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U.S. SECURITIES AND EXCHANGE COMMISSION

For the Quarterly Period Ended March 31, 2003

For the Transition Period From         to

COMMISSION FILE NUMBER 0-24765

hi/fn, inc.

750 University Avenue, Los Gatos, California 95032

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

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

Yes [X]   No [  ]

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

Yes [  ]   No [X]

The number of shares outstanding of the Registrant’s Common Stock, par value $.001 per share, was 10,610,043 at April 23, 2003.

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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 subsidiaries, Hifn Limited, Hifn Netherlands B.V. and Apptitude Acquisition Corporation (“Apptitude”). In January 2003, Apptitude was merged into Hifn. 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, 2002. 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 March 31, 2003 and its results of operations for the three and six months ended March 31, 2003 and 2002, 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 $76.4 million as of March 31, 2003 and incurred losses of $10.4 million during the six months ended March 31, 2003. The Company anticipates that its existing cash resources 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.

Reclassifications

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

Note 2 - Stock Options

     The Company accounts for its employee and stock option plans and employee stock purchase plans in accordance with provisions of the Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees” and Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation.”

     In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 148 (“SFAS 148”), “Accounting for Stock-Based Compensation —Transition and Disclosure,” which amends Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation,” and provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation. Furthermore, SFAS 148 amends the disclosure requirements of SFAS 123 to require more prominent and frequent disclosures in financial statements about the effects of stock-based compensation. The transition guidance and disclosure provisions of SFAS 148 are effective for financial reports of periods ending after December 15, 2002. The Company will continue to account for stock-based

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compensation of employees using the intrinsic value method prescribed in APB 25 and related interpretations. However, the Company has now adopted the enhanced disclosure provisions defined in SFAS 148.

     Had compensation expense for the Company’s stock-based compensation plans been determined based on the fair value method, the Company’s net loss and net loss per share would have been as follows:

     The weighted average fair value of options granted during the three months ended March 31, 2003 and 2002 were $3.46 and $8.95, respectively, and the weighted average fair value of options granted during the six months ended March 31, 2003 and 2002 were $3.00 and $8.54, respectively. The fair value of each stock award is estimated on the date of grant using the Black-Scholes model with the following assumptions used for grants during the respective periods: annual dividend yield of 0.0% for all periods; a weighted average expected stock award term of 4.0 years for all periods; during the three months ended March 31, 2003 and 2002, risk-free annual interest rates of 2.04% and 3.77%, respectively; and an expected volatility factor of 90% and 80%, respectively; and during the six months ended March 31, 2003 and 2002, risk-free annual interest rates of 2.48% and 3.77%, respectively; and an expected volatility factor of 90% and 80%, respectively.

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 were excluded from the computation of diluted earnings because of their anti-dilutive impact to the following periods:

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Note 4 - Detailed Balance Sheet:

Note 5 - Goodwill

     In June 2001, the FASB issued Statement of Financial Accounting Standards No. 141 (“SFAS 141”), “Business Combinations,” and Statement of Financial Accounting Standards No. 142 (“SFAS 142”), “Goodwill and Other Intangible Assets.” SFAS 141 applies to business combinations and eliminates the pooling-of-interests method of accounting. Goodwill and intangible assets deemed to have indefinite lives are no longer amortized and are subject to annual impairment tests, the first of which was conducted as of October 1, 2002, in accordance with the Statements. Other intangible assets are amortized over their useful lives. Under the new Statements, certain intangibles such as workforce acquired in a business combination were reclassified as goodwill and certain intangibles were reclassified as previously reported goodwill. In addition, we have ceased amortization of goodwill. As of March 31, 2003, the Company has goodwill of $1.0 million.

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     If amortization expenses related to goodwill that is no longer amortized with the adoption of SFAS 142 had been excluded from operating expenses for the three and six months ended March 31, 2002, earnings per share would have been as follows:

Note 6 - 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 District 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 June 10, 2002, the District Court entered an order preliminarily approving a Stipulation of Settlement, by which all claims against the Company and Mr. Farnham would be dismissed without any admission of liability or wrongdoing, and the shareholder class will receive $9.5 million, comprised of $6.8 million in cash, which was contributed by our insurance carriers, and the balance in cash or the Company’s stock, with a minimum of 270,000 shares to be issued. On September 4, 2002, the District Court approved the settlement and entered a Final Judgment and Order of Dismissal with Prejudice. In accordance with the settlement, we will issue at least 270,000 shares of the Company’s common stock, supplementing the allotment with cash or additional common stock equal to $2.7 million. To the extent that the trading price of the common stock exceeds $10.00 at the time of distribution, the Company would recognize an additional litigation settlement charge equal to the aggregate fair market value of the 270,000 shares of common stock less the $2.7 million already recognized and any such additional charge may negatively affect our financial condition and results of operations.

     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 the Company 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 granted plaintiff’s motion to voluntarily dismiss that action without prejudice. On June 26, 2002, the state court sustained the Company’s demurrer, with leave to amend, on the ground that plaintiff had failed to plead facts showing that they were excused from making demand on the Company’s board of directors. Plaintiff filed an amended complaint. On March 18, 2003, the court again sustained the Company’s demurrer, with leave to amend, on the ground that

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plaintiff had failed to plead facts showing that they were excused from making a demand on the Company’s board of directors. Plaintiff did not file an amended complaint within the time permitted. The Company and the individual director defendants believe the allegations contained in the complaint are without merit and intend to defend the action vigorously.

Note 7 - Recent Accounting Pronouncements

     In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146 (“SFAS 146”), “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS 146 addresses significant issues regarding the recognition, measurement, and reporting of costs that are associated with exit and disposal activities, including restructuring activities that are currently accounted for under EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The scope of SFAS 146 also includes costs related to terminating a contract that is not a capital lease and termination benefits that employees who are involuntarily terminated receive under the terms of a one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred-compensation contract. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002 and early application is encouraged. The Company has adopted SFAS 146 during the second fiscal quarter ended March 31, 2003. The effect on adoption of SFAS 146 will change on a prospective basis the timing of when restructuring charges are recorded from a commitment date approach to when the liability is incurred.

     In November 2002, the EITF reached a consensus on Issue 00-21 (“EITF 00-21”), “Multiple-Deliverable Revenue Arrangements.” EITF 00-21 addresses how to account for arrangements that may involve the delivery or performance of multiple products, services, and/or rights to use assets. The consensus mandates how to identify whether goods or services or both that are to be delivered separately in a bundled sales arrangement should be accounted for separately because they are separate units of accounting. The guidance can affect the timing of revenue recognition for such arrangements, even though it does not change rules governing the timing or pattern of revenue recognition of individual items accounted for separately. The final consensus will be applicable to agreements entered into in fiscal years beginning after June 15, 2003 with early adoption permitted. Additionally, companies will be permitted to apply the consensus guidance to all existing arrangements as the cumulative effect of a change in accounting principle in accordance with APB Opinion No. 20, “Accounting Changes.” The Company is assessing, but at this point does not believe the adoption of EITF 00-21 will have a material impact on its financial position, cash flows or results of operations.

     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, if any, in relation to any of the above guarantees and, accordingly, adoption of this standard did not have a material impact on our 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 No. 45 as they were in effect prior to December 31, 2002. As a

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result of the insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is minimal. Accordingly, the Company has not recorded any liabilities for these agreements as of March 31, 2003.

     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. However, to date, the Company has not incurred costs to defend lawsuits or settle claims related to these indemnification agreements. Accordingly, the Company believes the estimated fair value of these agreements is minimal and no liabilities have been recorded for these agreements as of March 31, 2003.

     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. Additionally, the Company warrants that its maintenance services will be performed consistent with generally accepted industry standards through completion of the agreed upon services. If necessary, the Company would provide for the estimated cost of product and service warranties based on specific warranty claims and claim history, however, the Company has not incurred significant expense under its product or service warranties. As a result, the Company believes the estimated fair value of these agreements is minimal and has not recorded any liabilities for these agreements as of March 31, 2003.

     In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”),“Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The Company does not believe that the adoption of FIN 46 will have a material impact on our financial position, cash flows or results of operations.

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

Cautionary Statement Regarding Forward-Looking Statements

     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, Risks 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 subsidiaries, (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. We design, develop and market 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 of America 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.

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The significant 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 are comprised primarily of original equipment manufacturers (“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 or determinable and collection of the 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. We base the levels of returns on historical experience. To the extent we experience increased levels of returns, revenue will decrease resulting in decreased gross profit.

     We receive software license revenue from OEMs that sublicense our 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. Our deferred revenue balance as of March 31, 2003 was $2.9 million and included approximately $256,000 in exchange rights for unsold licenses.

     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 us. We provide 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 March 31, 2003, inventories of $3.0 million that were previously written down were still on hand. Subsequent increases in projected demand will not result in a reversal of these reserves until the sale of the related inventory.

     We are 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 goodwill. In accordance with SFAS 142, “Goodwill and Other Intangible Assets,” goodwill and intangible assets deemed to have indefinite lives are no longer amortized but instead are subject to annual impairment tests. We adopted SFAS 142 during the first quarter of fiscal 2003. Other intangible assets will continue to be amortized over their useful lives. Goodwill amortization expense aggregated $2.4 million, $4.7 million and $8.6 million, during the three and six months ended March 31, 2002 and in fiscal 2002, respectively. As of March 31, 2003, goodwill was approximately $1.0 million. Asset impairment charges could have a material effect on our 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 fiscal 2002, we

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recorded a net tax expense of $6.0 million to establish a valuation allowance against deferred tax assets. Continuing losses in recent reporting periods increase the uncertainties regarding realizability of deferred tax assets. We have provided a full valuation allowance against deferred tax assets. 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 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.

     As of March 31, 2003, in relation to the class action suit against us, the court approved a settlement of all claims and we recognized approximately $2.7 million in accrued litigation settlement charges, which represent the uninsured portion of the settlement amount. In accordance with the settlement, we will issue at least 270,000 shares of our common stock, supplementing the allotment with cash or additional shares of common stock to compensate for any shortfall in fair value below $2.7 million. To the extent that the trading price of the common stock exceeds $10.00 at the time of distribution, we would recognize an additional litigation settlement charge equal to the aggregate fair market value of the 270,000 shares of common stock less the $2.7 million already recognized. Such an adjustment may materially affect our results of operations, financial condition and future cash flows.

     Results of Operations

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

     Net Revenues. Net revenues decreased 20.6% to $4.5 million for the quarter ended March 31, 2003 from $5.7 million for the quarter ended March 31, 2002. Net revenues for the first six months of fiscal 2003 was $9.0 million, a decrease of 26.1% from the $12.1 million reported for the first six months of fiscal 2002. The decrease in revenues for the three months ended March 31, 2003 over the same period in the prior year was primarily due to decreased sales of Hifn’s data compression and encryption processors of $1.4 million offset by an increase in revenues from

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software license and royalties of $234,000. The decrease in revenues for the six months ended March 31, 2003 over the same period in the prior year was due to decreases in sales of Hifn’s data compression and encryption processors of $2.2 million as well as in revenues from software license and royalties of $1.0 million. Semiconductor sales to Quantum, an OEM producer of high-performance tape storage devices, through its manufacturing subcontractor, comprised 40% and 36% of revenues for the three and six months ended March 31, 2003, respectively. Semiconductor sales to Cisco, an OEM producer of networking equipment, comprised 16% and 13% of revenues for the three and six months ended March 31, 2003, respectively.

     Cost of Revenues. Cost of revenues consists primarily of the cost to produce 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 remained at approximately the same levels at 39.3% for the three months ended March 31, 2003 and 39.6% for the same period in fiscal 2002. During the three months ended March 31, 2003 and 2002, we sold $72,000 and $150,000, respectively, in inventories that had previously been written down. Cost of processor revenues as a percentage of net processor revenues remained at approximately the same levels at 37.3% for the six months ended March 31, 2003 and 37.7% for the same period in fiscal 2002. During the six months ended March 31, 2003 and 2002, we sold $345,000 and $150,000, respectively, in inventories that had previously been written down. Cost of software licenses and other revenues is primarily comprised of engineering labor related to support and maintenance of sold licenses and was $99,000 and $45,000 during the three months ended March 31, 2003 and 2002, respectively, and $198,000 and $90,000 for the six months ended March 31, 2003 and 2002, respectively.

     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 $5.4 million and $4.3 million for the quarters ended March 31, 2003 and 2002, respectively. The increase is attributable to an increase in non-recurring engineering and software tools and maintenance costs of $815,000 related to new and existing product development projects as well as increased salaries and benefits of $281,000 as a result of additional headcount related to the asset acquisition completed in September 2002. The increases were offset by a reduction in deferred compensation amortization of $116,000. Research and development costs were $10.6 million and $9.5 million for the six months ended March 31, 2003 and 2002, respectively. Amortization of deferred stock compensation decreased by $1.5 million, inclusive of $1.3 million for options canceled during December 2001 in relation to a voluntary stock option exchange program, while nonrecurring engineering and software tools and maintenance costs relating to new product development increased by $1.7 million and salaries and benefits increased by $896,000 as a result of additional headcount related to the asset acquisition referred to above.

     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 $1.7 million and $2.2 million for the three months ended March 31, 2003 and 2002, respectively. The decrease primarily reflects reductions in salaries and benefits costs of $188,000 as a result of the reduction-in-force effected in October 2002 and decreases in travel and tradeshow expenses aggregating $145,000. Sales and marketing expense for the six months ended March 31, 2003 and 2002 were approximately $3.5 million and $4.4 million, respectively. The decrease primarily reflects reductions in salaries and benefits costs of $543,000 due to reduced headcount and decreases in travel and tradeshow expenses aggregating $187,000.

     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 $885,000 and $2.8 million for the three months ended March 31, 2003 and 2002, respectively. The decrease was primarily attributable to a charge recorded in March 2002 of $1.2 million related to vacant facility lease, a decrease in legal costs of $337,000 and a decrease in deferred compensation expense amortization of approximately $113,000. General and administrative expenses for the six months ended March 31, 2003 and 2002 were $1.9 million and $4.4 million, respectively. The decrease was primarily attributable to a charge recorded in March 2002 of $1.2 million related to vacant facility lease and decreases in legal costs of $549,000 and in deferred compensation expense amortization of approximately $299,000.

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     Amortization of Goodwill. Goodwill amortization relates to the acquisition of Apptitude and was $2.4 million and $4.7 million during the three and six months ended March 31, 2002, respectively. The Company ceased amortization of goodwill in October 2002 as a result of the adoption of SFAS 142.

     Amortization of Intangibles. Amortization of intangibles relate to acquired technology, workforce and patents. Amortization of intangibles was $359,000 and $611,000 for the three months ended March 31, 2003 and 2002, respectively, and $717,000 and $1.0 million for the six months ended March 31, 2003 and 2002, respectively. The decrease in amortization of intangibles is the result of full amortization of certain intangible assets.

     Interest and Other Income, net. Net interest and other income was $112,000 and $249,000 for the three months ended March 31, 2003 and 2002, respectively, and $342,000 and $613,000 for the six months ended March 31, 2003 and 2002, respectively. The decrease in interest and other income for the three and six months ended March 31, 2003 compared to the same periods in the prior fiscal year was mainly due to the continuing decrease in the average cash balance coupled with decreasing overall interest rates.

     Income Taxes. As a result of continuing losses over a longer period than previously expected, we recorded a tax valuation allowance during fiscal 2002 to reduce the carrying value of our deferred tax assets to zero. Accordingly, we have not recognized tax benefits for the three and six months ended March 31, 2003. The effective income tax rate for the three and six months ended March 31, 2002 was 27% and 25%, respectively. The resulting effective tax rate was mainly due to the non-deductibility of certain acquisition-related costs consisting primarily of the amortization of intangibles and goodwill.

Liquidity and Capital Resources

     Net cash used in operating activities was $8.0 million for the six months ended March 31, 2003. Net cash used in operating activities for the six months ended March 31, 2003 was the result of net loss of $10.4 million as adjusted for non-cash items including amortization of intangibles related to acquired technology of $1.2 million, amortization of deferred stock compensation of $223,000, depreciation and amortization costs of fixed assets of $784,000 as well as decreases in accounts receivable of $309,000, in inventories of $123,000 and in intangibles and other assets of $368,000 and an increase in accounts payable of $882,000. These adjustments were offset by increases in prepaid expenses and other current assets of $1.2 million, related to prepaid insurance, licenses and software tools and maintenance, and a decrease in accrued expenses and other current liabilities of $284,000.

     Net cash provided by operating activities was $5.7 million for the six months ended March 31, 2002. During the six months ended March 31, 2002, net cash used in operating activities was attributed to net loss of $11.2 million as adjusted for non-cash items including amortization of goodwill and intangibles and of deferred stock compensation of $8.2 million, depreciation and amortization costs of fixed assets of $967,000 as well as a decrease in accounts receivable and inventories of $380,000 and $922,000, respectively, and an increase in accrued and other current liabilities of $930,000 as a result of an increase in accrued compensation and benefits and vacant facility lease expense. These adjustments were offset by increases in deferred income taxes of $1.9 million, in prepaids and other current assets of $1.4 million, as a result of an increase in prepaid income taxes, and in intangibles and other assets of $2.5 million as a result of acquired intellectual property.

     Net cash provided by investing activities of $902,000 for the six months ended March 31, 2003 primarily reflects a decrease in short-term investments of $1.6 million partially offset by the purchase of property and equipment of $704,000. Net cash provided by investing activities for the six months ended March 31, 2002 of $6.7 million related primarily to the sale of short-term investments.

     Net cash provided by financing activities was $511,000 and $476,000 for the six month periods ended March 31, 2003 and 2002, respectively, and were primarily attributable to proceeds from issuance of common stock.

     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-

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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 anticipate 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 on terms acceptable to us.

     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 March 31, 2003 are as follows (in thousands):

Recent Accounting Pronouncements

     In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146 (“SFAS 146”), “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS 146 addresses significant issues regarding the recognition, measurement, and reporting of costs that are associated with exit and disposal activities, including restructuring activities that are currently accounted for under EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The scope of SFAS 146 also includes costs related to terminating a contract that is not a capital lease and termination benefits that employees who are involuntarily terminated receive under the terms of a one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred-compensation contract. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002 and early application is encouraged. We adopted SFAS 146 during the second fiscal quarter ended March 31, 2003. The effect on adoption of SFAS 146 will change on a prospective basis the timing of when restructuring charges are recorded from a commitment date approach to when the liability is incurred.

     In November 2002, the EITF reached a consensus on Issue 00-21 (“EITF 00-21”), “Multiple-Deliverable Revenue Arrangements.” EITF 00-21 addresses how to account for arrangements that may involve the delivery or performance of multiple products, services, and/or rights to use assets. The consensus mandates how to identify whether goods or services or both that are to be delivered separately in a bundled sales arrangement should be accounted for separately because they are separate units of accounting. The guidance can affect the timing of revenue recognition for such arrangements, even though it does not change rules governing the timing or pattern of revenue recognition of individual items accounted for separately. The final consensus will be applicable to agreements entered into in fiscal years beginning after June 15, 2003 with early adoption permitted. Additionally, companies will be permitted to apply the consensus guidance to all existing arrangements as the cumulative effect of a change in accounting principle in accordance with APB Opinion No. 20, “Accounting Changes.” We are

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assessing, but at this point do not believe the adoption of EITF 00-21 will have a material impact on our financial position, cash flows or results of operations.

     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 software license warranties, indemnification arrangements with officer and directors and indemnification arrangements with customers with respect to intellectual property. To date, we have not incurred material costs, if any, in relation to any of the above guarantees and, accordingly, adoption of this standard did not have a material impact on our financial position, results of operations or cash flows.

     In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”),“Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. We do not believe that the adoption of FIN 46 will have a material impact on our financial position, cash flows or results of operations.

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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 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.

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.

     During fiscal 2002, we performed an impairment analysis of goodwill and long-lived assets and determined that impairment had been realized on goodwill and certain developed technology, resulting in recognition of an impairment charge of $27.4 million. 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 assets, asset impairment charges will be recognized. Approximately $1.0 million of goodwill remains as of March 31, 2003.

We Depend Upon A Small Number Of Customers.

     Quantum Corporation (“Quantum”), through its manufacturing subcontractor, accounted for approximately 40% and 36% of our net revenues during the three and six months ended March 31, 2003, respectively, and 46% and 36% of our net revenues in fiscal 2002 and 2001, respectively. Cisco, an OEM producer of network equipment, comprised 16% and 13% of our net revenues for the three and six months ended March 31, 2003, respectively. Neither Quantum nor Cisco is under any binding obligation to order from us. If our sales to Quantum or Cisco 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 annual basis.

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     Limited numbers of network and storage equipment vendors account for a majority of packet processor purchases in their respective markets. In particular, the market for network equipment that would include packet processors, such as routers, remote access concentrators and firewalls, is dominated by a few large vendors, including Cisco 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 market, which continues to evolve, may not grow. Alternatively, if it continues 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.

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

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•

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

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

     In evaluating new product decisions, we must anticipate future demand for product features and performance characteristics, as well as available supporting technologies, manufacturing capacity, competitive product offerings and industry standards. We must also continue to make significant investments in research and development in order to continue to enhance the performance and functionality of our products to keep pace with competitive products and customer demands for improved performance, features and functionality. The technical innovations required for us to remain competitive are complicated and require a significant amount of time and money. 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 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 Analog Devices, Inc., SafeNet, Inc., IBM, Broadcom Corporation, Motorola, Inc. and Royal Philips Electronics. In 1994, Stac entered into two license agreements with IBM 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.

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

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

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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 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 17 United States patents and seven foreign patents. We also have two pending patent applications in Japan. Our issued patents and patent applications primarily cover various aspects of our compression, bandwidth management and rate shaping technologies and have expiration dates ranging from 2006 to 2017. 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. 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

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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 OKI Semiconductor. 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. 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 customers. We have also experienced yield and test anomalies on a different product manufactured by another subcontractor that could have interrupted our customer shipments. In this case, the manufacturer was able to correct the problem in a timely manner and customer shipments were not affected. The delay and expense associated with qualifying a new supplier or foundry and commencing volume production can result in lost revenue, reduced operating margins and possible harm to customer relationships. The steps required for a new manufacturer to begin production of a semiconductor product include:

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

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

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     Both Toshiba Corporation and OKI Semiconductor 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.

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.

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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. During fiscal 2002, we recorded an excess inventory reserve 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, 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 24 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 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.

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.

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;

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	•		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 and 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 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 and certain other assets and intellectual property acquired in September 2002, the anticipated benefits of these 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.

The Cyclicality 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.

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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 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 Hifn 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 Hifn’s stock between July 26, 1999 and October 7, 1999 (the “class period”). The complaint sought unspecified money damages and alleged that the Hifn 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 District Court dismissed the complaint as to all defendants, other than Raymond J. Farnham and Hifn. In February 2001, the District Court certified the purported class. On June 10, 2002, the District Court entered an order preliminarily approving a Stipulation of Settlement, by which all claims against Hifn and Mr. Farnham would be dismissed without any admission of liability or wrongdoing, and the shareholder class would receive $9.5 million, comprised of $6.8 million in cash, contributed by our insurance carriers, and the balance in cash or Hifn stock, with a minimum of 270,000 shares to be issued. On September 4, 2002, the District Court approved the settlement and entered a Final Judgment and Order of Dismissal with Prejudice. In accordance with the settlement, we will issue at least 270,000 shares of Hifn common stock, supplementing the allotment with cash or additional common stock equal to $2.7 million. To the extent that the trading price of the common stock exceeds $10.00 at the time of distribution, Hifn would recognize an additional litigation settlement charge equal to the aggregate fair market value of the 270,000 shares of common stock less the $2.7 million already recognized and any such additional charge may negatively affect our financial condition and results of operations.

     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 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 granted plaintiff's motion to voluntarily dismiss that 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 they were excused from making demand on Hifn’s board of directors. Plaintiff filed an amended complaint. On March 18, 2003, the court again sustained Hifn’s demurrer, with leave to amend, on the ground that plaintiff had failed to plead facts showing that they were excused from making a demand on Hifn’s board of directors. Plaintiff did not file an amended complaint within the time permitted. Hifn 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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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 March 31, 2003 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 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. Based on their evaluation as of a date within 90 days of the filing date of this Quarterly Report on Form 10-Q, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934 (the “Exchange Act”) are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

     (b)  Changes in internal controls. There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation. There were no significant deficiencies or material weaknesses, and therefore there were no corrective actions taken.

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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 Hifn 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 Hifn’s stock between July 26, 1999 and October 7, 1999 (the “class period”). The complaint sought unspecified money damages and alleged that the Hifn 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 District Court dismissed the complaint as to all defendants, other than Raymond J. Farnham and Hifn. In February 2001, the District Court certified the purported class. On June 10, 2002, the District Court entered an order preliminarily approving a Stipulation of Settlement, by which all claims against Hifn and Mr. Farnham would be dismissed without any admission of liability or wrongdoing, and the shareholder class will receive $9.5 million, comprised of $6.8 million in cash, contributed by our insurance carriers, and the balance in cash or Hifn stock, with a minimum of 270,000 shares to be issued. On September 4, 2002, the District Court approved the settlement and entered a Final Judgment and Order of Dismissal with Prejudice. In accordance with the settlement, we will issue at least 270,000 shares of Hifn common stock, supplementing the allotment with cash or additional common stock equal to $2.7 million. To the extent that the trading price of the common stock exceeds $10.00 at the time of distribution, Hifn would recognize an additional litigation settlement charge equal to the aggregate fair market value of the 270,000 shares of common stock less the $2.7 million already recognized and any such additional charge may negatively affect our financial condition and results of operations.

     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 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 granted plaintiff’s motion to voluntarily dismiss that 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 they were excused from making demand on Hifn’s board of directors. Plaintiff filed an amended complaint. On March 18, 2003, the court again sustained Hifn’s demurrer, with leave to amend, on the ground that plaintiff had failed to plead facts showing that they were excused from making a demand on Hifn’s board of directors. Plaintiff did not file an amended complaint within the time permitted. Hifn 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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Item 4.     Submission of Matters to a Vote of Security Holders

     The Company held its Annual Meeting of Stockholders on February 24, 2003. At the meeting, the following proposals received the votes listed below:

     Proposal I.     Election of Class III Director for three-year terms expiring 2006.

	The Company’s Board of Directors is currently comprised of seven members who are divided into three classes with overlapping three-year terms. The term for Class II directors (Dennis DeCoste, Taher Elgamal and Robert W. Johnson) will expire at the meeting of stockholders to be held in 2004. The term for Class III directors (Albert E. Sisto and Douglas L.Whiting) will expire at the meeting of stockholders to be held in 2005.
	Proposal II:     Approval of an amendment to the Company’s 1996 Amended and Restated 1996 Equity Incentive Plan to provide for an increase in the number of shares of common stock available for issuance thereunder by 500,000 shares to 4,949,900 shares.

	Proposal III:     Approval of ratification of the appointment of PricewaterhouseCoopers LLP as independent auditors of the Company for the fiscal year ending September 30, 2003.

Item 6.     Exhibits and Reports on Form 8-K

	(a)		Exhibits
			Exhibit Index