SAFENET INC - 10-Q Quarterly Report

8029 Corporate Drive, Baltimore, MD 21236
(Address of principal executive offices)

Indicate by a 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 twelve 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 a check mark whether the registrant is an accelerated filed (as defined in Rule 12b-2 of the Exchange Act). Yes X No ___


PART I: FINANCIAL INFORMATION			Page

	Item 1: Financial Statements (Unaudited)
		Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002		3
		Consolidated Statements of Operations for the three and nine months ended September 30, 2003 and 2002		4
		Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended September 30, 2003 and 2002		5
		Consolidated Statement of Stockholders’ Equity for the nine months ended September 30, 2003		6
		Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and 2002		7
		Notes to Consolidated Financial Statements – September 30, 2003		8
	Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations			19
	Item 3: Quantitative and Qualitative Disclosures About Market Risk			25
	Item 4: Controls and Procedures			26
PART II: OTHER INFORMATION
	Item 1: Legal Proceedings			27
	Item 6: Exhibits and Reports on Form 8-K			28
SIGNATURES				29

SAFENET, INC.
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)


					September 30,			December 31,
					2003			2002

					(unaudited)
				Assets
Current assets:
	Cash and cash equivalents				$	108,180		$	3,399
	Short-term investments					16,800			28,763
	Accounts receivable, net of allowance for doubtful accounts of $840 and $224					10,791			4,534
	Inventories, net of reserve of $1,338 and $958					1,414			1,008
	Other current assets					1,503			1,002
	Current assets of discontinued operations					—			93

		Total current assets				138,688			38,799
Equipment and leasehold improvements, net of accumulated depreciation of $6,441 and $4,734						2,998			1,246
Computer software development costs, net of accumulated amortization of $1,724 and $1,513						1,388			479
Goodwill						38,470			12,826
Other intangible assets, net of accumulated amortization of $6,857 and $1,640						14,087			595
Other assets						889			1,374

		Total assets			$	196,520		$	55,319

			Liabilities and Stockholders’ Equity
Current liabilities:
	Accounts payable				$	2,491		$	1,456
	Accrued salaries and commissions					3,460			2,162
	Income taxes payable					1,038			—
	Other accrued expenses					3,702			1,424
	Advance payments and deferred revenue					3,120			1,393
	Deferred income taxes					2,607			—
	Current liabilities of discontinued operations					—			377

		Total current liabilities				16,418			6,812
Deferred income taxes						2,677			129
Unfavorable lease liability						4,353			—

		Total liabilities				23,448			6,941
Commitments and contingencies						—			—
Stockholders’ equity:
	Preferred stock, $.01 par value per share Authorized 500 shares, none issued and outstanding					—			—
	Common stock, $.01 par value per share Authorized 50,000 shares, issued 13,259 and 7,894 shares					133			79
	Additional paid-in capital					199,498			65,665
	Accumulated other comprehensive income					3,846			2,859
	Accumulated deficit					(30,405	)		(20,225	)

		Total stockholders’ equity				173,072			48,378

		Total liabilities and stockholders’ equity			$	196,520		$	55,319

SAFENET, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited — In thousands, except per share amounts)


			Three Months Ended					Nine Months Ended
			September 30,					September 30,

			2003			2002		2003			2002

Revenues
	Licenses and royalties		$	3,304		$	1,277	$	7,702		$	4,622
	Products			11,085			6,916		31,922			15,784
	Service and maintenance			3,204			634		7,408			2,003

				17,593			8,827		47,032			22,409
Cost of revenues
	Licenses and royalties			48			151		292			577
	Products			3,723			2,261		9,649			5,675
	Service and maintenance			320			168		958			342
	Amortization of intangible assets			337			—		2,227			—

				4,428			2,580		13,126			6,594

		Gross profit		13,165			6,247		33,906			15,815

Research and development expenses				3,905			2,273		11,310			6,546
Sales and marketing expenses				3,956			1,820		10,571			5,198
General and administrative expenses				1,758			1,000		4,857			2,634
Write-off of acquired in-process research and development costs				—			—		9,681			3,375
Costs of integration of acquired companies				138			—		3,127			—
Amortization of intangible assets				1,313			400		3,349			1,102

		Total operating expenses		11,070			5,493		42,895			18,855

		Operating income (loss)		2,095			754		(8,989	)		(3,040	)
Interest and other income, net				193			123		416			421

	Income (loss) from continuing operations before income taxes			2,288			877		(8,573	)		(2,619	)
Income tax expense				(569	)		—		(1,607	)		—

	Income (loss) from continuing operations			1,719			877		(10,180	)		(2,619	)
Income (loss) from operations of discontinued GDS business (including loss on disposal of $0, $0, $0 and $3,506)				—			116		—			(4,066	)

Net income (loss)			$	1,719		$	993	$	(10,180	)	$	(6,685	)

Income (loss) per common share:
	Basic
		Income (loss) from continuing operations	$	0.13		$	0.11	$	(0.95	)	$	(0.34	)
		Income (loss) from discontinued operations (GDS)		—			0.02		—			(0.53	)

		Net income (loss) per share	$	0.13		$	0.13	$	(0.95	)	$	(0.87	)

	Diluted
		Income (loss) from continuing operations	$	0.13		$	0.11	$	(0.95	)	$	(0.34	)
		Income (loss) from discontinued operations (GDS)		—			0.01		—			(0.53	)

		Net income (loss) per share	$	0.13		$	0.12	$	(0.95	)	$	(0.87	)

Shares used in computation:
	Basic			12,769			7,736		10,700			7,701
	Diluted			13,546			8,062		10,700			7,701

SAFENET, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited — in thousands)


	Three Months Ended					Nine Months Ended
	September 30,					September 30,

	2003		2002			2003			2002

Net income (loss)	$	1,719	$	993		$	(10,180	)	$	(6,685	)
Other comprehensive income (loss):
Unrealized loss from available-for-sale securities		—		(56	)		—			(268	)
Foreign currency translation adjustment		248		383			987			1,828
Reclassification adjustment — realization of foreign currency translation adjustment upon disposal of GDS business		—		—			—			1,526

Comprehensive income (loss)	$	1,967	$	1,320		$	(9,193	)	$	(3,599	)

SAFENET, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
Nine months ended September 30, 2003
(Unaudited — in thousands)


							Accumulated
					Additional		other					Total
	Common stock				paid-in		comprehensive		Accumulated			stockholders'
	Shares		Amount		capital		income		deficit			equity

Balance at January 1, 2003		7,894	$	79	$	65,665	$	2,859	$	(20,225	)	$	48,378
Issuance of common stock in connection with secondary offering		2,698		27		83,893		—		—			83,920
Issuance of common stock in connection with the acquisition of Cylink Corporation		1,680		17		31,067		—		—			31,084
Assumption of stock options in connection with the acquisition of Cylink Corporation		—		—		1,399		—		—			1,399
Assumption of warrants in connection with the acquisition of Cylink Corporation		—		—		292		—		—			292
Issuance of common stock in connection with the asset acquisition of Raqia Networks		354		4		6,094		—		—			6,098
Income tax benefit related to stock option exercises		—		—		2,458		—		—			2,458
Issuance of common stock under Employee Stock Purchase Plan		7		—		162		—		—			162
Issuance of common stock for option exercises		626		6		8,468		—		—			8,474
Net loss for the nine months ended September 30, 2003		—		—		—		—		(10,180	)		(10,180	)
Foreign currency translation adjustment		—		—		—		987		—			987

Balance at September 30, 2003		13,259	$	133	$	199,498	$	3,846	$	(30,405	)	$	173,072

SAFENET, INC.
ANS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited — in thousands)


					Nine Months Ended
					September 30,

					2003			2002

Cash flows from operating activities:
	Net loss				$	(10,180	)	$	(6,685	)
	Adjustments to reconcile net loss to net cash provided by operating activities:
		Write-off of acquired in-process research and development costs				9,681			3,375
		Loss on disposal of discontinued GDS business				—			3,506
		Depreciation				892			571
		Amortization of computer software development costs				207			370
		Income tax benefit related to stock option exercises				2,458			—
		Deferred income taxes				(1,506	)		—
		Unfavorable lease liability				(532	)		—
		Amortization of other intangible assets				5,576			1,102
		Changes in operating assets and liabilities:
			Accounts receivable, net			(739	)		1,075
			Inventories, net			1,461			151
			Other current assets			547			448
			Accounts payable			785			(941	)
			Accrued salaries and commissions			(4,253	)		457
			Accrued income taxes			1,038			—
			Other accrued expenses			(1,917	)		(3	)
			Advanced payments and deferred revenue			(349	)		(809	)

				Net cash provided by operating activities		3,169			2,617

Cash flows from investing activities:
	Maturities of short-term investments					48,078			4,669
	Purchases of short-term investments					(36,181	)		(11,255	)
	Purchases of equipment and leasehold improvements					(1,474	)		(714	)
	Expenditures for computer software development					(1,117	)		(150	)
	Cash paid for Securealink, net of cash acquired					—			(3,769	)
	Cash received upon acquisition of Cylink, net of cash paid					703			—
	Cash paid for Raqia, net of cash acquired					(1,390	)		(500	)
	Other assets					485			342

		Net cash provided by (used in) investing activities				9,104			(11,377	)

Cash flows from financing activities:
	Proceeds from stock options exercised and issuance of stock under Employee Stock Purchase Plan, net					8,637			915
	Proceeds from secondary stock offering, net					83,920			—
	Repayment of Securealink line of credit					—			(1,484	)

		Net cash provided by (used in) financing activities				92,557			(569	)

Effect of exchange rate changes on cash						(49	)		(283	)

Net increase (decrease) in cash and cash equivalents						104,781			(9,612	)
Cash and cash equivalents at beginning of period						3,399			14,994

Cash and cash equivalents at end of period					$	108,180		$	5,382

SAFENET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
September 30, 2003
Amounts in thousands (except per share data)

The accompanying unaudited consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules or regulations. The interim financial statements are unaudited, but reflect all adjustments (consisting of normal recurring accruals), which are, in the opinion of management, necessary to present a fair statement of results for the interim periods presented. These financial statements should be read in conjunction with the financial statements and the notes thereto in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2002. The results of operations for the interim period are not necessarily indicative of results to be expected in future periods.

The Company offers a one-year warranty for substantially all of its products. The specific terms and conditions of those warranties vary depending upon the product sold and country in which the Company transacts business. The Company estimates the costs that may be incurred under its basic limited warranty and records a liability in the amount of such costs at the time product revenue is recognized. Factors that affect the Company’s warranty liability include the number of installed units, historical and anticipated rates of warranty claims, and cost per claim. The Company periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary. The balance in the Company’s warranty accrual totaled $259 and $50 at September 30, 2003 and December 31, 2002, respectively.

On December 31, 2002, the Company adopted Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure (“Statement 148”) which requires disclosure in the summary of significant accounting policies of the effects of an entity’s policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements.

The Company records compensation expense for all stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”). Under APB No. 25, compensation expense is recorded over the vesting period to the extent that the fair value of the underlying stock on the date of grant exceeds the exercise or acquisition price of the stock or stock-based award. Financial Accounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation (“Statement 123”) encourages companies to recognize expense for stock-based awards based on their estimated fair value on the date of grant. Statement 123 requires the disclosure of pro forma income and earnings per share data in the notes to the financial statements if the fair value method is not adopted.

SAFENET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)-Continued
September 30, 2003
Amounts in thousands (except per share data)

As of September 30, 2003, the Company has seven stock-based employee compensation plans. All options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of Statement 123 to stock-based employee compensation.


	Three months ended				Nine months ended
	September 30,				September 30,

	2003		2002		2003			2002

Net income (loss), as reported	$	1,719	$	993	$	(10,180	)	$	(6,685	)
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of taxes		1,243		839		2,981			2,985

Pro forma net income (loss)	$	476	$	154	$	(13,161	)	$	(9,670	)

Income (loss) per share:
Basic —as reported	$	0.13	$	0.13	$	(0.95	)	$	(0.87	)

Basic —pro forma	$	0.04	$	0.02	$	(1.23	)	$	(1.26	)

Diluted—as reported	$	0.13	$	0.12	$	(0.95	)	$	(0.87	)

Diluted—pro forma	$	0.04	$	0.02	$	(1.23	)	$	(1.26	)

The fair value of the stock-based awards was estimated at the date of grant using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model and other models were developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the Company’s stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock-based awards. The following assumptions were made in computing the fair value of stock-based awards:

SAFENET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)-Continued
September 30, 2003
Amounts in thousands (except per share data)

The Company uses the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.

Where appropriate, certain amounts in the 2002 consolidated financial statements and notes thereto have been reclassified to conform to the 2003 presentation.

In November 2002, the FASB issued Interpretation No. 45 (FIN 45), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN 45 requires additional disclosure for guarantees, including loan guarantees such as standby letters of credit. It also clarifies that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value, or the market value, of the obligations it assumes under the guarantee and must disclose that information in its interim and annual financial statements. The provisions related to recognizing a liability at inception of the guarantee for the fair value of the guarantor’s obligations does not apply to product warranties or to guarantees accounted for as derivatives. The initial recognition and initial measurement provisions apply on a prospective basis to guarantees issued or modified after December 31, 2002. The Company has adopted FIN 45 and has not realized a material impact on financial conditions or liquidity.

In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities. The objective of FIN 46 is to improve financial reporting by companies involved with variable interest entities. It requires variable interest entities to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or is entitled to receive a majority of the entity’s residual returns or both. The Company currently has not invested in any variable interest entities and, therefore, will apply the provisions of FIN 46 prospectively.

In November 2002, the EITF reached a consensus on Issue No. 00-21 (Issue No. 00-21), Accounting for Revenue Arrangements with Multiple Deliverables, which addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. Specifically, this Issue addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying this Issue, separate contracts with the same entity or related parties that are entered into at or near the same time are presumed to have been negotiated as a package and should, therefore, be evaluated as a single arrangement in considering whether there are one or more units of accounting. That presumption may be overcome if there is sufficient evidence to the contrary. This Issue also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. The guidance in this issue does not impact existing authoritative guidance, including SOP 97-2, Software Revenue Recognition. Issue No. 00-21 is effective for all revenue arrangements entered into in fiscal periods beginning after June 15, 2003, with early adoption permitted. The Company does not believe that the impact of adoption will be material to reported operating results.

SAFENET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)-Continued
September 30, 2003
Amounts in thousands (except per share data)

On February 5, 2003, SafeNet acquired 100% of the outstanding common shares of Cylink Corporation (“Cylink”) in accordance with an Agreement and Plan of Reorganization dated as of October 30, 2002. The results of operations of Cylink are included in the Company’s consolidated results of operations beginning on February 6, 2003. Cylink develops, manufactures, markets and supports a comprehensive portfolio of hardware and software security products for mission-critical private networks and business communications over the Internet. Cylink’s solutions enable its customers to merge their operations and transactions onto existing networks, maximize network use, reduce the costs of operations and expand their businesses. As a result of the acquisition, the Company believes that it will be able to grow its base of government and commercial customers, enhance its product line, expand its international sales and provide broader technology and expertise to its customers. It also expects to reduce costs through economies of scale.

The aggregate purchase price was $34,994 consisting primarily of 1,680 shares of common stock valued at $31,084, 194 options and warrants assumed with an aggregate value of $1,691, and estimated direct costs of the acquisition of $2,219. The value of the common shares issued was determined based on the average market price of the Company’s common shares over the period including three days before and after the terms of the acquisition were agreed to and announced.

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition. The Company is in the process of determining all of its direct costs of the acquisition; thus, the allocation of the purchase price is subject to refinement.


Cash and cash equivalents		$	2,922
Accounts receivable			4,928
Inventories			1,376
Insurance proceeds receivable			6,407
Other current assets			545
Property and equipment			786
Goodwill			24,880
Acquired in-process research and development			3,351
Intangible assets subject to amortization (2.7 year weighted average useful life)			17,529
Other assets			554

	Total assets acquired		63,278

Accounts payable			1,073
Accrued salaries and commissions			2,526
Accrued legal settlement			6,200
Other accrued expenses			4,671
Advance payments and deferred revenue			2,266
Deferred income taxes (including current portion of $2,579)			6,661
Unfavorable lease liability			4,887

	Total liabilities assumed		28,284

	Net assets acquired	$	34,994

SAFENET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)-Continued
September 30, 2003
Amounts in thousands (except per share data)

On the date of acquisition, $3,351 was written off as acquired in-process research and development costs, in accordance with FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method.

In connection with the acquisition, the Company recorded a liability to reflect the terms of certain operating office leases that are unfavorable relative to current market prices as determined by an independent real estate valuation specialist. The liability was calculated based on the difference between the contractual lease payments and the current market prices over the remaining lease terms and discounted using a risk-free interest rate adjusted for SafeNet’s credit standing. As of September 30, 2003, the liability consists of a current liability of $711 and a non-current liability of $4,353.

The $24,880 of goodwill was assigned to the Enterprise Security segment. Of that total amount, none is expected to be deductible for tax purposes.

The following unaudited consolidated pro forma results of operations of the Company for the nine-month periods ended September 30, 2003 and 2002, respectively, and the three months ended September 30, 2002 give effect to the February 5, 2003 acquisition as though it had occurred on January 1, 2002. There is no impact on the results of operations for the three months ended September 30, 2003.


	Three Months
	Ended			Nine Months Ended
	September 30,			September 30,

	2002			2003			2002

	(in thousands, except per share amounts)
Revenues	$	15,928		$	49,236		$	43,981
Loss from continuing operations	$	(1,536	)	$	(11,416	)	$	(14,560	)
Net loss	$	(1,420	)	$	(11,416	)	$	(18,626	)
Income (loss) per common share — basic and diluted:
Loss from continuing operations	$	(0.16	)	$	(1.05	)	$	(1.56	)
Income (loss) from discontinued operations (GDS)		0.01			—			(0.43	)

Net loss	$	(0.15	)	$	(1.05	)	$	(1.99	)

The pro forma results include the estimated amortization of intangibles. The pro forma results are not necessarily indicative of the results that would have occurred if the acquisition had actually been completed on January 1, 2002, nor are they necessarily indicative of future consolidated results.

SAFENET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)-Continued
September 30, 2003
Amounts in thousands (except per share data)

On February 27, 2003, SafeNet acquired substantially all the assets of Raqia Networks, Inc., a development stage company, consisting primarily of technology-related intangible assets. Total consideration paid by SafeNet was 354 shares of SafeNet common stock with an estimated value of $6,098 and $890 in cash. SafeNet had previously invested $1,000 in Raqia Networks.

The preliminary allocation of the cost to acquire the assets of Raqia is as follows:

Since Raqia was a development stage enterprise, the acquisition of its assets was not accounted for as a purchase business combination in accordance with accounting principles generally accepted in the United States. Accordingly, goodwill has not been recorded in the transaction. Instead, the difference between the total cost and the fair value of the assets acquired and liabilities assumed has been allocated based on the fair values of the acquired net assets.

The $6,330 assigned to acquired in-process research and development assets was written off as of the date of acquisition.

SAFENET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)-Continued
September 30, 2003
Amounts in thousands (except per share data)

Basic earnings per share (“EPS”) is calculated by dividing income (loss) from continuing operations by the weighted-average number of common shares outstanding for the applicable period. Diluted EPS is calculated after adjusting the numerator and the denominator of the basic EPS calculation for the effect of potential common shares outstanding during the period unless the result is anti-dilutive. Information related to the calculation of basic and diluted EPS is summarized as follows (in thousands, except per share amounts):


	Three Months Ended				Nine Months Ended
	September 30,				September 30,

	2003		2002		2003			2002

Income (loss) from continuing operations	$	1,719	$	877	$	(10,180	)	$	(2,619	)

Weighted-average common shares outstanding — basic		12,769		7,736		10,700			7,701
Effect of dilutive securities — options and warrants		777		326		—			—

Weighted-average common shares outstanding — diluted		13,546		8,062		10,700			7,701

Basic income (loss) from continuing operations per share	$	0.13	$	0.11	$	(0.95	)	$	(0.34	)

Diluted income (loss) from continuing operations per share	$	0.13	$	0.11	$	(0.95	)	$	(0.34	)

For the nine months ended September 30, 2003 and 2002, diluted loss per common share is equal to basic loss per common share because if potentially dilutive securities were included in the computation, the result would be anti-dilutive. These potentially dilutive securities consist of stock options and warrants.

The Company has two reportable segments: products, chips, intellectual property and software designed and manufactured for sale to companies that will embed the Company’s products into their products for ultimate sale to end-users (“Embedded Security Division”) and remote access software sold to Original Equipment Manufacturers (“OEMs”) and network security products designed and manufactured for direct sales to end-users (“Enterprise Security Division”). The reportable segments are strategic business units that offer different products and market focus. The segments are managed separately because each segment requires different technology and marketing strategies. Both divisions market extensively throughout the United States, Europe and Asia.

SAFENET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)-Continued
September 30, 2003
Amounts in thousands (except per share data)


	Three Months Ended					Nine Months Ended
	September 30,					September 30,

	2003			2002		2003			2002

Revenues from external customers:
Embedded security division	$	3,425		$	5,267	$	14,641		$	12,548
Enterprise security division		14,168			3,560		32,391			9,861

Consolidated revenues	$	17,593		$	8,827	$	47,032		$	22,409

Significant non-cash items other than depreciation and amortization:
Embedded security division	$	—		$	—	$	6,330		$	3,375
Enterprise security division		—			—		3,351			—

Consolidated significant non-cash items	$	—		$	—	$	9,681		$	3,375

Operating (loss) income:
Embedded security division	$	(761	)	$	152	$	(7,208	)	$	(4,791	)
Enterprise security division		2,856			602		(1,781	)		1,751

Consolidated operating income (loss)	$	2,095		$	754	$	(8,989	)	$	(3,040	)

Income (loss) from continuing operations before income taxes
Embedded security division	$	(696	)	$	195	$	(7,058	)	$	(4,599	)
Enterprise security division		2,984			682		(1,515	)		1,980

Consolidated income (loss) from continuing operations before income taxes	$	2,288		$	877	$	(8,573	)	$	(2,619	)

The Company does not allocate assets to its reportable segments, as assets generally are not specifically attributable to any particular segment. Accordingly, asset information by reportable segment is not presented.

For the three-month period ended September 30, 2003, one customer of the Enterprise Security Division accounted for 15% of the Company’s consolidated revenues. For the nine-month period ended September 30, 2003, one customer of the Enterprise Security Division accounted for 14% of the Company’s consolidated revenues.

For the nine-month period ended September 30, 2003, one commercial client of the Embedded Security Division segment accounted for 17% of the Company’s consolidated revenues, compared to 41% for the nine month period ended September 30, 2002.

In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets. Statement 142 prohibits the amortization of goodwill and intangible assets with indefinite useful lives. Statement 142 requires that these assets be reviewed for impairment at least annually. Intangible assets with finite lives will continue to be amortized over their estimated useful lives.

The following table displays the intangible assets that continue to be subject to amortization and intangible assets not subject to amortization as of September 30, 2003 (in thousands):

SAFENET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)-Continued
September 30, 2003
Amounts in thousands (except per share data)


		Gross
		Carrying		Accumulated
		Amount		Amortization			Net Book Value

Goodwill		$	38,470	$	—		$	38,470

Computer software development costs		$	3,112	$	(1,724	)	$	1,388

Other intangible assets:
	Patents	$	5,494	$	(1,167	)	$	4,327
	Developed technology		5,183		(2,038	)		3,145
	Customer contracts/relationships		6,735		(1,497	)		5,238
	Non-compete agreements		2,066		(689	)		1,377
	Purchase orders and contract backlog		1,466		(1,466	)		—

		$	20,944	$	(6,857	)	$	14,087

The goodwill resulted from the acquisition of Pijnenburg Securealink, Inc. in January 2002, and the Cylink acquisition in February 2003.

The acquired intangibles were acquired upon the acquisitions of Securealink, Cylink, and Raqia. The useful lives of these assets range from less than one year to five years. The weighted-average useful life is approximately 3.0 years.

The estimated amortization expense for other intangible assets and computer software development costs for each of the four years subsequent to December 31, 2002 is as follows:

The Company includes amortization of developed technology and contract backlog in cost of revenues.

The Company leases office facilities and equipment under non-cancelable operating leases expiring at various dates through 2013. The leases require the Company to pay a proportionate share of real estate taxes, insurance and maintenance. The Company recognizes rent expense on a straight-line basis. The future minimum payments under the leases for the years ending December 31, are as follows:

SAFENET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)-Continued
September 30, 2003
Amounts in thousands (except per share data)

The tax provisions for the three and nine-month periods ended September 30, 2003 and 2002 were based on the estimated effective tax rates applicable for the full year, based on the best available information. The Company’s income tax provisions for all periods consist of federal, state, and foreign income taxes. The Company’s effective tax rate from continuing operations was 18.7% for the nine months ended September 30, 2003, which is the rate the Company anticipates for the full year ending December 31, 2003.

The overall effective tax rate includes the recognition of a tax benefit for the reduction in deferred tax liabilities established in connection with the purchase price allocations for Securealink, Cylink and Raqia for certain intangible assets that are not deductible for tax purposes. This benefit is offset by the impact of utilizing U.S. net operating loss carryforwards created from the deduction of compensation expense resulting from the exercise of non-qualified stock options and the disqualified disposition of incentive stock options to reduce U.S. taxable income. When these net operating loss carryforwards are utilized, the resulting reduction in the valuation allowance is recorded as a direct increase to stockholders’ equity rather than a reduction to income tax expense. During the nine months ended September 30, 2003, an increase to stockholders’ equity of $2,458 was recorded related to the tax benefit of stock option deductions.

In 1998, Cylink filed with the Securities and Exchange Commission, or SEC, amendments to periodic reports, reflecting restated financial results for the first and third quarters of 1998, and for the fourth quarter of 1997. Between November 6, 1998 and December 14, 1998, several securities class action complaints were filed against Cylink and certain of its then current and former directors and officers in U.S. federal courts in California. These complaints alleged, among other things, that Cylink’s previously issued financial statements were materially false and misleading and that the defendants knew or should have known that these financial statements caused Cylink’s common stock price to rise artificially. The actions variously alleged violations of Section 10(b) of the Securities Exchange Act of 1934, as amended, and SEC Rule 10b-5 promulgated thereunder, and Section 20 of the Exchange Act. The securities class action lawsuits were ordered consolidated into a single action pending in the United States District Court for the Northern District of California, captioned In Re Cylink Securities Litigation, No. C98-4292 (VRW). On October 16, 2002, Cylink entered into an agreement with all plaintiffs in the securities class action lawsuit to settle all claims in the class action for $6.4 million. The United States District Court for the Northern District of California preliminarily approved the settlement agreement on November 12, 2002, and on July 23, 2003, the court issued an order granting final approval of the settlement and entering final judgment in accordance with the terms of the settlement agreement. The settlement amount of $6.4 million was paid entirely from insurance proceeds under insurance policies held by Cylink prior to September 30, 2003.

On June 25, 2003, we were served with a motion and complaint in a lawsuit filed by Thales E-Security, Inc. and Thales Communications, Inc. (together, Thales) in the 17th Judicial Circuit Court of Broward County, Florida. The court granted our motion to dismiss this lawsuit on jurisdictional grounds on July 3, 2003 and entered a final order to that effect on July 14, 2003. On July 22, 2003, Thales filed a motion and complaint for preliminary injunction in the Circuit Court for Montgomery County, Maryland. The motion and complaint allege that, among other things, we and a former Thales employee hired by us misappropriated trade secrets concerning one of Thales’ governmental customers, interfered with Thales’ business relationship with that customer, and interfered in Thales’ business and contractual relationships with a former supplier, CTAM PTY Ltd. SafeNet and Thales have entered into a stipulation of dismissal of this lawsuit with prejudice against Thales, dated October 6, 2003.

In addition, in the normal course of business, the Company, from time to time, receives inquiries or other communications with regard to possible infringement of third party intellectual property rights by the Company’s patents, or the features or content of certain of the Company’s products. The Company believes it is unlikely that the outcome of these infringement inquiries will have a material adverse effect on the Company’s financial position or results of operations; however, if litigation results from any of these inquiries and the outcome is unfavorable to the Company, it could have a material adverse effect on the Company’s cash flows, results of operations and financial condition.

SAFENET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)-Continued
September 30, 2003
Amounts in thousands (except per share data)

There has been substantial litigation regarding patent and other intellectual property rights in the software and network security and related industries. Further commercialization of the Company’s products could provoke claims of infringement from third parties. In the future, litigation may be necessary to enforce the Company’s patents, to protect the Company’s trade secrets or know-how or to defend against claimed infringement of the rights of others and to determine the scope and validity of the proprietary rights of others. Any such litigation could result in substantial cost and diversion of the Company’s efforts, which by itself could have a material adverse effect on the Company’s financial condition and operating results. Further, adverse determinations in such litigation could result in loss of proprietary rights, subject the Company to significant liabilities to third parties, require the Company to seek licenses from third parties or prevent the Company from manufacturing or selling the Company’s products, any of which could have a material adverse effect on the Company’s business, financial condition or results of operations.

On October 14, 2003, SafeNet entered into an agreement with SSH Communications Security Corp. (“SSH”), pursuant to which SafeNet will acquire substantially all of the assets and properties used in connection with the toolkit, IPVia VPN and VPN client businesses of SSH for approximately $14,000 in cash. SSH is a world-leading supplier of managed security middleware.

On October 22, 2003, SafeNet entered into an agreement to acquire Rainbow Technologies, Inc., a provider of information security solutions for mission-critical data and applications used in business, organization and government computing environments, in a stock-for-stock transaction. Consummation of the transaction is subject to customary closing conditions, including the approval of Rainbow’s stockholders and our stockholders. Under the terms of the agreement, each outstanding share of Rainbow common stock will be exchanged for 0.374 of a share of SafeNet common stock. All outstanding options to acquire Rainbow common stock will be assumed by us and converted into options to purchase shares of our common stock using the same exchange ratio. If the merger is consummated, the Company will issue in the transaction approximately 11.1 million shares of SafeNet common stock on a fully-diluted basis, which would represent approximately 43% of the outstanding stock of the combined company as of October 22, 2003, the date the proposed merger was announced. The Company expects the merger, if consummated, to close during the first quarter of 2004.

ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Quarterly Report on Form 10-Q contains “forward-looking” statements within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. These statements involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. These risks and other factors include, but are not limited to those listed in our periodic reports and registration statements filed with the Securities and Exchange Commission. As a general matter, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue” or the negative of such terms or other comparable terminology.

We develop, market, sell and support a portfolio of hardware and software network security products and services. Our products and services are used to create secure wide area networks (WANs) and virtual private networks over the Internet (VPNs) to prevent security breaches that could result in unauthorized access to confidential data, invasion of privacy and financial loss.

We have two reportable business segments. Through our Enterprise Security Division, we sell high-performance security solutions to address the needs of our government, financial institution and other security-sensitive commercial customers. We also provide, through our Embedded Security Division, a broad range of network security products, including silicon chips, accelerator cards, licensed intellectual property and software products, to OEMs that embed them in their own network infrastructure and wireless products. These divisions are managed separately because they offer different products and employ different marketing strategies (See Note 7 to the accompanying notes to consolidated financial statements).

We periodically review and consider possible acquisitions of companies that we believe will contribute to our long-term objectives and discuss such acquisitions with the management of those companies. Such acquisitions, which may be material, may be made from time to time.

In February 2003, we acquired Cylink Corporation, which expanded our customer base and our product offerings to include security solutions for WANs. Operations of Cylink were integrated into the Enterprise Security Division. This acquisition will have a significant impact on our business operations going forward.

In February 2003, we also acquired the assets of Raqia Networks, Inc., a development stage company, consisting primarily of technology-related intangible assets.

In January 2002, we acquired Pijnenburg Securealink, Inc., a Delaware corporation primarily engaged in the manufacture of security chips for e-commerce transactions through its European subsidiary. Securealink develops, markets and sells security chips and intellectual property, primarily in Europe and Asia. As a result of the acquisition, we broadened our market with the addition of new technologies and a larger presence in Europe. We integrated the operations of Securealink into our Embedded Security Division.

In February 2002, our management decided to discontinue our Swiss subsidiary operations at GretaCoder Data Systems (GDS), which was formerly our European operations segment (see note 3 to our 2002 audited consolidated financial statements). The decision to discontinue GDS’s operations was based on the amount of its operating and cash losses during 2000 and 2001, as well as a significant downturn in its future business prospects. We transferred certain employees from GDS’s sales and marketing group to our sales group to create a European sales office focused on selling our enterprise products and services in Europe. The operating results of the discontinued businesses has been reported in the discontinued operations section of the consolidated statements of operations.

Our historical operating results have been dependent on a variety of factors including, but not limited to, the length of the sales cycle, the timing of orders from and shipments to clients, product development expenses and the timing of development and introduction of new products. Our expense levels are based, in part, on expectations of future revenues. The size and timing of our historical revenues have varied substantially from quarter to quarter and year to year. Accordingly, the results of a particular period, or period to period comparisons of recorded sales and profits may not be indicative of future operating results.

On October 14, 2003, SafeNet entered into an agreement with SSH Communications Security Corp. (“SSH”), pursuant to which SafeNet will acquire substantially all of the assets and properties used in connection with the toolkit, IPVia VPN and VPN client businesses of SSH for approximately $14.0 million in cash. SSH is a world-leading supplier of managed security middleware.

On October 22, 2003, we entered into an agreement to acquire Rainbow Technologies, Inc., a provider of information security solutions for mission-critical data and applications used in business, organization and government computing environments, in a stock-for-stock transaction. Consummation of the transaction is subject to customary closing conditions, including the approval of Rainbow’s stockholders and our stockholders. Under the terms of the agreement, each outstanding share of Rainbow common stock will be exchanged for 0.374 of a share of SafeNet common stock. All outstanding options to acquire Rainbow common stock will be assumed by us and converted into options to purchase shares of our common stock using the same exchange ratio. If the merger is consummated, the Company will issue in the transaction approximately 11.1 million shares of SafeNet common stock on a fully-diluted basis, which would represent approximately 43% of the outstanding stock of the combined company as of October 23, 2003, the date the proposed merger was announced. The Company expects the merger, if consummated, to close during the first quarter of 2004. If this merger is consummated, it will have a significant impact on our business operations going forward

The following table sets forth certain of our Consolidated Statement of Operations data as a percentage of revenues for the periods indicated.


		Three Months Ended						Nine Months Ended
		September 30,						September 30,

		2003			2002			2003			2002

Revenues			100	%		100	%		100	%		100	%
Cost of revenues			25			29			28			29

	Gross profit		75			71			72			71

Research and development expenses			22			26			24			29
Sales and marketing expenses			23			20			23			23
General and administrative expenses			10			11			10			12
Write-off of acquired in process research and development costs			—			—			21			15
Cost of integration of acquired companies			1			—			7			—
Amortization of acquired intangible assets			7			5			7			5

	Total operating expenses		63			62			92			84

	Operating income (loss)		12			9			(20	)		(13	)
Interest and other income, net			1			1			1			1

	Income (loss) from continuing operations before income taxes		13			10			(19	)		(12	)
Income tax expense			(3	)		—			(3	)		—

	Income (loss) from continuing operations		10			10			(22	)		(12	)
Income (loss) from discontinued GDS business			—			1			—			(18	)

Net income (loss)			10	%		11	%		(22	)%		(30	)%

Three Months and Nine Months ended September 30, 2003 compared to Three Months and Nine Months ended September 30, 2002

Revenues increased 99%, or approximately $8.8 million, to $17.6 million for the three months ended September 30, 2003, from $8.8 million for the three months ended September 30, 2002. Revenues increased 110%, or approximately $24.6 million, to $47.0 million for the nine months ended September 30, 2003, from $22.4 million for the nine months ended September 30, 2002. A significant portion of the increase was attributable to the addition of Cylink products and services, especially WAN products. The remaining increase for the three and nine months ended September 30, 2003 over the same periods ended September 30, 2002 was due primarily to increased revenue from the Embedded Security Division, including chips and boards, intellectual property and software, as well as increased revenues from SafeNet BV. The revenue mix among Licenses and Royalties, Products, and Service and Maintenance changed from period to period with the mix for the three months ended September 30, 2003, being 19%, 63%, and 18%, respectively, compared to a revenue mix of 14%, 79%, and 7%, respectively, for the three months ended September 30, 2002. This mix was 16%, 68%, and 16% for the nine months ended September 30, 2003 compared to 21%, 70%, and 9% for the nine months ended September 30, 2002. Licenses and Royalties increased with stronger sales of software and IP licensing as well as increased royalty revenues. The increase in products revenues was the most significant factor in revenue growth and was attributed to increased product demand and sales in our enterprise security system which includes both VPN and WAN products sold to both the commercial and government sectors of our business. Service and maintenance revenues continued to increase primarily as a result of the increased sales of products and in part due to several significant installations and upgrade work for our installed customer base. One enterprise customer accounted for 15% of our consolidated revenues for the three months ended September 30, 2003. For the nine months ended September 30, 2003, one embedded customer and one enterprise customer accounted for 17% and 14%, respectively, of our consolidated revenues. For the three and nine months ended September 30, 2002, one embedded customer accounted for 44% and 41% of our consolidated revenues, respectively.

Gross margin increased 4% to 75% for the three months ended September 30, 2003 from 71% for the three months ended September 30, 2002. For the nine months ended September 30, 2003 and 2002, gross margin increased 1% to 72% from 71%. The Enterprise Security Division’s gross margin was 73% for the three and nine months ended September 30, 2003, increasing from 72% for the same periods in 2002. The increase in these margins was due primarily to an increase in the sales of higher margin products.

The Embedded Security Division’s gross margins were 83% and 69%, respectively, for the three and nine months ended September 30, 2003, increasing from 70% and 68%, respectively, for the three and nine months ended September 30, 2002. The increases in gross margins for the three months ended September 30, 2003 relate to a change in the revenue mix with a greater percentage of sales being generated from licenses and royalties than the same period last year. Licenses and royalties average a higher gross margin than product sales and service and maintenance sales. Included within the cost of revenues is amortization of intangibles at 2% and 2% of revenues for the three and nine months ended September 30, 2003, respectively.

Research and development expenses increased 72%, or approximately $1.6 million, to $3.9 million for the three months ended September 30, 2003, from $2.3 million for the three months ended September 30, 2002. These expenses increased 73%, or approximately $4.8 million, to $11.3 million for the nine months ended September 30, 2003, from $6.5 million for the same period in 2002. The increase was attributable to increased headcount from the Cylink and Raqia acquisitions as well as an increase in research and development projects. We expect to continue these research and development projects throughout 2003, as we continue to announce new product and technology offerings during 2003.

Sales and marketing expenses increased 117%, or approximately $2.1 million, to $4.0 million for the three months ended September 30, 2003, from $1.8 million for the three months ended September 30, 2002. These expenses increased 103%, or approximately $5.4 million, to $10.6 million for the nine months ended September 30, 2003, from $5.2 million for the same period in 2002. These increases were due primarily to an increase in sales personnel primarily related to the Cylink acquisition, increased commissions from increased sales and additional marketing and promotional costs associated with new product launches.

General and administrative expenses increased 76%, or approximately $0.8 million, to $1.8 million for the three months ended September 30, 2003, from $1.0 million for the three months ended September 30, 2002. These expenses increased 84%, or approximately $2.2 million, to $4.9 million for the nine months ended September 30, 2003, from $2.6 million for the same period in 2002. The increase was primarily due to increased staffing from 11 to 20 people from 2002 to 2003. As a percentage of sales, general and administrative expenses decreased from 11% for the three months ended September 30, 2002 to 10% for the three months ended September 30, 2003 and from 12% for the nine months ended September 30, 2002 to 10% for the same period in 2003. We expect these costs to increase in the future as a result of our compliance with the Sarbanes-Oxley Act of 2002.

The write-off of acquired in-process research and development costs during the nine months ended September 30, 2003 was $9.7 million, and was directly attributable to the acquisition of the Raqia assets and the acquisition of Cylink. These write-offs represent the estimated fair value of the in-process research and development projects that have not yet reached technological feasibility at the acquisition dates, and had no alternate future use. The values assigned to these acquired in-process technologies relate entirely to three distinct projects: a specific content inspection chip and compiler; a specific gateway design for security applications; and a fully-integrated policy and security manager for multiple platforms and networks. The estimated fair value of these projects was determined by the use of a discounted cash flow model, using a discount rate that took into account the stage of completion, and the risks surrounding the successful development and commercialization of the technology and product. Subsequent to the acquisitions, we incurred approximately $0.5 million in additional research and development charges to complete the development of these technologies. For the nine months ended September 30, 2002, the write-off of in process research and development costs amounted to $3.4 million, all of which related to the acquisition of Securealink, which was for the in-process development of a new application specific integrated circuit that was completed and licensed to a customer in 2002.

Costs of integration of acquired companies for the three and nine months ended September 30, 2003 were $0.1 million and $3.1 million, respectively, and are costs specifically incurred as a result of integrating the people and products of Cylink and the Raqia assets, which were substantially completed during the second quarter of 2003. There were no integration costs for the three months and nine months ended

September 30, 2002, respectively. We may incur some additional integration expenses in connection with these acquisitions.

The amortization of acquired intangible assets for the three and nine months ended September 30, 2003 of $1.3 million and $3.3 million, respectively, relate to the acquisitions of Cylink and the Raqia assets, as well as Securealink. We acquired intangible assets, including developed technology, patents, customer relationships/contracts, backlog, and non-compete agreements. The amortization of developed technology and backlog is included in costs of revenues and the remainder is included in amortization of intangible assets. The Cylink intangible assets total $17.5 million and are being amortized over an average of 2.7 years. The Raqia intangible assets total $1.2 million and are being amortized over three years. The Securealink intangible assets total $1.9 million and are being amortized over estimated useful lives ranging from one to five years. For the three and nine months ended September 30, 2002, the amortization of intangible assets was $0.4 million and $1.1 million, respectively, and relates only to the acquisition of Securealink.

Interest and other income, net increased $0.1 million to $0.2 million for the three months ended September 30, 2003, from $0.1 million for the three months ended September 30, 2002. The increase is attributable to higher cash balances in 2003. Interest and other income remained constant at $0.4 million for the nine months ended September 30, 2003 and 2002.

We estimate that the effective income tax rate for the year ending December 31, 2003 will be approximately (19%). This overall rate reflects the recognition of a tax benefit related to the reduction in deferred tax liabilities established in purchase accounting for non-deductible intangible assets, offset by the usage of U.S. net operating loss carryforwards (“NOLs”) related to the exercise of non-qualified stock options and the disqualified disposition of incentive stock options for which the tax benefit is recorded as a direct increase to stockholders’ equity rather than as a reduction of income tax expense. During the three and nine months ended September 30, 2002, we incurred operating losses for which we recorded a full valuation allowance, as we could not predict the ultimate realization of the related deferred tax asset. We believe the issuance of shares in the public offering we completed on July 15, 2003, when combined with the issuance of shares in connection with acquisitions in 2002 and 2003, may result in a change in control for purposes of Section 382 of the Internal Revenue Code of 1986, as amended, which would limit our ability to utilize a portion of these NOLs. While we do not believe this limitation on the use of these NOLs would have a significant impact on our business, we are not able to quantify the amount of the limitation at this time.

The three and nine months ended September 30, 2002 included income from discontinued operations of $0.1 million and $4.1 million, respectively, which resulted from our decision to discontinue operations at GretaCoder Data Systems (GDS), which was formerly our European operations segment, in the first quarter of 2002. Because the discontinuation of GDS’s operations was completed in May 2002, there was no loss or income from discontinued operations for the three and nine months ended September 30, 2003.

We had net income of $1.7 million and a net loss of $10.2 million for the three and nine months ended September 30, 2003, respectively, compared to net income of $0.9 million and a net loss of $6.7 million for the same periods in 2002. We had net income per diluted share $0.13 and a net loss per diluted share of $0.95 for the three and nine months ended September 30, 2003, respectively, compared to net income per diluted share of $0.12 and a net loss per diluted share of $0.87 for the three and nine months ended September 30, 2002, respectively.

As of September 30, 2003 and December 31, 2002, we had working capital of $122.3 million and $32.0 million, respectively, including cash and cash equivalents and short-term investments totalling $125.0 million and $32.2 million, respectively. On July 15, 2003, we completed a public offering pursuant to which we sold 2.7 million shares of our common stock and received net proceeds of $83.9 million. We believe that our current cash resources will be sufficient to meet our needs for the next twelve months.

For the nine month period ended September 30, 2003, compared to the same period in 2002, cash provided by operating activities increased by $0.6 million. Cash provided by (used in) investing activities increased $19.9 million, primarily due an increase in net cash received from purchases and maturities of short-term investments of $18.6 million. Cash provided by (used in) financing activities increased $93.1 million, which is mainly attributed to cash proceeds from our July 2003 secondary offering of $83.9 million and an increase in cash received from stock option exercises of $7.7 million.

We have expended, and will continue to expend, significant amounts of cash for acquisition and integration costs related to prior and future acquisitions. As of September 30, 2003, we consider the Cylink acquisition and integration substantially complete.

Pursuant to the terms of the merger agreement related to the proposed merger with Rainbow Technologies, we may be obligated to pay Rainbow Technologies a termination fee of $15.0 million if the merger agreement is terminated because our Board of Directors fails to support the merger in certain ways or in other specified circumstances following the public announcement of a competing acquisition proposal involving SafeNet.

The following table sets forth, as of September 30, 2003, our commitments and contractual obligations for the years indicated (amounts in thousands):

We do not believe that inflation will significantly impact our business. We do not believe our business is seasonal. However, because we generally recognize product revenues upon shipment and software revenues upon establishing fair value of undelivered elements, such recognition may be irregular and uneven, thereby disparately impacting quarterly operating results and balance sheet comparisons.

We are exposed to the fluctuations in foreign currency exchange rates, principally related to the Euro and the British Pound. Such fluctuations impact the recorded values of our investments in foreign subsidiaries in our consolidated balance sheet, and our currency translation adjustment, a component of other comprehensive income. For the nine months ended September 30, 2003, a 10% change in average exchange rates for the Euro and British Pound would have changed our reported currency translation adjustment of $1.0 million by approximately $0.1 million. The Company’s exposure to foreign currency transaction risk is not significant, and therefore a 10% fluctuation in exchange rates would have a negligible impact on earnings.

We are exposed to investment risk to the extent we purchase short-term interest bearing investment securities, which are considered cash equivalents. For the nine months ended September 30, 2003, we had net interest income of approximately $0.4 million. A 10% change in the average interest rate for the nine months ended September 30, 2003 would have had a negligible effect on earnings.

As of September 30, 2003, we did not have any interest bearing obligations. In addition, we do not hold any derivative instruments and do not have any commodity risk.

As required by Rule 13a-15 under the Exchange Act, as of the end of the fiscal quarter covered by this quarterly report, we carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures. This evaluation was carried out under the supervision and with the participation of our management, including the chief executive officer and chief financial officer. Based upon that evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures are effective. Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosures.

As required by Rule 13a-15 under the Exchange Act, we carried out an evaluation of any changes in our internal control over financial reporting that occurred during the fiscal quarter covered by this quarterly report. This evaluation was carried out under the supervision and with the participation of our management, including the chief executive officer and chief financial officer. Based upon that evaluation, we concluded that there was no change in our internal control over financial reporting during this period that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Internal control over financial reporting is a process designed by, or under the supervision of, the principal executive officer and principal financial officer, and effected by the board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.

In 1998, Cylink filed with the Securities and Exchange Commission, or SEC, amendments to periodic reports, reflecting restated financial results for the first and third quarters of 1998, and for the fourth quarter of 1997. Between November 6, 1998 and December 14, 1998, several securities class action complaints were filed against Cylink and certain of its then current and former directors and officers in U.S. federal courts in California. These complaints alleged, among other things, that Cylink’s previously issued financial statements were materially false and misleading and that the defendants knew or should have known that these financial statements caused Cylink’s common stock price to rise artificially. The actions variously alleged violations of Section 10(b) of the Securities Exchange Act of 1934, as amended, and SEC Rule 10b-5 promulgated thereunder, and Section 20 of the Exchange Act. The securities class action lawsuits were ordered consolidated into a single action pending in the United States District Court for the Northern District of California, captioned In Re Cylink Securities Litigation, No. C98-4292 (VRW). On October 16, 2002, Cylink entered into an agreement with all plaintiffs in the securities class action lawsuit to settle all claims in the class action for $6.4 million. The United States District Court for the Northern District of California preliminarily approved the settlement agreement on November 12, 2002, and on July 23, 2003, the court issued an order granting final approval of the settlement and entering final judgment in accordance with the terms of the settlement agreement. The settlement amount was paid entirely from insurance proceeds under insurance policies held by Cylink.

On June 25, 2003, we were served with a motion and complaint in a lawsuit filed by Thales E-Security, Inc. and Thales Communications, Inc. (together, Thales) in the 17^th Judicial Circuit Court of Broward County, Florida. The court granted our motion to dismiss this lawsuit on jurisdictional grounds on July 3, 2003 and entered a final order to that effect on July 14, 2003. On July 22, 2003, Thales filed a motion and complaint for preliminary injunction in the Circuit Court for Montgomery County, Maryland. The motion and complaint allege that, among other things, we and a former Thales employee hired by us misappropriated trade secrets concerning one of Thales’ governmental customers, interfered with Thales’ business relationship with that customer, and interfered in Thales’ business and contractual relationships with a former supplier, CTAM PTY Ltd. SafeNet and Thales have entered into a stipulation of dismissal of this lawsuit with prejudice against Thales, dated October 6, 2003.

We are not aware of any other litigation or proceeding, pending or threatened, to which we are or may become a party.


3.1	Restated Certificate of Incorporation of SafeNet, Inc., as filed with the Secretary of State of Delaware on May 23, 2001	I/B/R (1)
3.2	By-laws of Registrant	I/B/R (2)
31.1	Certification Pursuant to Rule 13a-14(a) Under the Securities Exchange Act of 1934, as amended
31.2	Certification Pursuant to Rule 13a-14(a) Under the Securities Exchange Act of 1934, as amended
32.1	Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(b)

We filed Current Reports on Form 8-K on July 8, 2003, October 21, 2003, October 23, 2003 and October 24, 2003.

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


[X]		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

		For the quarterly period ended September 30, 2003

[ ]		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934


Delaware		52-1287752
(State or other jurisdiction of		(IRS Employer Identification No.)
incorporation or organization)


	Three Months Ended							Nine Months Ended
	September 30,							September 30,

		2003			2002				2003			2002

Risk-free interest rate			3.11	%		3.88	%			3.11	%		3.88	%
Dividend yield			0	%		0	%			0	%		0	%
Option life		0-5years			3-5years				0-5years			3-5years
Stock price volatility		104% to 106%			119% to 122%				104% to 111%			119% to 122%
Weighted average fair value of granted options		$	24.05		$	11.23			$	16.09		$	10.67


Working capital	$	(285	)
Property and equipment		776
Acquired in-process research and development assets		6,330
Acquired patents		1,167

Net assets acquired	$	7,988


	September 30,			December 31,
	2003			2002

Raw materials	$	188		$	252
Finished goods		2,564			1,714

		2,752			1,966
Reserve for excess and obsolete inventory		(1,338	)		(958	)

	$	1,414		$	1,008


Remaining in 2003	$	1,658
2004	$	6,717
2005	$	5,770
2006	$	942
2007	$	222
2008 and thereafter	$	166


Remaining in 2003	$	641
2004	$	2,191
2005	$	1,989
2006	$	2,084
2007	$	2,040
2008 and thereafter	$	6,016


			Less than		1-3		3-5		More than 5
	Total		One Year		Years		Years		Years

Operating leases⁽¹⁾	$	14,961	$	2,284	$	4,100	$	3,984	$	4,593
Sales and marketing agreement⁽²⁾	$	1,000		—		1,000		—		—

	$	15,961	$	2,284	$	5,100	$	3,984	$	4,593


(1)		– The operating leases are for the multiple facilities that we lease for our operations, sales, and headquarters.

(2)		– This agreement requires certain payments to be made in the future to complete our acquisition of these exclusive sales and marketing rights.

(1)		Filed as an exhibit to the Form 10-Q for the quarterly period ended June 30, 2002 and incorporated herein by reference.

(2)		Filed as an exhibit to the Registration Statement on Form S-18 (File No. 33-28673) of the Registrant and incorporated herein by reference.


		SAFENET, INC.



November 14, 2003		/s/ Anthony A. Caputo ANTHONY A. CAPUTO Chairman, President and Chief Executive Officer



November 14, 2003		/s/ Carole D. Argo CAROLE D. ARGO Senior Vice President and Chief Financial Officer