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FORM 10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

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

RAINBOW TECHNOLOGIES, INC.

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 o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).

Yes x No o

The number of shares of common stock, $.001 par value, outstanding as of July 31, 2003, was 26,659,972.

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RAINBOW TECHNOLOGIES, INC.

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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 certain matters discussed in this report are “forward-looking statements” intended to qualify for the safe harbor from liability established by the Private Securities Litigation Reform Act of 1995. These forward-looking statements can generally be identified by the context of the statement which may include words such as the Company “believes,” “anticipates,” “expects,” “forecasts,” “estimates,” or other words of similar meaning and context. Similarly, statements that describe future plans, objectives, outlooks, targets, models or goals are also deemed forward-looking statements. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those forecasted or anticipated as of the date of this report. Certain of such risks and uncertainties are described in close proximity to such statements and elsewhere in this report, including Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Stakeholders, potential investors and other readers are urged to consider these factors in evaluating the forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements or construe such statements to be a representation by the Company that the objectives or plans of the Company will be achieved. The forward-looking statements included in this report are made only as of the date of this report, and the Company undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances.

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PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

RAINBOW TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)

See accompanying notes.

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

See accompanying notes.

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

See accompanying notes.

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

See accompanying notes.

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RAINBOW TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
(unaudited)

1. Description of the Company and Summary of Significant Accounting Policies

The Company

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 high assurance satellite communications and voice and data links.

Basis of Consolidation

The accompanying financial statements consolidate the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated.

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 June 30, 2003 and results of operations for the three and six months ended June 30, 2003 and 2002. The condensed consolidated financial statements do not include certain footnotes and 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, 2002 Annual Report on Form 10-K. Results of operations for the three and six months ended June 30, 2003 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, Mexico, Hong Kong and Brazil. Excluding Hong Kong, the Company utilizes the currencies of the countries where its foreign subsidiaries operate as the functional currency. Balance sheet accounts denominated in foreign currencies 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 Income within Shareholders’ Equity. The Company has adopted local currencies as the functional currencies for these subsidiaries because their principal economic activities are most closely tied to the respective local currencies. For its Hong Kong subsidiary, the Company utilizes the U.S. dollar as the functional currency as the majority of its transactions are in U.S. dollars.

Basis of Presentation

In the second quarter of 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 closed its facility in Long Beach, California. In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” Spectria’s results of operations are included in the loss from discontinued operations in the consolidated statements of operations for the three and six months ended June 30, 2003 and 2002 (see Note 12). Certain amounts previously reported have been reclassified to conform with the 2003 presentation. Unless otherwise indicated, the Notes to Consolidated Financial Statements relate to continuing operations.

Use of Estimates

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.

Marketable Securities

All investment securities are considered to be either trading or available-for-sale. Management determines the classification of its investments in marketable securities at the time of purchase and re-evaluates its appropriateness at each balance sheet date. 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 gains and losses included in earnings. Available-for-sale securities are carried at fair value, with the

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unrealized gains and losses, net of tax, reported as a separate component of Accumulated Other Comprehensive Income within Shareholders’ Equity.

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 six months ended June 30, 2003 assumes the conversion of stock options of 1,274,000. For the three months ended June 30, 2003 and three and six months ended June 30, 2002, the Company incurred losses and, therefore, all stock options were anti-dilutive and not included in the computation of diluted earnings per share.

3.

Stock Option Plans

The Company follows the disclosure-only provisions of SFAS 123, “Accounting for Stock-Based Compensation,” as amended, and, accordingly, accounts for its stock-based compensation plans using the intrinsic value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations.

For purposes of pro forma disclosures, the following table illustrates the effect on net income (loss) and income (loss) per share, had compensation expense for the employee stock-based plans been recorded based on the fair value method under SFAS 123: (in thousands, except per share amounts)

4.

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 contracts completed during the previous year.

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.

5.

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.

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Inventories consist of the following:
(in thousands)

6. Income taxes

The effective tax rates from continuing operations for the three and six months ended June 30, 2003 were (3%) and 18%, respectively. The effective tax rate for 2003 was different from the statutory rate of 35% primarily due to the release of the Company’s federal valuation allowance which reduced income tax expense for the three and six months ended June 30, 2003. During 2002, the Company recorded income tax expense from continuing operations of $13.4 million and $13.7 million for the three and six months ended June 30, 2002, which included a valuation allowance of $11.6 million in accordance with SFAS 109, “Accounting for Income Taxes.”

7. Warranty

The Company generally warrants its products for periods of ninety days to two years. The standard warranties require the Company to repair or replace defective products returned at no cost to the customer. The Company records an estimate for warranty related costs based on amounts required to cover warranty expense on products sold and actual historical return rates at the time revenue is recognized. While warranty costs have historically been within management’s expectations and the provisions established, the Company cannot guarantee that it will continue to experience the same warranty return rates as in the past. A significant increase in product return rates could have a material adverse effect on the Company’s operating results for the period in which such returns materialize.

The following details the Company’s warranty reserve:
(in thousands)

8. Industry segments

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 and easy to deploy Web security solutions (eSecurity segment). 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 authentification for government and defense applications, and custom design services for enterprises, government and defense applications requiring either extraordinary performance and/or security (Secure Communications segment). The identifiable assets, after applicable eliminations, for each segment as of June 30, 2003 were $100.0 million and $19.5 million, respectively, compared with $90.7 million and $20.9 million as of December 31, 2002. Operating loss for eSecurity segment for the three and six months ended June 30, 2003 was ($2.4) million and ($2.3) million, respectively, compared with ($17.8) million and ($19.8) million, respectively, for the corresponding periods in the prior year. Operating income for Secure Communications segment for the three and six months ended June 30, 2003 were $1.9 million and $5.7 million, respectively, compared with $2.2 million and $5.5 million, respectively, for the corresponding periods in the prior year.

There were no intercompany revenues for the three and six months ended June 30, 2003 while intercompany revenues for the three and six months ended June 30, 2002 were $16,000 and $17,000, respectively. Intercompany revenues are generated by the Secure Communications segment.

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9. Recent accounting pronouncements

In May 2003, the Financial Accounting Standards Board (FASB) issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (SFAS 150). This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS 150 requires that certain financial instruments, which under previous guidance were accounted for as equity, must now be accounted for as liabilities (or an asset in some circumstances). The financial instruments affected include mandatorily redeemable stock, certain financial instruments that require or may require the issuer to buy back some of its shares in exchange for cash or other assets and certain obligations that can be settled with shares of stock. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period after June 15, 2003. The Company does not expect the adoption of SFAS 150 to have a material impact on its consolidated financial condition or results of operations.

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46). FIN 46 requires the primary beneficiary of a variable interest entity (VIE) to consolidate the entity and also requires majority and significant variable interest investors to provide certain disclosures. A VIE is an entity in which the equity investors do not have a controlling interest, equity investors participate in losses or residual interests of the entity on a basis that differs from its ownership interest, or the equity investment at risk is insufficient to finance the entity’s activities without receiving additional subordinated financial support from the other parties. For arrangements entered into with VIEs created prior to January 31, 2003, the provisions of FIN 46 are required to be adopted at the beginning of the first interim or annual period beginning after June 15, 2003. The Company is currently reviewing its investments and other arrangements to determine whether any of its investee companies are VIEs. The Company does not expect to identify any significant VIEs that would be consolidated, but may be required to make additional disclosures. The provisions of FIN 46 are effective immediately for all arrangements entered into with new VIEs created after January 31, 2003. The Company has not invested in any new VIEs created after January 31, 2003.

10. Legal proceedings

In July 1998, a patent infringement claim was filed against the Company. The complaint sought unspecified monetary damages. The Company filed a motion for summary judgment of non-infringement that was decided by the District Court in favor of the Company in December 2000. That decision was appealed and on April 3, 2002, the United States Court of Appeals issued an opinion that modified the trial court’s construction of the patent claims in certain respects, revised the summary judgment and remanded the case to the trial court for further proceedings. On May 1, 2003, after remand, the District Court granted another motion for summary judgment of non-infringement brought by the Company, thereby removing half of the products at issue from litigation and granted a motion for summary judgment re: damages, thereby limiting any recovery by the plaintiff to a reasonable royalty. The patent-in-suit expired in June 30, 2003, thereby removing the threat of any injunction against the Company from the litigation. Subsequent to June 30, 2003, pursuant to court order, the Company expects a settlement of this litigation for which it had been incurring significant legal expenses. The settlement expense of $3.6 million was included in the results of operations for the quarter ended June 30, 2003.

The Company is also involved in other legal proceedings and claims arising in the ordinary course of business. The Company believes that the outcome of all current litigation will not have a material adverse effect on its business, financial condition, cash flows or results of operations.

11. Restructuring

In the third quarter of 2001, the Company restructured and consolidated its Digital Rights Management and iVEA operations (eSecurity segment), resulting in a net staff reduction of 97 employees across all employee groups, primarily in the U.S. and recorded restructuring charges of $5.8 million.

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

The current portion of the restructuring reserve of $0.4 million relating to office space reduction is recorded in other accrued liabilities while the long-term portion of the reserve of $2.1 million is shown separately as long-term accrued restructuring costs, on the accompanying condensed consolidated balance sheets.

12. Discontinued operations

The revenues and loss from discontinued operations for the three and six months ended June 30, 2003 and 2002 related to the disposal of Spectria are as follows:
(in thousands)

The assets and liabilities of Spectria at June 30, 2003 and December 31, 2002 consisted of the following:
(in thousands)

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

The following is management’s discussion and analysis of certain significant factors, which have affected the consolidated results of operations, and the consolidated financial position of the Company during the periods included in the accompanying condensed consolidated financial statements. This discussion should be read in conjunction with the related condensed consolidated financial statements and accompanying notes.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The Company’s financial statements are based on the selection and application of significant accounting policies, which require management to make significant estimates and assumptions. The Company believes that the following are some of the more critical judgment areas in the application of its accounting policies that currently affect its consolidated financial condition and results of operations.

Revenue Recognition

eSecurity recognizes revenues from product sales at the time of shipment. Secure Communications recognizes revenue and profit as work progresses on long-term contracts using the percentage-of-completion method, which relies on estimates of total expected contract revenue and costs. Catalog product revenues and revenues under certain fixed-price contracts calling for delivery of a

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specified number of units are recognized as deliveries are made. Revenues under cost-reimbursement contracts are recognized as costs are incurred and include estimated earned fees in the proportion that costs incurred to date bear to total estimated costs. Certain contracts are awarded on a fixed-price incentive fee basis. Incentive fees on such contracts are considered when estimating revenues and profit rates and are recognized when the amounts can reasonably be determined. The costs attributed to units delivered under fixed-price contracts are based on the estimated average cost per unit at contract completion. Profits expected to be realized on long-term contracts are based on total revenues and estimated costs at completion. Revisions to contract profits are recorded in the accounting period in which the revisions are known. Estimated losses on contracts are recorded when identified. For research and development and other cost-plus-fee type contracts, the Company recognizes contract earnings using the percentage-of-completion method. The estimated contract revenues are recognized based on percentage-of-completion as determined by the cost-to-cost basis whereby revenues are recognized as contract costs are incurred.

Accounts Receivable

The Company is required to estimate the collectibility of its trade receivables and unbilled costs and fees. A considerable amount of judgment is required in assessing the ultimate realization of these receivables including the current credit-worthiness of each customer. Significant changes in required reserves have been recorded in prior periods and may occur in the future depending on future market conditions.

Inventory

The Company is required to state its inventories at the lower of cost or market. In assessing the ultimate realization of inventories, the Company is required to exercise judgment in its assessment of future demand requirements and compare that with the current or committed inventory levels. The Company has recorded charges for required reserves in prior periods and it is possible that changes in required inventory reserves may continue to occur in the future due to market conditions.

Deferred Taxes

The Company records a valuation allowance to reduce its deferred tax assets to the amount that it believes is more likely than not to be realized. In assessing the need for a valuation allowance, the Company considers all positive and negative evidence, including reversals of existing deferred tax liabilities, estimated future taxable income, prudent and feasible tax planning strategies, and recent financial performance. As a result of recent cumulative losses and the full utilization of the Company’s loss carryback potential, the Company had concluded that a full valuation allowance against its net deferred tax assets at December 31, 2002 was appropriate. For the quarter ended March 31, 2003, the Company realized certain deferred tax assets which resulted in a reduction in the Company’s valuation allowance and the effective tax rate for the three and six months ended June 30, 2003.

Capitalized Software Development Costs

The Company’s policy on capitalized software costs determines the timing of recognition of certain development costs. In addition, this policy determines whether the cost is classified as development expense or cost of license fees. Management is required to use professional judgment in determining whether development costs meet the criteria for immediate expense or capitalization. SFAS 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 upon 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 is determined using the straight-line method over the expected useful lives of the respective products. Software development costs are written-off when projects are abandoned or when the estimated cash flows from a product are not expected to be sufficient to recover the capitalized software development costs.

RESULTS OF OPERATIONS
(in thousands)

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REVENUES

On a consolidated basis, revenues from continuing operations for the three and six months ended June 30, 2003 increased by 8% for both periods to $33.3 million and $67.2 million from the same periods in the prior year. Revenues from eSecurity segment decreased for the quarter ended June 30, 2003 as compared to the same period in 2002, which was offset by increased revenues from the Secure Communications segment. The increase in revenues for the six months ended June 30, 2003 as compared to the same period in 2002 was due to higher revenues in both eSecurity and Secure Communications segments. Revenues from international markets for the three and six months ended June 30, 2003 increased 5% to $7.0 million and 20% to $14.3 million, respectively, as compared to the same periods in the prior year. The increase in revenues from international markets for the three months ended June 30, 2003 was primarily due to additional revenues from acquisitions and increase in revenues from Europe partially offset by a decrease in revenues from Asia Pacific. The increase in revenues from Europe was brought by stronger conversion rates of euros to the US dollar experienced during the current year while the decrease in revenues from Asia Pacific was primarily due to a slowdown in the economy of Asia, as affected by the SARS disease, which had slightly affected revenues from the Company’s Hong Kong office. Overall, revenues from international markets for the six months ended June 30, 2003 increased for both Europe and Asia Pacific. Revenues from domestic markets for the three and six months ended June 30, 2003 also increased by 8% to $26.3 million and 5% to $52.8 million, respectively, as compared to the same periods in the prior year. The increase in domestic revenues was primarily due to a decrease in revenues in eSecurity North America being offset by an increase in revenues in the Secure Communications segment. The decrease in revenues in eSecurity North America was primarily due to a decline in OEM markets for Cryptoswift SSL acceleration devices and the ongoing softness in IT spending particularly in North America.

eSecurity revenues for the three and six months ended June 30, 2003 decreased by 2% to $12.1 million and increased by 4% to $25.3 million, respectively, when compared to the same periods in 2002. The decrease in revenues for the three months ended June 30, 2003 was primarily due to planned attrition in OEM product revenues while the increase in revenues for the six months ended June 30, 2003 was primarily attributable to solid demand for software protection and authentication products from international markets, which was partially offset by the decline in OEM markets for Cryptoswift SSL acceleration devices.

Secure Communications revenues for the three and six months ended June 30, 2003 increased 14% to $21.3 million and 11% to $41.9 million, respectively, when compared to the same periods in 2002. The increase in revenues was primarily due to strong demand for network link encryptors, voice and data security solutions and high-assurance commercial security products. The Company expects continued favorable performance for this segment, as a result of increased product demand and strong backlog.

GROSS PROFIT

Gross profit from eSecurity products for the three months ended June 30, 2003 increased to 66% of revenues compared to (57%) of revenues for the corresponding period in 2002. Gross profit for the six months ended June 30, 2003 increased to 64% of revenues compared to (4%) of revenues for the corresponding period in 2002. Cost of revenues for the three and six months ended June 30, 2002 included increases in the reserve for excess and obsolete products and a write-off of capitalized and developed software. Excluding these charges, gross profit for the three and six months ended June 30, 2002 were 60% of revenues and 54% of revenues, respectively, and the fiscal 2003 improvement was primarily due to increased efficiencies in manufacturing operations and lower overhead costs.

Gross profit from Secure Communications for the three months ended June 30, 2003 increased to 27% of revenues as compared to 19% of revenues for the corresponding period in 2002. Gross profit for the six months ended June 30, 2003 increased to 25% of revenues compared to 20% of revenues for the corresponding period in 2002. The increase in gross profit was primarily due to a change in product mix as higher margin products were sold during the current year.

SELLING, GENERAL AND ADMINISTRATIVE

Selling, general and administrative expenses consist primarily of personnel-related expenses, sales commissions, promotional activities, and professional fees. Selling, general and administrative expenses from continuing operations for the three months ended June 30, 2003 were $8.2 million or 25% of revenues as compared to $9.4 million or 30% of revenues for the corresponding period in 2002. Selling, general and administrative expenses from continuing operations for the six months ended June 30, 2003 were $15.9 million or 24% of revenues as compared to $16.1 million or 26% of revenues for the corresponding period in 2002. The decrease in selling, general and administrative expenses was primarily attributable to lower marketing expenses partially offset by higher legal and other professional fees.

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RESEARCH AND DEVELOPMENT

Research and development expenses consist primarily of engineering salaries and other personnel-related expenses, costs related to engineering development tools, and subcontracting costs. Research and development expenses from continuing operations for the three months ended June 30, 2003 were $2.2 million or 7% of revenues, as compared with research and development expenses of $2.9 million or 9% of revenues for the corresponding period in 2002. Research and development expenses from continuing operations for the six months ended June 30, 2003 were $3.9 million or 6% of revenues, as compared with research and development expenses of $4.7 million or 8% of revenues for the corresponding period in 2002. The decrease in research and development expenses was primarily due to a decrease in engineering salaries as a result of greater use of research and development personnel in India and China.

LITIGATION SETTLEMENT

Subsequent to June 30, 2003, pursuant to court order, the Company expects a settlement relating to a pending litigation matter for which it has been incurring substantial legal expenses. The settlement of $3.6 million was included in the results of operations for the quarter ended June 30, 2003 (see Note 10 to Notes to Condensed Consolidated Financial Statements).

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. At June 30, 2003 and March 31, 2003, it was determined by the Company that certain of its investments had incurred an other-than-temporary decline in fair value which resulted in realized losses of $0.4 million and $0.8 million, respectively, and were recognized in earnings during the corresponding periods in the current year.

PROVISION FOR INCOME TAXES

The effective tax rates from continuing operations for the three and six months ended June 30, 2003 were (3%) and 18%, respectively. The reduction in the Company’s effective tax rate was primarily due to the release of the Company’s federal valuation allowance, which resulted in a reduction of income tax expense for the three and six months ended June 30, 2003. During 2002, the Company recorded income tax expense from continuing operations of $13.4 million and $13.7 million for the three and six months ended June 30, 2002, which included a valuation allowance of $11.6 million in accordance with SFAS 109, “Accounting for Income Taxes.”

RESULTS OF DISCONTINUED OPERATIONS

Discontinued operations for the six months ended June 30, 2003 reported operating results and net losses of $0.1 million. There were no reported losses for the three months ended June 30, 2003. Operating results and net losses for the three and six months ended June 30, 2002 were $16.0 million and $16.7 million, respectively, which included $12.8 million of write-off of goodwill and $2.1 million provision for impairment of assets.

LIQUIDITY AND CAPITAL RESOURCES

The Company’s principal sources of operating funds have been from operations and proceeds from exercises of the Company’s common stock options. Net cash provided by operating activities for the six months ended June 30, 2003 and 2002 were $6.9 million and $7.2 million, respectively. Operating activities in 2003 included a $1.2 million loss on long-term investments and marketable securities and a $3.6 million litigation settlement. Operating activities in 2002 included a decrease in accounts receivable of $4.8 million, $9.6 million increase in the provision for excess and obsolete inventory, $5.4 million write-off of capitalized and developed software, $14.9 million write-off of goodwill and provisions for impairment of assets relating to discontinued operations and $16.3 million in deferred income taxes primarily due to the Company’s valuation allowance for deferred tax assets.

Net cash used in investing activities for the six months ended June 30, 2003 and 2002 were $0.8 million and $0.9 million, respectively. Investing activities in 2003 included $0.5 million of net cash paid for acquisitions of Proteq Ltda. and Alladin Ltda. in Brazil.

Net cash provided by financing activities for the six months ended June 30, 2003 and 2002 were $2.2 million and $2.3 million, respectively. Financing activities in 2003 and 2002 primarily included proceeds from exercises of common stock options.

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The Company intends to use its capital resources to expand its product lines and for possible acquisitions of additional products and technologies. The Company has no significant capital commitments or requirements at this time.

At June 30, 2003, the Company’s subsidiaries in the United Kingdom, Germany, France, Netherlands, Switzerland and Japan carry approximately $1.9 million, $0.4 million, $5.5 million, $2.7 million, $3.7 million and $1.0 million, respectively, in interest earning deposits which may result in foreign exchange gains or losses due to the fact that the functional currency in those subsidiaries is not the U.S. dollar.

The Company believes that its current working capital of $71.6 million and anticipated working capital to be generated by future operations will be sufficient to support the Company’s working capital requirements for at least the next twelve months and for the foreseeable future. The foregoing is a forward-looking statement.

Item 4. Controls and Procedures

(a)  Evaluation of Disclosure Controls and Procedures

The Chief Executive Officer and Chief Financial Officer of the Company have concluded, based on their evaluation as of the date within 90 days prior to the date of the filing of this quarterly report on Form 10-Q, the effectiveness of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-14 and 15d-14. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective in ensuring that all material information required to be filed in this quarterly report have been made known to them, to allow timely decisions regarding required disclosure.

(b)  Changes in Internal Controls

There have been no significant changes in internal controls, or in other factors that could significantly affect internal controls subsequent to the date the Chief Executive Officer and Chief Financial Officer completed their evaluation.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

In July 1998, a patent infringement claim was filed against the Company. The complaint sought unspecified monetary damages. The Company filed a motion for summary judgment of non-infringement that was decided by the District Court in favor of the Company in December 2000. That decision was appealed and on April 3, 2002, the United States Court of Appeals issued an opinion that modified the trial court’s construction of the patent claims in certain respects, revised the summary judgment and remanded the case to the trial court for further proceedings. On May 1, 2003, after remand, the District Court granted another motion for summary judgment of non-infringement brought by the Company, thereby removing half of the products at issue from litigation and granted a motion for summary judgment re: damages, thereby limiting any recovery by the plaintiff to a reasonable royalty. The patent-in-suit expired in June 30, 2003, thereby removing the threat of any injunction against the Company from the litigation. Subsequent to June 30, 2003, pursuant to court orders, the Company expects a settlement of this litigation for which it had been incurring significant legal expenses. The settlement expense of $3.6 million was included in the results of operations for the quarter ended June 30, 2003.

The Company is also involved in other legal proceedings and claims arising in the ordinary course of business. The Company believes that the outcome of all current litigation will not have a material adverse effect on its business, financial condition, cash flows or results of operations.

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

At the Company’s Annual Meeting of Shareholders held on June 12, 2003, the following actions were approved by the votes indicated:

1.

Five directors were elected:

2.

The Company’s 2003 Stock Option Plan was approved:

3.

The ratification of Ernst & Young, LLP as independent auditors of the Company was approved:

Item 6. Exhibits and Reports on Form 8-K

(a)  Exhibits

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