Table of Contents

UNITED STATESSECURITIES AND
EXCHANGE COMMISSIONWashington, D.C. 20549

---

# FORM 10-Q

|                                                 |   |  |                                                                                         
|------------------------------------------------ | - |  | ----------------------------------------------------------------------------------------
|                                                 | þ |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|For the Quarterly Period Ended December 31, 2005
|                                                
|                                                 |  ̈ |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|For the Transition Period From _____ to _____   

COMMISSION FILE NUMBER
0-24765

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

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

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

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

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

YESþ
NO ̈

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

YESþ
NO ̈

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

YES ̈
NOþ

The number of shares outstanding of
the Registrants Common Stock, par value $.001 per share, was 13,658,480 at
February 6, 2006.

---

# TABLE OF CONTENTS

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

---

Table of Contents

# HIFN, INC.

# INDEX TO FORM 10-Q

|                  |  |                                                                                                         |  |        
|----------------- |  | ------------------------------------------------------------------------------------------------------- |  | -------
|PART I.           |  | FINANCIAL INFORMATION                                                                                   |  |        
|Item 1.           |  | Financial Statements (unaudited)                                                                        |  |        
|                  |  | Condensed Consolidated Balance Sheets as of December 31, 2005 and September 30, 2005                    |  | 3      
|                  |  | Condensed Consolidated Statements of Operations for the three months ended   December 31, 2005 and 2004 |  | 4      
|                  |  | Condensed Consolidated Statements of Cash Flows for the three months ended   December 31, 2005 and 2004 |  | 5      
|                  |  | Notes to Condensed Consolidated Financial Statements                                                    |  | 6 - 14 
|Item 2.           |  | Management's Discussion and Analysis of Financial Condition and Results of Operations                   |  | 15 - 32
|Item 3.           |  | Quantitative and Qualitative Disclosure About Market Risks                                              |  | 32     
|Item 4.           |  | Controls and Procedures                                                                                 |  | 32     
|PART II.          |  | OTHER INFORMATION                                                                                       |  | 33     
|Item 6.           |  | Exhibits                                                                                                |  | 33     
|Signatures        |  | 34                                                                                                     
|Index to Exhibits |  |                                                                                                        

-2-

---

Table of Contents

PART
1  FINANCIAL INFORMATION

Item 1.
Financial Statements

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

|                                               | December 31,
2005 |  | September 30,
2005 |         
|---------------------------------------------- | ----------------- |  | ------------------ | --------
|                                               |                   |  |                    |         
|ASSETS                                        
|CURRENT ASSETS:                                |                   | 
|Cash and cash equivalents                      |                   |  | $                  | 31,607  
|Short-term investments                         |                   |  |                    | 13,235  
|Accounts receivable, net                       |                   |  |                    | 5,145   
|Inventories                                    |                   |  |                    | 1,606   
|Prepaid expenses and other current assets      |                   |  |                    | 947     
|                                               |                   |  |                    |         
|Total current assets                           |                   |  |                    | 52,540  
|Property and equipment, net                    |                   |  |                    | 1,990   
|Intangible assets, net                         |                   |  |                    | 9,245   
|Other assets                                   |                   |  |                    | 2,045   
|                                               |                   |  |                    |         
|                                               |                   |  | $                  | 65,820  
|                                               |                   |  |                    |         
|LIABILITIES AND STOCKHOLDERS EQUITY          
|CURRENT LIABILITIES:                          
|Accounts payable                               |                   |  | $                  | 3,869   
|Accrued expenses and other current liabilities |                   |  |                    | 6,031   
|                                               |                   |  |                    |         
|Total current liabilities                      |                   |  |                    | 9,900   
|                                               |                   |  |                    |         
|STOCKHOLDERS' EQUITY:                          |                   | 
|Common stock                                   |                   |  |                    | 14      
|Additional paid-in capital                     |                   |  |                    | 164,280 
|Accumulated other comprehensive loss           |                   |  |                    | (8      
|Accumulated deficit                            |                   |  |                    | (104,113
|Treasury stock, at cost                        |                   |  |                    | (4,253  
|                                               |                   |  |                    |         
|Total stockholders' equity                     |                   |  |                    | 55,920  
|                                               |                   |  |                    |         
|                                               |                   |  | $                  | 65,820  
|                                               |                   |  |                    |         

See accompanying notes
to condensed consolidated financial statements.

-3-

---

Table of Contents

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

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

See accompanying notes
to condensed consolidated financial statements.

-4-

---

Table of Contents

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

|                                                                     | Three Months Ended
December 31, | 
|-------------------------------------------------------------------- | ------------------------------- | 
|
|Cash flows from operating activities:                                |                                 | 
|Net loss                                                             |                                 | 
|Adjustments to reconcile net loss to net cash provided by           
|(used in) operating activities:                                     
|Depreciation and amortization                                        |                                 | 
|Amortization of intangible assets                                    |                                 | 
|Stock-based compensation expense related to                          |                                 | 
|employee stock options and employee stock purchases                  |                                 | 
|Changes in assets and liabilities:                                  
|Accounts receivable                                                  |                                 | 
|Inventories                                                          |                                 | 
|Prepaid expenses and other current assets                            |                                 | 
|Other assets                                                         |                                 | 
|Accounts payable                                                     |                                 | 
|Accrued expenses and other current liabilities                       |                                 | 
|                                                                     |                                 | 
|Net cash provided by (used in) operating activities                  |                                 | 
|                                                                     |                                 | 
|Cash flows from investing activities:                               
|Sale and maturity (purchases) of short-term investments, net         |                                 | 
|Purchases of property and equipment                                  |                                 | 
|                                                                     |                                 | 
|Net cash provided by (used in) investing activities                  |                                 | 
|                                                                     |                                 | 
|Cash flows from financing activities:                               
|Proceeds from exercise of stock options and issuance of common stock |                                 | 
|Installment payments on acquired software licenses                   |                                 | 
|                                                                     |                                 | 
|Net cash provided by financing activities                            |                                 | 
|                                                                     |                                 | 
|Net increase (decrease) in cash and cash equivalents                 |                                 | 
|Cash and cash equivalents at beginning of period                     |                                 | 
|                                                                     |                                 | 
|Cash and cash equivalents at end of period                           |                                 | 
|                                                                     |                                 | 
|                                                                     |                                 | 

See accompanying notes
to condensed consolidated financial statements.

-5-

---

Table of Contents

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

# Note 1  Basis of Presentation

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

The
accompanying condensed consolidated financial statements have been prepared pursuant to
the rules and regulations of the Securities and Exchange Commission regarding interim
financial reporting. Accordingly, they do not include all of the information and footnotes
required by generally accepted accounting principles for complete financial statements and
should be read in conjunction with the Financial Statements and notes thereto included in
the Companys Annual Report on Form 10-K for the year ended September 30, 2005. In the opinion of
management, the accompanying condensed consolidated financial statements contain all
adjustments, consisting only of normal recurring adjustments, which the Company believes
is necessary for a fair statement of the Companys financial position as of December
31, 2005 and its results of operations for the three months ended December 31, 2005 and
2004, respectively. These condensed consolidated financial statements are not necessarily
indicative of the results to be expected for the entire year.

The
Company has an accumulated deficit of $104.1 million as of December 31, 2005 and has
incurred a net loss of $1.7 million during the three months ended December 31, 2005. The
Company believes that its existing cash, cash equivalents and short-term investments will
fund any anticipated operating losses, purchases of capital equipment and provide adequate
working capital for the next twelve months. The Companys liquidity is affected by
many factors including, among others, the extent to which the Company pursues additional
capital expenditures, the level of the Companys product development efforts, and
other factors related to the uncertainties of the industry and global economies.
Accordingly, there can be no assurance that events in the future will not require the
Company to seek additional capital sooner or, if so required, that such capital will be
available on terms acceptable to the Company.

# Stock-Based Compensation
Expense

On
October 1, 2005, the Company adopted Statement of Financial Accounting Standards
No. 123 (revised 2004), Share-Based Payment, (SFAS 123(R))
which requires the measurement and recognition of compensation expense for all share-based
payment awards, including employee stock options and employee stock purchases, based on
estimated fair values. SFAS 123(R) supersedes the Companys previous accounting under
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees (APB 25) for periods beginning in fiscal 2006. In March 2005,
the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107
(SAB 107) relating to SFAS 123(R). The Company has applied the provisions of
SAB 107 in its adoption of SFAS 123(R). The Company adopted SFAS 123(R) using the modified
prospective transition method, which requires the application of the accounting standard
as of October 1, 2005, the first day of the Companys fiscal year 2006. The
Companys Consolidated Financial Statements as of and for the three months ended
December 31, 2005 reflect the effect of SFAS 123(R).

-6-

---

Table of Contents

Stock-based
compensation expense recognized under SFAS 123(R) for the three months ended December 31,
2005 was $207,000 which was related to employee stock options and employee stock
purchases. Under the modified prospective transition method, the Companys
Consolidated Financial Statements for prior periods need not be restated to reflect or
include the effect of SFAS 123(R). Accordingly, there was no stock-based compensation
expense related to employee stock options and employee stock purchases recognized during
the three months ended December 31, 2004.

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

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

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

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

-7-

---

Table of Contents

# Reclassifications

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

# Note 2  Detailed
Balance Sheet

|                                                                             |  | December 31,2005 |   | September 30,2005 | 
|---------------------------------------------------------------------------- |  | ---------------- | - | ----------------- | 
|
|Property and equipment:                                                      |  |                  |   |                   | 
|Computer equipment                                                           |  |                  |   |                   | 
|Furniture and fixtures                                                       |  |                  |   |                   | 
|Leasehold improvements                                                       |  |                  |   |                   | 
|Office equipment                                                             |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|Less: accumulated depreciation                                               |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|Intangible assets:                                                          
|Developed and core technology                                                |  |                  |   |                   | 
|Workforce                                                                    |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|Less: accumulated amortization                                               |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|Goodwill                                                                     |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|The estimated future amortization expense related to intangible assets as of
|December 31, 2005 is as follows:                                            
|Fiscal year ending September 30,                                            
|2006 (9 months ended)                                                        |  |                  | $ | 2,363             | 
|2007                                                                         |  |                  |   | 2,910             | 
|2008                                                                         |  |                  |   | 2,354             | 
|2009                                                                         |  |                  |   | 589               | 
|                                                                             |  |                  |   |                  
|Total estimated amortization                                                 |  |                  | $ | 8,216             | 
|                                                                             |  |                  |   |                  
|Other assets:                                                               
|Design tools and other licensed intellectual property                        |  |                  |   |                   | 
|Refundable deposits                                                          |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|Accrued expenses and other current liabilities:                             
|Accrued vacant facility lease cost                                           |  |                  |   |                   | 
|Accrued non-recurring engineering costs                                      |  |                  |   |                   | 
|Compensation and employee benefits                                           |  |                  |   |                   | 
|Deferred income and revenue                                                  |  |                  |   |                   | 
|Income taxes payable                                                         |  |                  |   |                   | 
|Other                                                                        |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 
|                                                                             |  |                  |   |                   | 

-8-

---

Table of Contents

# Note 3  Net Loss Per
Share

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

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

# Note 4 
Comprehensive Income (Loss)

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

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

# Note 5  Employee
Stock Benefit Plans

# Employee Stock Option
Plan

As
of December 31, 2005, the Company had two employee stock option plans: the 1996 Equity
Incentive Plan (the 1996 Plan) and the 2001 Nonstatutory Stock Option Plan
(the 2001 Plan). Within the quarter ended December 31, 2005, the Company also
had a third stock option plan, the Apptitude Plan, which was assumed in connection with
the acquisition of Apptitude, Inc. in August 2000. The Apptitude Plan expired on October
25, 2005. Options granted under the Apptitude Plan remain outstanding until exercised or
cancelled.

The
1996 Plan had 4,949,900 shares of the Companys Common Stock reserved for issuance
pursuant to nonqualified and incentive stock options and restricted stock awards. The 1996
Plan is administered by the Board of Directors of the Company or its designees and
provides generally that nonqualified stock options and restricted stock may be awarded at
a price not less than 85% of the fair market value of the stock at the date of the award.
Incentive stock options must be awarded at a price not less than 100% of the fair market
value of the stock at the date of the award, or 110% of fair market value for awards to
more than 10% stockholders. Options granted under the 1996 Plan may have a term of up to
10 years. Options typically vest at a rate of 25% of the total grant per year over a
four-year period. However, the Company may, at its discretion, implement a different
vesting schedule with respect to any new stock option grant. As a result of early exercise
features as provided for by the 1996 Plan, options granted are immediately exercisable
subject to the Companys repurchase rights which expire as options vest.

-9-

---

Table of Contents

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

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

|                              | Options Available
for Grant |  | Options
Outstanding |           | Weighted Average
Exercise Price (pershare) of Options
Outstanding | 
|----------------------------- | --------------------------- |  | ------------------- | --------- | ----------------------------------------------------------------- | 
|Balance at September 30, 2005 |                             |  |                     | 1,016,811 |                                                                   | 
|Options granted               |                             |  |                     | (10,000   | )                                                                 | 
|Options exercised             |                             |  |                     | -         |                                                                   | 
|Options cancelled             |                             |  |                     | 102,282   |                                                                   | 
|                              |                             |  |                     |           |                                                                  
|Balance at December 31, 2005  |                             |  |                     | 1,109,093 |                                                                   | 
|                              |                             |  |                     |           |                                                                  

The
intrinsic value of options exercised during the three months ended December 31, 2005 was
approximately $64,000.

The
following table summarizes options outstanding at December 31, 2005 and related weighted
average exercise prices and lives as follows (aggregate intrinsic value in thousands):

|  | Options Outstanding |  | Options Vested and Exercisable |       
|- | ------------------- |  | ------------------------------ | ------
|
|
|$ | 0.60                |  | -                              | $4.12 
|  | 4.82                |  | -                              | 6.00  
|  | 6.01                |  | -                              | 6.66  
|  | 6.74                |  | -                              | 8.99  
|  | 9.00                |  | -                              | 10.94 
|  | 11.01               |  | -                              | 13.94 
|  | 14.69               |  | -                              | 15.99 
|  | 16.00               |  | -                              | 19.00 
|  | 26.75               |  | -                              | 49.94 
|  | 69.88               |  | -                              | 125.50
|  |                     |  |                                |       
|$ | 0.60                |  | -                              | 125.50
|  |                     |  |                                |       

Options
vested and exercisable as of December 31, 2005 include 172,400 shares, with a weighted
average exercise price of $10.88, related to options held by the Companys executive
officers for which vesting was accelerated as of August 2005 and for which a holding
period relating to the timing of the sale of exercised options, if any, was imposed.
The aggregate intrinsic value of options outstanding and exercisable as of December 31, 2005
represents the total intrinsic value, based on the Companys closing stock price of
$5.61 as of December 30, 2005 (the last business day for the first fiscal quarter of
2006), which would have been received by the option holders had the options been exercised
as of such date.

-10-

---

Table of Contents

# Employee Stock Purchase
Plan

The
Company has an employee stock purchase plan (the ESPP) through which qualified
employees of the Company may participate in stock ownership of the Company. The price of
shares purchased under the ESPP is the lower of 85% of the fair market value of the shares
on the first day of each semi-annual offering period, or 85% of the fair market value of
the shares on the last day of the semi-annual offering period. During the three months
ended December 31, 2005, 98,633 shares were issued pursuant to the ESPP, at a weighted
average price of $4.51 per share. As of December 31, 2005, there were 189,850 shares
available for future purchases under the ESPP. During the quarter ended December 31, 2005,
$70,000 was charged to compensation expense relating to the ESPP. Prior to the adoption of FAS
123(R), the Company was not required to record compensation expense for the ESPP.

# Stock-Based Compensation
under SFAS 123(R)

On
October 1, 2005, the Company adopted SFAS 123(R), on the modified prospective application
method, which requires the measurement and recognition of compensation expense for all
share-based awards made to the Companys employees and directors including employee
stock options and employee stock purchases outstanding as of and awarded after October 1,
2005. The total stock-based compensation expense recognized for the three months ended
December 31, 2005 was allocated as follows (in thousands):

|                                       | 
|-------------------------------------- | 
|Cost of revenues                       | 
|Research and development               | 
|Sales and marketing                    | 
|General and administrative             | 
|                                       | 
|Total stock-based compensation expense | 
|                                       | 

As of
December 31, 2005, there was approximately $817,000 of total stock-based
compensation expense, after estimated forfeitures, related to unvested employee stock options, which is expected
to be recognized over an estimated weighted average amortization period of 2.46 years. The Company did not
capitalize any stock-based compensation expense. The tax benefit, and the resulting effect on cash flows from
operations and financial activities, related to stock-based compensation expense was not recognized as the
Company currently provides a full valuation allowance for its deferred tax assets. The effect of adoption of
SFAS 123(R) for the three months ended December 31, 2005 was an increase in net loss of $207,000 and an increase
in net loss per share of $0.01.

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

The
fair value of employee stock options granted and employee stock purchased in the quarter
ended December 31, 2005 was estimated based on the following
assumptions:

|                                      | Stock
Options |  | Purchase
Plan
|------------------------------------- | ------------- |  | -------------
|Weighted-average estimated fair value | $3.37         |  | $1.45        
|Estimated life                        | 5.46 years    |  | 0.50 years   
|Risk-free interest rate               | 4.24%         |  | 3.72%        
|Expected stock price volatility       | 67.0%         |  | 31.8%        
|Dividend yield                        | 0.00%         |  | 0.00%        

-11-

---

Table of Contents

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

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

For
purposes of pro forma disclosures under SFAS 123 for the three months ended
December 31, 2004, the estimated fair value of the stock options was assumed to be
amortized to expense over the stock options vesting periods. The pro forma effects
of recognizing estimated compensation expense under the fair value method on net loss and
net loss per share for the three months ended December 31, 2004 were as follows (in
thousands, except per share data):

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

The
fair value of employee stock options granted and employee stock purchased in the quarter ended December 31, 2004 was estimated
using the Black-Scholes model based on the following
assumptions:

|                                      | Stock
Options |  | Purchase
Plan
|------------------------------------- | ------------- |  | -------------
|Weighted-average estimated fair value | $3.66         |  | $2.65        
|Estimated life                        | 2.80 years    |  | 0.50 years   
|Risk-free interest rate               | 2.02%         |  | 2.13%        
|Expected stock price volatility       | 58.5%         |  | 53.0%        
|Dividend yield                        | 0.00%         |  | 0.00%        

# Stock Repurchase Program

On
April 25, 2005, the Companys Board of Directors authorized a stock repurchase
program whereby the Company may repurchase shares of the Companys common stock with
an aggregate fair market value of up to $10 million from time to time through open market
and privately negotiated transactions at prices determined by management. The timing and
amount of repurchases under this program is dependent upon market conditions and corporate
and regulatory considerations. The purchases are funded from available working capital.
The stock repurchase program expires on April 25, 2006. The Company did not repurchase any
shares during the three months ended December 31, 2005, however, as of December 31, 2005,
a total of 692,894 shares have been repurchased under the program, which shares are held
in treasury stock, at a cost of $4.3 million.

# Note 6  Segment
and Geographic Information

The
Company operates in one industry segment comprising the design, development and marketing
of high-performance, multi-protocol packet processors  semiconductor devices and
software. Sales by major geographic

-12-

---

Table of Contents

area are based on the geographic
location of the distributor, manufacturing subcontractor or OEM who purchased our
products which may be different from the geographic locations of our end customers.

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

# Major Customers

Revenues
from Cisco Systems, Inc. (Cisco), an original equipment producer of networking
equipment, through its manufacturing subcontractors, and from Huawei Technologies, Inc.
(Huawei), a producer of networking equipment, represented 56% and 10% of the
Companys net revenues for the three months ended December 31, 2005. Revenues from
Cisco, Quantum Corporation, an OEM producer of high-performance tape storage devices,
through its manufacturing subcontractor, and Huawei represented 46%, 13% and 10% of the
Companys net revenues for the three months ended December 31, 2004. No other
customers accounted for more than 10% of revenues in the periods presented.

# Property and Equipment

As
of December 31, 2005, the Company had net property and equipment of $1.3 million and
$666,000 in the United States and China, respectively.

# Note 7  Income
Taxes

The
Company has a valuation allowance for its net deferred tax asset associated with its U.S.
operations.  Until such time as the Company utilizes its U.S. net operating loss
carryforwards and unused tax credits, a provision for taxes on the Companys U.S.
operations is expected to be substantially offset by a reduction in the valuation
allowance.  The benefit from income taxes for the quarter ended December 31, 2005
relates to a reversal of previously accrued tax liability for the Companys non-U.S.
operations. The provision for income taxes for the quarter ended December 31, 2004
relates to taxes on the Companys non-U.S. operations.

# Note 8  Guarantees
and Product Warranties

# Guarantees

In
November 2002, the FASB issued FASB Interpretation No. 45 (FIN 45),
Guarantors Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others.  FIN 45 requires that a
liability be recorded in the guarantors balance sheet upon issuance of a guarantee.
In addition, FIN 45 requires disclosures about the guarantees that an entity has issued,
including a reconciliation of changes in the entitys product warranty liabilities.
The initial recognition and initial measurement provisions of FIN 45 are applicable on a
prospective basis to guarantees issued or modified after December 31, 2002. The disclosure
requirements of FIN 45

-13-

---

Table of Contents

are effective for financial
statements of interim or annual periods ending after December 15, 2002. Agreements that
we have determined to be within the scope of FIN 45 include hardware and software license
warranties, indemnification arrangements with officers and directors and indemnification
arrangements with customers with respect to intellectual property. To date, the Company
has not incurred material costs in relation to any of the above guarantees and,
accordingly, adoption of this standard did not have a material impact on its financial
position, results of operations or cash flows.

As
permitted under Delaware law, the Company has agreements that provide indemnification of
officers and directors for certain events or occurrences while the officer or director is,
or was serving, at the Companys request in such capacity. The indemnification period
is effective for the officers or directors lifetime. The maximum potential
amount of future payments that the Company could be required to make under these
indemnification agreements is unlimited; however, the Company has a Director and Officer
insurance policy that limits its exposure and enables the Company to recover a portion of
any future amounts paid. All of the indemnification agreements were grandfathered under
the provisions of FIN 45 as they were in effect prior to December 31, 2002. As a result of
the insurance policy coverage, the Company believes the estimated fair value of the
potential liability under these agreements is minimal. Accordingly, the Company has not
recorded any liabilities for these agreements as of December 31, 2005.

The
Company enters into standard indemnification agreements in the ordinary course of
business. Pursuant to these agreements, the Company indemnifies, holds harmless, and
agrees to reimburse the indemnified party, generally business partners or customers, for
losses suffered or incurred in connection with patent, copyright or other intellectual
property infringement claims by any third party with respect to the Companys
products. The term of these indemnification agreements is generally perpetual, effective
after execution of the agreement. The maximum potential amount of future payments the
Company could be required to make under these indemnification agreements is unlimited. To
date, the Company has not incurred costs to defend lawsuits or settle claims related to
these indemnification agreements. Accordingly, the Company has not recorded any
liabilities for these agreements as of December 31, 2005. However, the Company may, in the
future, record charges related to indemnification obligations and, depending upon the
nature of any such lawsuit or claim, the estimated fair value of such indemnification
obligations may be material.

The
Company warrants that its hardware products are free from defects in material and
workmanship under normal use and service and that its hardware and software products will
perform in all material respects in accordance with the standard published specifications
in effect at the time of delivery of the licensed products to the customer. The warranty
periods generally range from three months to one year for software and one year for
hardware. Additionally, the Company warrants that its maintenance services will be
performed consistent with generally accepted industry standards through completion of the
agreed upon services. The Companys policy is to provide for the estimated cost of
product and service warranties based on specific warranty claims and claim history as a
charge to cost of revenues. To date, the Company has not incurred significant expense
under its product or service warranties. As a result, the Company has not recorded an
accrual related to product or warranty services as of December 31, 2005. The Company
assesses the need for a warranty accrual every quarter. There is no assurance that a
warranty accrual will not be necessary in the future.

# Note 9  Recent
Accounting Pronouncements

In
May 2005, as part of a broader attempt to eliminate differences with the
International Accounting Standards Board, the Financial Accounting Standards Board
(FASB) issued Statement of Financial Accounting Standards No. 154
(SFAS 154), Accounting Changes and Error Corrections, which
replaces Accounting Principles Board Opinion No. 20 (APB 20),
Accounting Changes, and FASB Statement of Financial Accounting Standards
No. 3, Reporting Accounting Changes in Interim Financial Statements.
APB 20 had required that changes in accounting principles be recognized by including
the cumulative effect of the change in the period in which the new accounting principle
was adopted. SFAS 154 requires retrospective application of the change to prior
periods financial statements, unless it is impracticable to determine the
period-specific effects of the change. The Statement is effective for fiscal years or periods

beginning after December 15, 2005. The adoption of this statement is not expected to
have a material effect on the Companys financial statements.

-14-

---

Table of Contents

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

Cautionary Statement
Regarding Forward-Looking Statements

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

# Overview

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

Our
encryption/compression and public key processors allow network equipment vendors to add
security functions to their products. Our encryption/compression and public key processors
provide industry-recognized algorithms that are used in products, such as VPNs, which
enable businesses to reduce wide area networking costs by replacing dedicated leased-lines
with lower-cost IP-based networks such as the Internet. Using VPNs, businesses can also
provide customers, partners and suppliers with secure, authenticated access to the
corporate network, increasing productivity through improved communications. Storage
equipment vendors use our compression processor products to improve the performance and
capacity of a wide range of disk and tape back-up systems.

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

-15-

---

Table of Contents

# Results for First Fiscal
Quarter

During
the three months ended December 31, 2005, our net revenues of $10.7 million represented an
increase of 22% from the $8.8 million in net revenues reported in the previous quarter and a
decrease of 15% from the $12.5 million in net revenues reported in the first quarter of
fiscal 2005. The increase from the prior quarter was a result of an
increase in orders from our primary customers, Cisco and Huawei. Fluctuation in ordering
patterns from these two customers significantly affect our revenue levels from period to
period. Such fluctuation was notable between the third and fourth quarters of fiscal 2005
when revenues from Cisco and Huawei decreased 26% and 83%, respectively, as compared to
the immediately preceding quarter.

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

Our
expense levels during the three months ended December 31, 2005 were lower than those of the
preceding quarter, mainly due to a reduction in non-recurring engineering costs as we near
completion of the development work on our follow-on network processor.

# Critical Accounting
Policies

The
Companys critical accounting policies are disclosed in the Companys Form 10-K
for the year ended September 30, 2005 and have not changed materially as of December 31,
2005, with the exception of the following:

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

# Results of Operations

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

Net
Revenues.

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

|                            | Three Months Ended
December 31, |  |   |       
|--------------------------- | ------------------------------- |  | - | ------
|
|
|Processors                  |                                 |  | $ | 9,906 
|Software licenses and other |                                 |  |   | 766   
|                            |                                 |  |   |       
|                            |                                 |  | $ | 10,672
|                            |                                 |  |   |       

-16-

---

Table of Contents

Net
revenues decreased by $1.8 million for the quarter ended December 31, 2005 as compared to
net revenues for the quarter ended December 31, 2004. Our processor revenues decreased
$1.3 million, mainly as a result of a decrease of $1.1 million in sales of our network
processors, due to an overall reduction in customer orders. Also contributing to the
overall decrease in net revenues was a decrease in revenues from software licenses and
royalties of $585,000, which is generally dependent upon variability in the mix, demand
for and timing of customers purchase of certain of the Companys licensed
software products.

Semiconductor
and software sales to Cisco, an OEM producer of networking equipment, comprised 56% and
46% of net revenues for the three months ended December 31, 2005 and 2004, respectively.
Semiconductor sales to Quantum, an OEM producer of high-performance tape storage devices,
through its manufacturing subcontractor, comprised slightly less than 10% and 13% of
net revenues for the three months ended December 31, 2005 and 2004, respectively.
Semiconductor sales to Huawei, an OEM producer of networking equipment, comprised 10% of
net revenues for each of the three months ended December 31, 2005 and 2004.

Cost
of Revenues.

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

|                            | Three Months Ended
December 31, |  |   |      
|--------------------------- | ------------------------------- |  | - | -----
|
|
|Processors                  |                                 |  | $ | 3,571
|Software licenses and other |                                 |  |   | 126  
|                            |                                 |  |   |      
|                            |                                 |  | $ | 3,697
|                            |                                 |  |   |      

Cost
of revenues consists primarily of cost of semiconductors which were manufactured to our
specifications by third parties for resale by us. Cost of processor revenues as a
percentage of net processor revenues increased two percentage points for the three months
ended December 31, 2005 as compared to the same period in fiscal 2004 mainly as a result
of the mix of processor products sold during the respective periods. Cost of software
licenses and other revenues is primarily comprised of engineering labor related to support
and maintenance of sold licenses. The fluctuation in software licenses and other costs as
a percentage of software licenses and other revenues is dependent upon the mix and level
of licensed software and royalties earned during the period.

Operating
Expenses

Research
and Development.

|                                | Three Months Ended
December 31, |  | Year-over- |      
|------------------------------- | ------------------------------- |  | ---------- | -----
|
|Research & development expenses |                                 |  | $          | 5,076
|As a percentage of net revenues |                                 |  |            | 48%  

Research
and development costs consist primarily of salaries, employee benefits, overhead, outside
contractors and non-recurring engineering fees. Such research and development expenses
decreased $338,000 for the three months ended December 31, 2005 over the same period in
the prior year. The decrease reflects a decrease of $480,000 in non-recurring engineering
costs and services associated with tape-out, mask activities and qualification testing of
products under development which is contingent upon the stage of development of projects,
$70,000 in expenses related to travel between design facilities, including a reduction in
travel to and from China as training of engineers and product development planning were
completed, $94,000 in consulting fees related to the transfer of the technical designs of
the IBM network processors as such transfers near completion, a reduction in building

-17-

---

Table of Contents

expenses of $74,000 as a result of
reduced allocation of rental and other costs due to the expiration of a portion of the
lease at our corporate facility, and a decrease in software maintenance expense of
$44,000 resulting from the consolidation of certain software maintenance arrangements
coupled with the termination of maintenance arrangements related to completed projects.
These decreases were offset by an increase of $461,000 in salaries and benefits expense
mainly as a result of a combination of higher average salary rates in connection with
employee performance reviews in October 2005 and forty-six additional engineers during
the period, mainly in our China development facility, as compared to the same period in
the prior fiscal year.

Sales
and Marketing.

|                                | Three Months Ended
December 31, |  | Year-over- |      
|------------------------------- | ------------------------------- |  | ---------- | -----
|
|Sales & marketing expenses      |                                 |  | $          | 1,801
|As a percentage of net revenues |                                 |  |            | 17%  

Sales
and marketing expenses consist primarily of salaries, commissions and benefits of sales,
marketing and support personnel as well as consulting, advertising, promotion and overhead
expenses. Such expenses decreased $118,000 for the three months ended December 31, 2005
over the same period in the prior year. The decrease primarily relates to a decrease in
sales representative commissions of $126,000 due to a lower level of sales made through
sales representatives, a decrease in travel costs of $57,000 as a result of the timing of
sales and marketing conferences and decreased travel to Asia as local personnel were put
in place to pursue the potential market opportunities in the region. The decrease was
partially offset by increased salaries and benefits of $88,000 due to salary increases in
connection with the employee performance reviews in October 2005.

General
and Administrative.

|                                  | Three Months Ended
December 31, |  | Year-over- |      
|--------------------------------- | ------------------------------- |  | ---------- | -----
|
|General & administrative expenses |                                 |  | $          | 1,455
|As a percentage of net revenues   |                                 |  |            | 14%  

General
and administrative expenses are comprised primarily of salaries for administrative and
corporate services personnel, legal and other professional fees. Such expenses increased
$278,000 for the three months ended December 31, 2005 over the same period in the prior
year as a result of increases in salaries and benefits expense of $166,000 in connection
with the employee performance reviews in October 2005 and $95,000 in accounting fees as a
result of costs associated with work related to testing and attestation of internal
controls.

Amortization
of Intangibles.

|                                | Three Months Ended
December 31, |  | Year-over- |    
|------------------------------- | ------------------------------- |  | ---------- | ---
|
|Amortization of intangibles     |                                 |  | $          | 797
|As a percentage of net revenues |                                 |  |            | 8% 

Amortization
of intangibles relate to acquired technology, workforce and patents. Amortization of
intangibles decreased $31,000 for the three months ended December 31, 2005 over the same
period in the prior year mainly as a result of the full amortization of previously
capitalized intangible assets related to the Apptitude and NetOctave asset acquisitions
upon reaching their estimated useful lives as of the prior fiscal year end.

-18-

---

Table of Contents

Interest
and Other Income, net.

|                                | Three Months Ended
December 31, |  | Year-over- |    
|------------------------------- | ------------------------------- |  | ---------- | ---
|
|Interest & other income, net    |                                 |  | $          | 415
|As a percentage of net revenues |                                 |  |            | 4% 

Interest
and other income, net, increased $226,000 during the three months ended December 31, 2005
as compared to the same period in the prior fiscal year. The increase was primarily a
result of the timing in purchases of higher-average-yield instruments to take advantage of
rising interest rates.

Income
Taxes.

|                                          | Three Months Ended
December 31, |  | Year-over- |     
|----------------------------------------- | ------------------------------- |  | ---------- | ----
|
|Provision for (benefit from) income taxes |                                 |  | $          | (77 
|As a percentage of net revenues           |                                 |  |            | (1)%

We
recognize income tax expense based on an asset and liability approach that requires
recognition of deferred tax assets and liabilities related to future tax consequences of
events recognized in both our financial statements and income tax returns. Prior to fiscal
2003, we recorded a full valuation allowance for our deferred tax assets. In fiscal 2003,
we recognized a tax benefit of $1.8 million related to carry back of net operating losses
to prior years. We have not recognized tax benefits as a result of continuing losses over a longer period than previously
expected. The benefit from income taxes for the three months ended December 31, 2005 reflects
the reversal of previously accrued tax liability for our non-U.S. operations. We continue to consider
future taxable income and ongoing prudent and feasible tax planning strategies in
assessing the valuation allowance.

# Liquidity and Capital
Resources

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

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

Net
cash provided by operating activities of $333,000 for the three months ended
December 31, 2005 was the result of a decrease in inventory of $530,000, mainly due
to the timing of receipt of inventory purchases, and an increase in accounts payable of
$2.3 million, which was related to the timing of payments made. These items were mainly offset by the net loss of $1.7
million, as adjusted for non-cash items including depreciation and amortization of
$399,000 related to property and equipment and licensed software, amortization of
intangibles of $797,000 and stock-based compensation expense of $207,000, which was
the effect of the adoption of SFAS 123(R) during the period, as well as a reduction of
$1.9 million in accrued liabilities including $1.3 million in non-recurring engineering
services and costs and $134,000 in compensation and employee benefits, reflecting a
reduction in accrued employee stock purchase plan withholding as a result of the purchase
in October 2005 and in accrued vacation as a result of utilization of accrued vacation
during the holiday shut-down in December.

-19-

---

Table of Contents

Net
cash used in operating activities of $220,000 for the three months ended December 31,
2004 was the result of net loss of $576,000, as adjusted for non-cash items including
depreciation and amortization costs of $347,000 related to property and equipment and
amortization of intangibles of $828,000, as well as an increase in accrued and other
current liabilities of $164,000 mainly as a result of increases in deferred revenues,
related to the timing of maintenance contract purchases amortizable over the service term,
and in accrued non-recurring engineering costs, related to projects under development.
These adjustments were offset by an increase in accounts receivable of $86,000,
inventories of $684,000 reflecting increased purchases based on anticipated sales for the
upcoming periods and in prepaid expenses and in other current assets of $212,000 mainly as
a result of insurance policy renewals during the period.

Net
cash provided by investing activities was $7.7 million for the three months ended
December 31, 2005, which primarily reflects the net sale and maturities of short-term
investments of $8.1 million offset by the purchase of property and equipment of
$396,000. Net cash used in investing activities of $1.9 million for the three months
ended December 31, 2004 primarily reflects the net purchase of short-term investments
of $1.6 million offset by the purchase of property and equipment of $334,000.

Net
cash provided by financing activities for the three months ended December 31, 2005 of
$435,000 was comprised of cash proceeds from the issuance of common stock for stock option
exercises and employee stock purchase plan purchases which aggregated $589,000 offset by
installment payments on acquired software licenses of $154,000. Net cash provided by
financing activities for the three months ended December 31, 2004 was $433,000 and was
comprised of cash proceeds from the issuance of common stock for stock option exercises
and employee stock purchase plan purchases which aggregated $612,000 offset by installment
payments on acquired software licenses of $179,000.

The
Companys inventory balance decreased by $530,000 to $1.6 million at December 31,
2005 as compared to $2.1 million as of September 30, 2005. The decrease in inventory is a
result of the timing of inventory purchases relative to manufacturer lead-time coupled
with anticipated shipment schedules to fill customer orders for the succeeding quarter.
The Companys annualized inventory turns for the three months ended December 31, 2005
were 7.6 times as compared to 6.8 times for the year ended September 30, 2005. The
Companys accounts receivable balance, which is contingent upon the timing of product
shipment within the respective periods, increased $74,000 from September 30, 2005 to
December 31, 2005, reflecting higher customer purchase levels and revenues in December
2005 as compared to September 2005.

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

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

On
April 25, 2005, the Companys Board of Directors authorized a stock repurchase
program whereby the Company may repurchase shares of the Companys common stock with
an aggregate fair market value of up to $10 million from time to time through open market
and privately negotiated transactions at prices determined by management. The timing and
amount of repurchases under this program will depend on market conditions and

-20-

---

Table of Contents

corporate and regulatory
considerations. The purchase will be funded from available working capital. The stock
repurchase program will expire on April 25, 2006. During the quarter ended June 30, 2005,
the Company repurchased 422,700 shares under the program at a cost of $2.5 million.
During the quarter ended September 30, 2005, the Company repurchased 270,194 shares at a
cost of $1.8 million. The Company did not repurchase any shares during the three months
ended December 31, 2005, accordingly, as of December 31, 2005, the aggregate repurchase
was a total of 692,894 shares at a cost of approximately $4.3 million.

The
Company occupies its facilities under several non-cancelable operating leases that expire
at various dates through June 2010, and which contain renewal options. Additionally,
contractual obligations were also entered into related to non-recurring engineering
services and inventory purchases. Payment obligations for such commitments as of December
31, 2005 are as follows:

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

# Off-Balance Sheet
Arrangements

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

# Guarantees

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

As
permitted under Delaware law, the Company has agreements that provide indemnification of
officers and directors for certain events or occurrences while the officer or director is,
or was serving, at the Companys request in such capacity. The indemnification period
is effective for the officers or directors lifetime. The maximum potential
amount of future payments that the Company could be required to make under these
indemnification agreements is unlimited; however, the Company has a Director and Officer
insurance policy that limits its exposure and enables the Company to recover a portion of
any future amounts paid. All of the indemnification agreements were grandfathered under
the provisions of FIN 45 as they were in effect prior to December 31, 2002. As a result of
the insurance policy coverage, the Company believes the estimated fair value of the
potential liability under these agreements is minimal. Accordingly, the Company has not
recorded any liabilities for these agreements as of December 31, 2005.

-21-

---

Table of Contents

The
Company enters into standard indemnification agreements in the ordinary course of
business. Pursuant to these agreements, the Company indemnifies, holds harmless, and
agrees to reimburse the indemnified party, generally business partners or customers, for
losses suffered or incurred in connection with patent, copyright or other intellectual
property infringement claims by any third party with respect to the Companys
products. The term of these indemnification agreements is generally perpetual, effective
after execution of the agreement. The maximum potential amount of future payments the
Company could be required to make under these indemnification agreements is unlimited. To
date, the Company has not incurred costs to defend lawsuits or settle claims related to
these indemnification agreements. Accordingly, the Company has not recorded any
liabilities for these agreements as of December 31, 2005. However, the Company may, in the
future, record charges related to indemnification obligations and, depending upon the
nature of any such lawsuit or claim, the estimated fair value of such indemnification
obligations may be material.

The
Company warrants that its hardware products are free from defects in material and
workmanship under normal use and service and that its hardware and software products will
perform in all material respects in accordance with the standard published specifications
in effect at the time of delivery of the licensed products to the customer. The warranty
periods generally range from three months to one year for software and one year for
hardware. Additionally, the Company warrants that its maintenance services will be
performed consistent with generally accepted industry standards through completion of the
agreed upon services. The Companys policy is to provide for the estimated cost of
product and service warranties based on specific warranty claims and claim history as a
charge to cost of revenues. To date, the Company has not incurred significant expense
under its product or service warranties. As a result, the Company has not recorded an
accrual related to product or warranty services as of December 31, 2005. The Company
assesses the need for a warranty accrual every quarter. There is no assurance that a
warranty accrual will not be necessary in the future.

Trends, Risks and
Uncertainties

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

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

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

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

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

-22-

---

Table of Contents

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

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

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

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

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

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

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

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

Semiconductor
and software sales to Cisco Systems, Inc., an OEM producer of networking equipment,
through its manufacturing subcontractors, comprised 56% and 49% of our net revenues for
the three months ended December 31, 2005 and fiscal year ended September 30, 2005,
respectively. Semiconductor sales to Quantum Corporation, through its manufacturing
subcontractor, represented slightly less than 10% and 11% of our net revenues for the
three months ended December 31, 2005 and fiscal year ended September 30, 2005, respectively.
Semiconductor sales to Huawei Technologies, Inc., an OEM producer of networking equipment,
represented 10% for each of the three months ended December 31, 2005 and fiscal year ended
September 30, 2005.

Cisco,
Quantum and Huawei are not under any binding obligation to order from us. If our
sales to Cisco, Quantum or Huawei decline, our business, financial condition and results
of operations could suffer. During the three months ended December 31, 2005, sales to
Cisco increased 29% over sales to such customer in the preceding quarter, while during the
three months ended September 30, 2005, sales to Huawei and Cisco decreased 83% and 26%,
respectively, over revenues generated from each respective customer in the preceding
quarter. Such fluctuations significantly affected the Companys revenue levels and
results of operations from quarter to quarter. It is possible that our most significant
customers in the future could be different from our largest customers today for a number
of reasons, including customers deployment schedules and budget considerations. As a
result, we believe we may experience significant fluctuations in our results of operations
on a quarterly and annual basis.

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

-23-

---

Table of Contents

# Our Operating Results
May Fluctuate Significantly.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

-24-

---

Table of Contents

operating margins and possible harm
to customer relationships. The steps required for a new manufacturer to begin production
of a semiconductor product include:

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

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

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

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

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

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

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

# We Face Risks Associated
With Acquisitions.

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

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

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

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

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

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

-25-

---

Table of Contents

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

On
 December 31, 2003, we acquired certain assets and intellectual property related to
the IBM network processor product line. In addition to integrating the network processor products into our
product line, we are also developing a follow-on product based on the acquired technology. While the Company
has, to date, been able to retain the customers in existence for the network processors as of the time of the
acquisition, there can be no assurance that the established customer base will maintain their relationship with
us in the future for follow-on products. Our success in integrating the acquired assets and intellectual property
into our business depends upon our ability to merge the acquired assets into our ongoing and future operations,
including maintaining a continuing relationship with established customer base for the network processor and our
third party supplier, in this case, IBM. Without the successful integration of the follow-on product, there can
be no assurance that we will be able to maintain the revenue and profit performance levels we have experienced
thus far with the existing network processors. If we fail to integrate the follow-on products into our operations
successfully, our business, financial condition and results of operations could suffer.

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

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

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

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

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

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

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

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

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

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

-26-

---

Table of Contents

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

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

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

In
evaluating new product decisions, we must anticipate future demand for product features
and performance characteristics, as well as available supporting technologies,
manufacturing capacity, competitive product offerings and industry standards. We must also
continue to make significant investments in research and development in order to continue
to enhance the performance and functionality of our products to keep pace with competitive
products and customer demands for improved performance, features and functionality. The
technical innovations required for us to remain competitive are complicated and require a
significant amount of time and money. During fiscal 2004, we acquired certain technology
for embedded processors, pattern matching and network processors. We may experience
substantial difficulty in introducing new products, such as new products containing the
acquired technologies and we may be unable to offer enhancements to existing products on a
timely or cost-effective basis, if at all. For instance, the performance of our
encryption/compression and public key processors depends upon the integrity of our
security technology. If any significant advances in overcoming cryptographic systems are
made, then the security of our encryption/compression and public key processors will be
reduced or eliminated unless we are able to develop further technical innovations that
adequately enhance the security of these products. Our inability to develop and introduce
new products or enhancements directed at new industry standards could harm our business,
financial condition and results of operations.

# Our Markets Are Highly
Competitive.

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

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

Many
of our current and prospective competitors offer broader product lines and have
significantly greater financial, technical, manufacturing and marketing resources than us.
As a result, they may be able to adapt more quickly to new or emerging technologies and
changes in customer requirements or to devote greater resources to

-27-

---

Table of Contents

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

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

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

| |  | Price;
| | - | ------

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

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

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

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

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

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

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

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

# Our Success Depends Upon
Protecting Our Intellectual Property.

Our
proprietary technology is critical to our future success. We rely in part on patent,
trade, trademark, mask work and copyright law to protect our intellectual property. We own
twenty-four (24) United States patents and eight foreign patents. Our issued patents and
patent applications primarily cover various aspects of our compression, flow
classification, bandwidth management, cryptographic packet processing, rate shaping and
pattern matching technologies and have expiration dates ranging from 2006 to 2022. We also
have three pending patent applications in the United States and a total of fifteen (15) in
Europe, Asia and Australia covering flow classification, cryptographic packet processing,
and pattern matching. Patents may not be issued under our current or future patent
applications, and the patents issued under such patent applications could be invalidated,
circumvented or challenged. In addition, third parties could make infringement claims
against us in the future. Such infringement claims could result in costly litigation. We
may not prevail in any such litigation or be able to license any valid and infringed
patents from third parties on commercially reasonable terms, if at all. Regardless of the
outcome, an infringement claim would likely result in substantial cost and diversion of
our resources. Any infringement claim or other litigation against us or by us could harm
our business, financial condition and results of operations. The patents issued to us may
not be adequate to protect our proprietary rights, to deter misappropriation or to prevent
an unauthorized third party from copying our technology, designing around the patents we
own or otherwise obtaining and using our products, designs or other information. In
addition, others could develop technologies that are similar or superior to our
technology.

-28-

---

Table of Contents

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

# Network And Storage
Equipment Prices Typically Decrease.

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

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

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

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

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

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

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

# We Depend Upon Key
Personnel.

Our
success greatly depends on the continued contributions of our key management and other
personnel, many of whom would be difficult to replace. We do not have employment contracts
with any of our key personnel, nor do we maintain any key man life insurance on any of our
personnel. We have recently entered into severance and change of control agreements with
our executive and other officers, however, there can be no assurance that such personnel
will necessarily remain with the Company. It may be difficult for us to integrate new
members of our management team. We must also attract and retain experienced and highly
skilled engineering, sales and marketing and managerial personnel. Competition for such
personnel has, in the past, been intense in the geographic areas and market segments in
which we compete, and we may not be successful in hiring and retaining such people. If we
lose the services of any key personnel, or cannot attract or retain qualified personnel,
particularly engineers, our business, financial condition and results of operations could
suffer. In addition, companies in technology industries whose employees accept positions
with competitors have in the past claimed that their competitors have engaged in unfair
competition or hiring practices. We could receive such claims in the future as we seek to
hire qualified personnel. These claims could result in material litigation. We could incur
substantial costs in defending against any such claims, regardless of their merits.

-29-

---

Table of Contents

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

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

# We Face Risks Associated
With Our International Business Activities.

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

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

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

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

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

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

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

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

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

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

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

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

# Our Products Are Subject
To Export Restrictions.

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

-30-

---

Table of Contents

market than our network equipment
customers. In addition, the list of products and countries for which export approval is
required, and the regulatory policies with respect thereto, could be revised, and laws
limiting the domestic use of encryption could be enacted. While the U.S. government now
allows U.S. companies to assume that exports to non-government end-users will be approved
within 30 days of official registration with the Department of Commerce, the sale of our
packet processors could be harmed by the failure of our network equipment customers to
obtain the required approvals or by the costs of compliance.

# Our Stock Price May Be
Volatile.

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

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

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

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

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

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

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

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

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

On
April 25, 2005, our Board of Directors authorized a stock repurchase program for the
repurchase of shares of the Companys Common Stock with an aggregate fair market value
of up to $10 million from time to time through open market and privately negotiated
transactions at prices determined by management. The timing and amount of repurchases
under this program is dependent upon market conditions and corporate and regulatory
considerations. The stock repurchase program expires on April 25, 2006. Through December
31, 2005, the Company repurchased a total of 692,894 shares under the program, which
shares have been held in treasury stock, at a cost of $4.3 million. The increase or
decrease in our levels of repurchase could affect the market price of our Common Stock.

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

We
perform impairment analyses of goodwill and long-lived and intangible assets on an annual
basis. During fiscal 2003 and 2002, we determined that impairment had been realized on
certain developed technology and goodwill, resulting in recognition of impairment charges
of $3.9 million and $27.4 million, respectively. Pursuant to SFAS 142, Goodwill and
Other Intangible Assets, we will continue to perform an annual impairment test and
if, as a result of this analysis, we determine that there has been an impairment of our
goodwill and other long-lived and intangible assets, asset impairment charges will be
recognized. Approximately $1.0 million of goodwill remains as of December 31, 2005. If we
determine that our long-lived assets have been impaired or that our goodwill has been
further impaired, our financial condition and results of operations may suffer.

-31-

---

Table of Contents

# Recent Accounting
Pronouncements

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

# Item 3. Quantitative and
Qualitative Disclosures About Market Risk

Interest
Rate Risk  The Company does not use derivative financial instruments in its
investment portfolio. The Companys investment portfolio is generally comprised of
commercial paper. The Company places investments in instruments that meet high credit
quality standards. These securities are subject to interest rate risk, and could decline
in value if interest rates fluctuate. Due to the short duration and conservative nature of
the Companys investment portfolio, the Company does not expect any material loss
with respect to its investment portfolio. A 10% change in interest rates at December 31,
2005 would not have a material effect on the Companys pre-tax earnings and the fair
value of its investments.

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

# Item 4. Controls and
Procedures

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

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

(b) Changes
in internal controls over financial reporting. There was no change in our internal
control over financial reporting that was identified in connection with our evaluation of
disclosure controls and procedures that occurred during the quarter ended December 31,
2005 that has materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting.

-32-

---

Table of Contents

PART
II  OTHER INFORMATION

# Item 6. Exhibits

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

-33-

---

Table of Contents

SIGNATURES

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

|Date: February 8, 2006 |  | hi/fn, inc.(Registrant)By: /s/ William R. Walker
William R. WalkerVice President, Finance, Chief Financial Officer and Secretary (principal financial and accounting officer)
|---------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

-34-

---

Table of Contents

# INDEX TO EXHIBITS

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

-35-

---