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U.S. SECURITIES AND EXCHANGE COMMISSION

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

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

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

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

Yes No

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

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HIFN, INC.

INDEX TO FORM 10-Q

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PART 1 – FINANCIAL INFORMATION

Item 1. Financial Statements

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

See accompanying notes to condensed consolidated financial statements.

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HIFN, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

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

See accompanying notes to condensed consolidated financial statements.

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HIFN, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)
(unaudited)

See accompanying notes to condensed consolidated financial statements.

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

Note 1 — Basis of Presentation

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

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

Note 2 — Net Loss Per Share

         Basic earnings per share is computed using the weighted average number of common shares outstanding for the period, without consideration for the dilutive impact of potential common shares that were outstanding during the period. Diluted earnings per share is computed using the weighted average number of common and common equivalent shares outstanding for the period. Common equivalent shares consist of incremental common shares issuable upon the exercise of stock options, using the treasury method, and are excluded from the calculation of diluted net loss per share if anti-dilutive. Outstanding options to purchase 3,442,083 shares of common stock, or 278,382 weighted average shares, for the three months ended June 30, 2002 and 4,956,601 shares of common stock, or 336,254 weighted average shares, for the nine months ended June 30, 2002 were not included in the computation of diluted earnings per share because their impact would be anti-dilutive. Outstanding options to purchase 3,923,024 shares of common stock, or 464,605 weighted average shares, for the three months ended June 30, 2001 and 3,605,769 shares of common stock, or 640,972 weighted average shares, for the nine months ended June 30, 2001 were not included in the computation of diluted earnings per share because their impact would be anti-dilutive.

         Note 3 — Detailed Balance Sheet:

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Note 4 — Voluntary Stock Option Exchange

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

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Note 5 – Employee Stock Option Plan

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

Note 6 – Taxation

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

Note 7 — Legal Matters

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

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

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Note 8 – Recent Accounting Pronouncements

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

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

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

Cautionary Statement Regarding Forward-Looking Statements

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

Overview

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

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

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

Critical Accounting Policies

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Results of Operations

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

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

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

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

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

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

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

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

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

Liquidity and Capital Resources

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

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

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

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

         We require substantial working capital to fund our business, particularly to finance accounts receivable and inventory, and for investments in property and equipment. Our need to raise capital in the future will depend on many factors including the rate of sales growth, market acceptance of our existing and new products, the amount and timing of research and development expenditures, the timing and size of acquisitions of businesses or technologies, the timing of the introduction of new products and the expansion of sales and marketing efforts. We believe that our current cash and cash equivalents, short-term investments and cash generated from operations will satisfy our expected working capital, capital expenditure and investment requirements through at least the next twelve months.

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

Recent Accounting Pronouncements

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

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

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

Trends and Uncertainties

Our Operating Results May Fluctuate Significantly.

         Our operating results have fluctuated significantly in the past and we expect that they will continue to fluctuate in the future. This fluctuation is a result of a variety of factors including, but not limited to, the following:

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

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

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

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We Depend Upon A Small Number Of Customers.

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

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

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

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

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

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

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

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

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

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

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

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

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

Our Markets Are Highly Competitive.

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

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

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

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

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

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

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

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

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

Our Success Depends Upon Protecting Our Intellectual Property.

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

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

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

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

We Depend Upon Independent Manufacturers And Limited Sources Of Supply.

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

         We depend on our suppliers to deliver sufficient quantities of finished product to us in a timely manner. Since we place orders on a purchase order basis and do not have long-term volume purchase agreements with any of our suppliers, our suppliers may allocate production capacity to other products while reducing deliveries to us on short notice. For example, in June 1995, one of our suppliers delayed the delivery of one of our products. As a result, we switched production of the product to a new manufacturer. This caused a 3-month delay in shipments to customers. We also experienced yield and test anomalies on a different product manufactured by another subcontractor that could have interrupted our customer shipments. In this case, the manufacturer was able to correct the problem in a

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timely manner and customer shipments were not affected. The delay and expense associated with qualifying a new supplier or foundry and commencing volume production can result in lost revenue, reduced operating margins and possible harm to customer relationships. The steps required for a new manufacturer to begin production of a semiconductor product include:

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

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

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

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

Network And Storage Equipment Prices Typically Decrease.

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

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

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

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

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

We Face Order And Shipment Uncertainties.

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

We Depend Upon Key Personnel.

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

Our Products Are Subject To Export Restrictions.

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

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We Face Risks Associated With Our International Business Activities.

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

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

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

We Face Risks Associated With Acquisitions.

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

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

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

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The Cyclicality Of The Semiconductor Industry May Harm Our Business.

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

Our Stock Price May Be Volatile.

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

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

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

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

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

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

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

Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

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

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PART II — OTHER INFORMATION

Item 1. Legal Proceedings

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

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

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

Item 2. Changes in Securities

                  None.

Item 3. Defaults Upon Senior Securities

                  None.

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

                  None.

Item 5. Other Information

                  None.

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Item 6. Exhibits and Reports on Form 8-K

(a)

Exhibits

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

(b)

Reports on Form 8-K

                      None

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SIGNATURES

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

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