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FORM 10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACTS OF 1934

For the Quarter ended SEPTEMBER 30, 2002

Commission file number: 0-16641

RAINBOW TECHNOLOGIES, INC.
(Exact name of Registrant as specified in its charter)

DELAWARE		95-3745398
(State of incorporation)		(I.R.S. Employer Identification No.)

50 TECHNOLOGY DRIVE, IRVINE, CALIFORNIA		92618
(Address of principal executive offices)		(Zip Code)

Indicate by check mark whether the Registrant (i) 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 (ii) has been subject to such filing requirements for the past 90 days.

Yes [X]    No [   ]

The number of shares of common stock, $.001 par value, outstanding as of October 31, 2002, was 26,216,249.

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RAINBOW TECHNOLOGIES, INC.

TABLE OF CONTENTS

						Page
PART I - FINANCIAL INFORMATION
Item 1.		Condensed Consolidated Financial Statements
		Condensed Consolidated Balance Sheets at September 30, 2002 (unaudited) and December 31, 2001					4
		Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2002 and 2001 (unaudited)					5
		Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended September 30, 2002 and 2001 (unaudited)					6
		Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2002 and 2001 (unaudited)					7
		Notes to Condensed Consolidated Financial Statements (unaudited)					8
Item 2.		Management's Discussion and Analysis of Financial Condition and Results of Operations					14
Item 3.		Not applicable
Item 4.		Controls and Procedures					18
PART II - OTHER INFORMATION
Item 1 to 5 - Not applicable
Item 6.		Exhibits and reports on Form 8K					19
SIGNATURES							21
CERTIFICATIONS OF FINANCIAL REPORTS PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002							22

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INTRODUCTORY NOTE

     The Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 and the Company intends that such forward-looking statements be subject to the safe harbors created thereby. These forward-looking statements include (i) the existence and development of the Company’s technical and manufacturing capabilities, (ii) anticipated competition, (iii) potential future growth in revenues and income, (iv) potential future decreases in costs, and (v) the need for, and availability of additional financing.

     The forward-looking statements included herein are based on current expectations that involve a number of risks and uncertainties. These forward-looking statements are based on the assumption that the Company will not lose a significant customer or customers or experience increased fluctuations of demand or rescheduling of purchase orders, that the Company’s markets will continue to grow, that the Company’s products will remain accepted within their respective markets and will not be replaced by new technology, that competitive conditions within the Company’s markets will not change materially or adversely, that the Company will retain key technical and management personnel, that the Company’s forecasts will accurately anticipate market demand, that there will be no material adverse change in the Company’s operations or business and that the Company will not experience significant supply shortages with respect to purchased components, sub-systems or raw materials. Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions, and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond the control of the Company. In addition, the business and operations of the Company are subject to substantial risks, which increase the uncertainty inherent in the forward-looking statements. In light of the significant uncertainties inherent in the forward-looking information included herein, the inclusion of such information should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved.

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PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

RAINBOW TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except per share amounts)

						September 30, 2002				December 31, 2001
						(unaudited)
ASSETS
Current assets:
		Cash and cash equivalents				$	42,128			$	28,778
		Marketable available-for-sale and trading securities					160				1,195
		Accounts receivable, net of allowance for doubtful accounts of $988 and $1,858 in 2002 and 2001, respectively					17,045				24,492
		Inventories					10,080				20,711
		Income tax receivable					5,013				1,844
		Deferred income taxes					—				13,901
		Unbilled costs and fees					1,470				2,227
		Prepaid expenses and other current assets					1,558				1,634
				Total current assets			77,454				94,782
Property, plant and equipment, at cost:
		Equipment					22,167				20,838
		Buildings					7,344				6,655
		Furniture					2,937				2,810
		Leasehold improvements					2,941				2,946
							35,389				33,249
		Less accumulated depreciation and amortization					21,013				17,336
				Net property, plant and equipment			14,376				15,913
		Goodwill, net of accumulated amortization of $35,496 and $22,104 in 2002 and 2001, respectively					1,684				15,638
		Software development costs, net of accumulated amortization of $19,050 and $11,218 in 2002 and 2001, respectively					3,945				10,768
		Product licenses, net of accumulated amortization of $5,094 and $3,537 in 2002 and 2001, respectively					4,425				4,030
		Deferred income taxes					—				2,421
		Other assets					1,861				2,413
						$	103,745			$	145,965
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
		Accounts payable				$	7,464			$	9,929
		Accrued payroll and related expenses					6,039				5,063
		Accrued restructuring costs					2,326				3,130
		Warranty reserve					2,261				2,417
		Other accrued liabilities					6,024				5,041
		Long-term debt, due within one year					234				211
				Total current liabilities			24,348				25,791
		Long-term debt, net of current portion					351				476
		Other liabilities					2,713				2,959
		Commitments and contingencies
		Shareholders’ equity:
		Common stock, $.001 par value, 55,000,000 shares authorized, 26,713,270 and 26,157,594 shares issued and outstanding in 2002 and 2001, respectively					27				26
		Additional paid-in capital					60,250				56,885
		Accumulated other comprehensive loss					(363	)			(1,539	)
		Retained earnings					18,830				61,367
							78,744				116,739
Less cost of treasury shares (517,000 shares)							(2,411	)			—
				Total shareholders’ equity			76,333				116,739
						$	103,745			$	145,965

See accompanying notes.

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RAINBOW TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except per share amounts)

See accompanying notes.

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RAINBOW TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(dollars in thousands)

See accompanying notes.

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RAINBOW TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)

See accompanying notes.

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RAINBOW TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002
(Unaudited)

1. Basis of presentation

Rainbow Technologies, Inc. (the Company) develops, manufactures, programs and markets software and internet security products which prevent the unauthorized use of intellectual property, including software programs, provides privacy and security for network communications and develops and manufactures secure communication products for satellite communications. The accompanying financial statements consolidate the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated. Certain amounts previously reported have been reclassified to conform to the 2002 presentation.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the accompanying financial statements. Actual results could differ from those estimates. Significant estimates made in preparing these financial statements include the allowance for doubtful accounts, the reserve for excess and obsolete inventory, goodwill valuations, accrued warranty costs, restructuring costs, the valuation allowance for deferred tax assets and total estimated contract costs associated with billed and unbilled contract revenue.

Management determines the appropriate classification of its investments in marketable securities at the time of purchase. Securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and carried at fair value with the unrealized holding gains and losses included in earnings. Available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of tax, reported as a separate component of Accumulated Other Comprehensive Loss within Shareholders’ Equity.

In the opinion of the Company’s management, the accompanying condensed consolidated financial statements include all normal recurring adjustments necessary for a fair presentation of the financial position at September 30, 2002 and results of operations for the three and nine months ended September 30, 2002 and 2001. The condensed consolidated financial statements do not include footnotes and certain financial information normally presented annually under accounting principles generally accepted in the United States and, therefore, should be read in conjunction with the Company’s December 31, 2001 Annual Report on Form 10-K. Results of operations for the three and nine months ended September 30, 2002 are not necessarily indicative of results to be expected for the full year.

The Company has subsidiaries in the United Kingdom, Germany, France, Netherlands, India, Australia, China, Taiwan, Japan and Mexico. The Company utilizes the currencies of the countries where its foreign subsidiaries operate as the functional currency. Balance sheet accounts denominated in foreign currency are translated at exchange rates as of the date of the balance sheet and income statement accounts are translated at average exchange rates for the period. Translation gains and losses are accumulated as a separate component of Accumulated Other Comprehensive Loss within Shareholders’ Equity. The Company has adopted local currencies as the functional currencies for its subsidiaries because their principal economic activities are most closely tied to the respective local currencies.

2. Earnings per share

Basic earnings per share is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share for the three months ended September 30, 2002 assumes the conversion of 206,000 stock options. The Company incurred losses for the three months ended September 30, 2001 and the nine months ended September 30, 2002 and 2001 and, therefore, all stock options were anti-dilutive and not included in the computation of diluted earnings per share.

3. Government Contracts

The Company is both a prime contractor and subcontractor under fixed-price and cost-reimbursement contracts with the U.S. Government (Government). At the commencement of each contract or contract modification, the Company submits pricing proposals to the Government to establish indirect cost rates applicable to such contracts. These rates, after audit and approval by the Government, are used to settle costs on completed contracts.

To facilitate interim billings during the performance of its contracts, the Company establishes provisional billing rates, which are used in recognizing contract revenue and contract accounts receivable. The provisional billing rates are adjusted to actual at year-end and are subject to adjustment after Government audit.

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4. Inventories

Inventoried costs relating to long-term contracts are stated at actual production costs, including pro-rata allocations of factory overhead and general and administrative costs incurred-to-date, reduced by amounts identified with revenue recognized on units delivered. The costs attributed to units delivered under such long-term contracts are based on the estimated average cost of all units expected to be produced.

Inventories, other than inventoried costs relating to long-term contracts, are stated at the lower of cost (first-in, first-out basis) or market.

Inventories consist of the following:
(dollars in thousands)

5. Goodwill and other intangible assets

Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations” and No. 142, “Goodwill and other Intangible Assets.” SFAS No. 141 addresses financial accounting and reporting for a business combination and requires all business combinations to be accounted for using the purchase method. SFAS No. 141 is effective for any business combinations initiated after June 30, 2001. SFAS No. 142 addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. Goodwill and other intangible assets with indefinite lives are no longer amortized but instead are subject to an impairment test at least annually. The impairment test is comprised of two parts. The first step compares the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount exceeds the fair value of the reporting unit, the second step of the goodwill impairment test must be performed. The second step compares the implied fair value of the reporting unit’s goodwill with the respective carrying amount in order to determine the amount of impairment loss, if any. In accordance with SFAS No. 142, the Company performed the first part of the two-step goodwill impairment test for its business segments with goodwill, excluding the $12.8 million of goodwill related to the Spectria business segment, which was written-off and included in the loss from discontinued operations in the consolidated statement of operations for the nine months ended September 30, 2002 (see note 12). For each of the Company’s business segments for which goodwill was recorded, the Company determined that the fair value exceeded the carrying amount as of January 1, 2002. As a result, the second step of the impairment test was not required. Additionally, under SFAS No. 142, the Company ceased amortizing its remaining goodwill balance which will result in reduced amortization of approximately $0.6 million, net of tax, in fiscal 2002. Total amortization expense for the three and nine months ended September 30, 2002 for other intangible assets subject to amortization, were $1.0 million and $3.3 million, respectively.

The following table reconciles the Company’s net income (loss) and net income (loss) per share from continuing operations as reported, to the amounts adjusted for the exclusion of goodwill amortization, net of the related income tax effect for the period prior to the adoption of SFAS No. 142.
(dollars in thousands, except per share amounts):

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The following table presents details of the Company’s other intangible assets that are subject to amortization:

At September 30, 2002, the amortization of the remaining balance of other intangible assets of $8.4 million will be $0.9 million for the remainder of 2002. The amortization for each of the fiscal years 2003, 2004 and 2005 will be $3.0 million, $2.8 million and $1.5 million, respectively. At September 30, 2002, the Company had $0.2 million of unamortized software development costs included in the remaining balance of other intangible assets of $8.4 million, which had not begun amortization. Amortization of software development costs commences when the products are available for general release to customers.

6. Software development costs

SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,” requires capitalization of certain software development costs subsequent to the establishment of technological feasibility. Based on the Company’s product development process, technological feasibility is established upon completion of a working model. Amortization of capitalized software development costs commences when the products are available for general release to customers and are determined using the straight-line method over the expected useful lives of the respective products. These amounts are written-off if it is determined that the projects cannot be brought to market.

7. Other assets

Other assets primarily represent investments in early stage companies that are accounted for on the cost basis. The Company periodically reviews these investments for other-than-temporary declines in fair value and writes down investments to their fair value when an other-than-temporary decline has occurred based on the specific identification method. The Company generally believes an other-than-temporary decline has occurred when the fair value of the investment is below the carrying value for two consecutive quarters, absent evidence to the contrary.

8. Industry segments

In June 2002, the Company announced that its Spectria segment had experienced rapidly deteriorating business prospects due to a severe decline in IT services infrastructure spending. Consequently, the Company discontinued Spectria and is closing its facility in Long Beach, California. Spectria’s results of operations are included in the loss from discontinued operations in the consolidated statement of operations for the three and nine months ended September 30, 2002 and 2001. The identifiable assets, after applicable eliminations for Spectria as of September 30, 2002 were $0.3 million as compared to $16.5 million as of December 31, 2001 (see note 12).

The Company has two business segments comprising continuing operations. The first segment focuses on commercial security products, including solutions for reliable identity, secure internet and wireless transaction acceleration, licensing solutions for software publishers, easy to deploy Web security solutions and security training and consulting for enterprise IT staff (eSecurity Products). The second segment provides products and services for enterprise, government and defense applications for products providing security for classified information, for products providing personal identity authentication for government and defense applications, and custom design services for enterprises, government and defense applications requiring either extraordinary performance and/or security (Secure Communications Products). These two business segments are increasingly working closely together. The identifiable assets, after applicable eliminations, for each segment from continuing operations as of September 30, 2002, were $81.2 million and $22.2 million, respectively, compared with $101.8 million and $27.7 million as of December 31, 2001.

Intercompany revenues for the three and nine months ended September 30, 2002 were $1,000 and $18,000, respectively, and $14,000 and $280,000, respectively, for the corresponding periods in the prior year. Intercompany revenues are generated by the Secure Communications segment.

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9. Recent accounting pronouncements

In June 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146). This standard addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue 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 principal difference between SFAS No. 146 and EITF 94-3 relates to SFAS 146’s requirements for recognition of a liability for a cost associated with an exit or disposal activity. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF 94-3, a liability for an exit costs as generally defined in EITF 94-3 was recognized at the date of an entity’s commitment to an exit plan. The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The Company does not expect SFAS No. 146 to have a material impact on its consolidated results of operations.

In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. SFAS No. 144 supersedes FASB Statement No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,” and the accounting and reporting provisions of APB Opinion No. 30, “Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,” for the disposal of a segment of a business (as previously defined in that opinion). SFAS No. 144 requires that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and broadens the presentation of discontinued operations to include more disposal transactions than were included under the previous standards. Under SFAS No. 144, a component of a business that either has been disposed of or is classified as held for sale is reported in discontinued operations if (i) the operations and cash flows will be, or have been, eliminated from the on-going operations of the company as a result of the disposal transaction and, (ii) the company will not have any significant continuing involvement in such operations.

In June 2002, the Company announced that its Spectria segment had experienced rapidly deteriorating business prospects due to a severe decline in IT services infrastructure spending. Consequently, the Company discontinued Spectria and is closing its facility in Long Beach, California. During the second quarter of 2002, the Company wrote-off Spectria’s goodwill balance of $12.8 million and recorded a $2.1 million provision based on management’s estimates of the amounts to be realized on the disposal of its assets. During the third quarter of 2002, the Company increased the provision by $0.3 million due to additional severance and lease obligations related to the discontinuation of Spectria. The amount the Company will ultimately realize could differ from the assumptions currently used in arriving at the anticipated loss. Spectria’s results of operations are included in the loss from discontinued operations in the consolidated statement of operations for the three and nine months ended September 30, 2002 (see note 12).

10. Litigation

In September 1998, a patent infringement action was filed against the Company by Globetrotter, Inc., alleging that certain of the Company’s products infringe patents owned by Globetrotter. The complaint seeks unspecified monetary damages and a permanent injunction banning the use of the products alleged to infringe the Globetrotter patents. On September 24, 2001, the District Court granted partial summary judgment in favor of the Company as it relates to allegations by Globetrotter. The Company has filed a counterclaim alleging antitrust and unfair competition and has been vigorously prosecuting their antitrust and other business tort claims. The counterclaims are presently set for trial on December 2, 2002.

In July 1998, a patent infringement claim was filed against the Company by Andrew Pickholtz, alleging that certain of the Company’s products infringe a patent owned by Pickholtz. The complaint seeks unspecified monetary damages. The Company filed a motion for summary judgment of noninfringement that was decided in favor of the Company in December 2000. In January 2001, Mr. Pickholtz filed a notice of appeal. After considering legal briefs filed by the Company and by Mr. Pickholtz, the Court of Appeals for the Federal Circuit heard oral arguments in the case on November 7, 2001. On April 3, 2002, the appellate court issued an opinion which reversed the trial court’s entry of summary judgment in favor of the Company, and remanded the case to the trial court for further proceedings. Mr. Pickholtz filed a petition seeking a rehearing as to certain issues, which the appellate court denied on April 29, 2002. The Company continues to believe the claims are without merit and intends to continue to vigorously defend against any infringement claims made by Mr. Pickholtz.

In June 2002, a breach of contract lawsuit was filed against the Company by a supplier. The complaint seeks damages of $3.9 million. The Company has recorded $2.6 million related to this matter that is included in accounts payable. The Company believes that the additional claim is without merit and intends to vigorously defend this matter.

The Company is also involved in other legal proceedings and claims arising in the ordinary course of business. The Company does not believe that any liabilities related to the legal proceedings to which it is a party are likely to be, individually or in the aggregate, material to the Company’s consolidated financial condition, results of operations or cash flows.

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11. Restructuring charges

In the third quarter of 2001, the Company restructured and consolidated its Digital Rights Management and iVEA operations (eSecurity Products), resulting in a net staff reduction of 97 employees across all employee groups, primarily in the U.S., and recorded restructuring charges of $6.4 million.

The following table summarizes the Company’s restructuring costs and activities from continuing operations in the restructuring reserves:
(dollars in thousands):

The following table summarizes the Company’s restructuring costs and activities from discontinued operations in the restructuring reserves:

The current portion of the restructuring reserve of $2.3 million relating to office space reduction is shown separately under current liabilities while the long-term portion of the reserve of $1.2 million is recorded in other liabilities. Exit activities are anticipated to continue through 2002 with certain lease obligations currently expiring in 2005.

12. Discontinued operations and other charges

In June 2002, the Company announced that its Spectria segment had experienced rapidly deteriorating business prospects due to a severe decline in IT services infrastructure spending. Consequently, the Company discontinued Spectria and is closing its facility in Long Beach, California. During the second quarter of 2002, the Company wrote-off Spectria’s goodwill balance of $12.8 million and recorded a $2.1 million provision based on management’s estimates of the amounts to be realized on the disposal of its assets. During the third quarter of 2002, the Company increased the provision by $0.3 million due to additional severance and lease obligations related to the discontinuation of Spectria. The amount the Company will ultimately realize could differ from the assumptions currently used in arriving at the anticipated loss. Spectria’s results of operations are included in the loss from discontinued operations in the consolidated statement of operations for the three and nine months ended September 30, 2002.

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The revenues and loss from discontinued operations for the three and nine months ended September 30, 2002 and 2001 related to the disposal of Spectria are as follows:

The assets and liabilities of Spectria at September 30, 2002 and December 31, 2001 consisted of the following: