolidated
into In re Hi/fn, Inc. Securities Litigation No. 99-04531 SI. The consolidated
complaint was filed on behalf of persons who purchased the Companys stock
between July 26, 1999 through October 7, 1999 (the class period). The
complaint sought unspecified money damages and alleged that the Company and
certain of its officers and directors violated federal securities laws in
connection with various public statements made during the class period. In
August 2000, the Court dismissed the complaint as to all defendants, other than
Raymond J. Farnham and the Company. In February 2001, the District Court
certified the purported class. On May 15, 2002, the parties entered into a
memorandum of Understanding to settle all claims in the consolidated securities
class action. Under the terms of the settlement, all claims will be dismissed
without any admission of liability or wrongdoing by any defendant; the
shareholder class will receive $9.5 million, comprised of $6.8 million in cash,
which was contributed by the Companys directors and officers insurance
carriers, and the balance to be paid by the Company and shall consist of a
minimum of 270,000 shares of common (assuming the trading price at the date of
distribution is at least $10). Should the trading price be below $10.00, the
Company will supplement the difference between the trading price and $10 with
either cash or additional shares of common stock such that the total settlement
amount is no less than $9.5 million. On June 10, 2002, the District Court
entered an order preliminarily approving the Stipulation of Settlement and
providing for notice and an opportunity to object to the shareholder class. The
settlement is subject to final court approval, which is scheduled for August
30, 2002. During the three months ended June 30, 2002, the Company recorded a
liability of $2.7 million representing its portion of the settlement
obligation. Should the fair market value of the Companys common stock exceed
$10, the Company would recognize an additional charge equal to the aggregate
fair market value of the 270,000 shares of common stock less the $2.7 million
already recognized. If the settlement is disapproved or terminated and the
action proceeds, the Company intends to defend the action vigorously.

In March 2002, two purported shareholder derivative actions were filed,
one in the United States District Court for the Northern District of California
and one in the Superior Court of California for the County of Santa Clara (the
federal derivative action and the state derivative action, respectively).
These complaints were filed against

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nominal defendant Hifn, Inc. and certain of its current and former officers and
directors. The derivative complaints alleged violations of California
Corporations Code Section 25402, breach of fiduciary duty and waste of
corporate assets, based on the same facts and events alleged in the class
action. On June 7, 2002, the federal court entered an order granting
plaintiffs motion to voluntarily dismiss the federal derivative action without
prejudice. On June 26, 2002, the state court sustained nominal defendant Hifns
demurrer, with leave to amend, on the ground that plaintiff had failed to plead
facts showing that he was excused from making demand on the Companys board of
directors. The court also ordered limited discovery relating solely to the
issue whether demand is excused. The court did not rule upon the demurrer to
the derivative complaint filed by the individual director defendants. The
Company and the individual director defendants believe the allegations
contained in the complaint are without merit and intend to defend the action
vigorously.

It is possible that an adverse outcome of these matters, either
individually or in the aggregate, could have a material adverse effect on our
business and results of operations and our stock price could be negatively
affected as a result.




Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk  The Company does not use derivative financial
instruments in its investment portfolio. The Companys investment portfolio is
generally comprised of commercial paper. The Company places investments in
instruments that meet high credit quality standards. These securities are
subject to interest rate risk, and could decline in value if interest rates
fluctuate. Due to the short duration and conservative nature of the Companys
investment portfolio, the Company does not expect any material loss with
respect to its investment portfolio. A 10% move in interest rates at June 30,
2002 would not have a material effect on the Companys pre-tax earnings and the
carrying value of its investments over the next fiscal year.

Foreign Currency Exchange Rate Risk  All of the Companys sales, cost of
manufacturing and marketing are transacted in US dollars. Accordingly, the
Companys results of operations are not subject to foreign exchange rate
fluctuations. Gains and losses from such fluctuations have not been incurred by
the Company to date.

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PART II  OTHER INFORMATION




Item 1. Legal Proceedings

In October and November 1999, six purported class action complaints were
filed in the United States District Court for the Northern District of
California (the District Court) against the Company and certain of its
officers and directors. On March 17, 2000, these complaints were consolidated
into In re Hi/fn, Inc. Securities Litigation No. 99-04531 SI. The consolidated
complaint was filed on behalf of persons who purchased the Companys stock
between July 26, 1999 through October 7, 1999 (the class period). The
complaint sought unspecified money damages and alleged that the Company and
certain of its officers and directors violated federal securities laws in
connection with various public statements made during the class period. In
August 2000, the Court dismissed the complaint as to all defendants, other than
Raymond J. Farnham and the Company. In February 2001, the District Court
certified the purported class. On May 15, 2002, the parties entered into a
memorandum of Understanding to settle all claims in the consolidated securities
class action. Under the terms of the settlement, all claims will be dismissed
without any admission of liability or wrongdoing by any defendant; the
shareholder class will receive $9.5 million, comprised of $6.8 million in cash,
which was contributed by the Companys directors and officers insurance
carriers, and the balance to be paid by the Company and shall consist of a
minimum of 270,000 shares of common (assuming the trading price at the date of
distribution is at least $10). Should the trading price be below $10.00, the
Company will supplement the difference between the trading price and $10 with
either cash or additional shares of common stock such that the total settlement
amount is no less than $9.5 million. On June 10, 2002, the District Court
entered an order preliminarily approving the Stipulation of Settlement and
providing for notice and an opportunity to object to the shareholder class. The
settlement is subject to final court approval, which is scheduled for August
30, 2002. During the three months ended June 30, 2002, the Company recorded a
liability of $2.7 million representing its portion of the settlement
obligation. Should the fair market value of the Companys common stock exceed
$10, the Company would recognize an additional charge equal to the aggregate
fair market value of the 270,000 shares of common stock less the $2.7 million
already recognized. If the settlement is disapproved or terminated and the
action proceeds, the Company intends to defend the action vigorously.

In March 2002, two purported shareholder derivative actions were filed,
one in the United States District Court for the Northern District of California
and one in the Superior Court of California for the County of Santa Clara (the
federal derivative action and the state derivative action, respectively).
These complaints were filed against nominal defendant Hifn, Inc. and certain of
its current and former officers and directors. The derivative complaints
alleged violations of California Corporations Code Section 25402, breach of
fiduciary duty and waste of corporate assets, based on the same facts and
events alleged in the class action. On June 7, 2002, the federal court entered
an order granting plaintiffs motion to voluntarily dismiss the federal
derivative action without prejudice. On June 26, 2002, the state court
sustained nominal defendant Hifns demurrer, with leave to amend, on the ground
that plaintiff had failed to plead facts showing that he was excused from
making demand on the Companys board of directors. The court also ordered
limited discovery relating solely to the issue whether demand is excused. The
court did not rule upon the demurrer to the derivative complaint filed by the
individual director defendants. The Company and the individual director
defendants believe the allegations contained in the complaint are without merit
and intend to defend the action vigorously.

See our Report on Form 10-Q for the quarter ended March 31, 2002, file May
2, 2002.




Item 2. Changes in Securities

None.




Item 3. Defaults Upon Senior Securities

None.




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

None.




Item 5. Other Information

None.

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Item 6. Exhibits and Reports on Form 8-K



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



| | 3.1  |  | Third Amended and Restated Certificate of
Incorporation (incorporated by reference from our Form 10
filed August 7, 1998, as amended (File No. 0-25765)).
| | ---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | 3.2  |  | Amended and Restated Bylaws (incorporated by
reference from our Form 10 filed August 7, 1998, as amended
(File No. 0-25765)).                            
|
| | 99.1 |  | Certification pursuant to
18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.                                  



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

None

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SIGNATURES

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

|                     |  |                          |  |                                                                                                                              
|-------------------- |  | ------------------------ |  | -----------------------------------------------------------------------------------------------------------------------------
|                     |  | hi/fn, inc.
(Registrant)
|                    
|                    
|                    
|                    
|                     |  |                          |  |                                                                                                                              
|                    
|                    
|                    
|                    
|Date: August 8, 2002 |  | By:                      |  | /s/ WILLIAM R. WALKER                                                                                                        
|                     |  |                          |  |                                                                                                                              
|                     |  |                          |  | William R. Walker
Vice President, Finance, Chief Financial Officer
and Secretary (principal financial and accounting
officer)

28