UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2004

Commission File Number 0-20634

SAFENET, INC.

4690 Millennium Drive, Belcamp, MD 21017
(Address of principal executive offices)

443-327-1200
(Registrant’s telephone number)

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 þ No o

Indicate by a check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes þ No o

APPLICABLE ONLY TO CORPORATE ISSUERS

The number of shares outstanding of the issuer’s Common Stock as of August 2, 2004, was 23,877,368.

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INDEX TO FINANCIAL STATEMENTS

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PART I: FINANCIAL INFORMATION

Item 1: Financial Statements

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

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

See accompanying notes to consolidated financial statements.

4

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

See accompanying notes to consolidated financial statements.

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SAFENET, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
Six Months Ended June 30, 2004
(Unaudited, in thousands)

See accompanying notes to consolidated financial statements.

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SAFENET, INC
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)

See accompanying notes to consolidated financial statements.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2004

(Unaudited, in thousands except per share amounts)

(1) BASIS OF PRESENTATION

     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 for the year ended December 31, 2003. The results of operations for the interim period are not necessarily indicative of results to be expected in future periods.

     As disclosed in the Company’s Annual Report on Form 10-K, during the fourth quarter of fiscal year 2003, the Company identified certain adjustments to its financial statements that impacted the results of operations that were previously reported in its quarterly reports on Forms 10-Q. The results of operations and cash flows for the previously reported interim periods in 2003 have been restated to reflect those adjustments that are described in detail in the Form 10-K.

(2) BUSINESS

     SafeNet is a global leader in information security. Founded more than 20 years ago, the company provides complete security utilizing its encryption technologies to protect communications, intellectual property and digital identities, and offers a full spectrum of products including hardware, software, and chips.

     In February 2003, the Company acquired Cylink, Inc. (“Cylink”). Cylink developed, marketed and supported a comprehensive portfolio of hardware and software security products for mission-critical private networks and business communications over the Internet. The results of Cylink are included in the Company’s consolidated results of operations beginning on February 6, 2003.

     In February 2003, the Company acquired the assets of Raqia Networks, Inc. (“Raqia”), a development stage company that was developing content inspection technology.

     In November 2003, the Company acquired the OEM Products Group of SSH Communication Security Corp. (“SSH”), a European developer of VPN client software and security and networking toolkits. The results of operation of SSH have been included in the Company’s consolidated results of operations beginning on November 19, 2003.

     On March 15, 2004, the Company acquired Rainbow Technologies, Inc. (“Rainbow”). Rainbow provided information security solutions for mission-critical data and applications used in business, organization and government computing environments. The results of operations of Rainbow have been included in the Company’s consolidated results of operations beginning on March 16, 2004.

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(3) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Revenue Recognition

     As a result of the acquisition of Rainbow, the Company has added the following significant accounting policies related to revenue recognition for the products and services offered by the acquired business.

     Certain products are designed, developed and produced by the Company for use in U.S. Government and commercial high assurance applications. The products consist of application specific integrated circuits (“ASICs”), modules, electronic assemblies and stand-alone products to protect information. Catalog product revenues and revenues under certain fixed-price contracts calling for delivery of a 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.

Product Warranties

     The changes in the carrying amount of product warranties from December 31, 2003 to June 30, 2004 are as follows:

     The Company offers warranties on its products ranging from ninety days to two years. The specific terms and conditions of those warranties vary depending upon the product sold and the country in which the Company does business. The Company estimates the costs that may be incurred under its warranties and records a liability 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 the estimated cost per claim. The Company periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary. While warranty costs have historically been within management’s expectations, it is possible that warranty rates will change in the future based on new product introductions and other factors.

Employee Stock-Based Compensation

     As of June 30, 2004, the Company had five stock-based employee compensation plans. The Company accounts for those plans using the intrinsic value method prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Compensation cost is reflected in the statements of operations, in general and administrative costs.

     The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

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     For purposes of the pro forma disclosures above, the estimated fair values of options granted are amortized to expense over the options’ vesting periods. During the six months ended June 30, 2004, the Company granted 628 options to employees.

Reclassifications

     Where appropriate, certain amounts in the prior year consolidated financial statements have been reclassified to conform to the 2004 presentation.

(4) ACQUISITIONS

Rainbow Technologies, Inc.

     On March 15, 2004, SafeNet acquired 100% of the outstanding common shares of Rainbow Technologies, Inc (“Rainbow”) in accordance with an Agreement and Plan of Reorganization dated October 22, 2003. The results of operations of Rainbow have been included in the Company’s consolidated results of operations beginning on March 16, 2004. Rainbow provided information security solutions for mission-critical data and applications used in business, organization and government computing environments. As a result of the acquisition, the Company believes that it will be able to accelerate growth in the government security market, strengthen the Company’s competitive position in the commercial market, leverage SafeNet’s distribution platform and realize substantial economies of scale and synergy opportunities.

     The aggregate purchase price was $412,636, consisting primarily of 10,306 shares of common stock valued at approximately $375,128, 1,944 options to purchase common stock with an aggregate value of the vested portion of $31,440, and estimated direct costs of the acquisition of $6,068. The fair value of the common stock issued was determined based on the average market price of the Company’s common stock over the period including three days before and after the terms of the acquisition were agreed to and announced.

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     The following table summarizes the preliminary estimated fair values of the assets acquired and liabilities assumed at the date of acquisition. The Company is in the process of completing certain analyses and obtaining certain third-party valuations primarily related to deferred income taxes and leased and owned properties. The Company is also finalizing its estimates of the direct costs of the acquisition, and thus, the allocation of the purchase price is subject to refinement.

     The $130,797 of acquired intangibles was assigned to the following asset classes: $10,247 of patents, $89,000 of developed technology, $16,890 of customer contracts, $1,140 of key account list, and $13,520 of trademarks. The weighted-average amortization periods are as follows: for patents 9 years, for developed technology 9 years, for customer contracts 10 years, and for key account list 5 years. The trademarks are assumed to have an indefinite useful life.

     The Company has preliminarily assigned $167,087 of goodwill to the Embedded Security segment and $99,399 to the Enterprise Security segment. Of the $266,486 of goodwill, none is expected to be deductible for tax purposes. The primary factors contributing to a purchase price for Rainbow that resulted in the recognition of goodwill included the belief that the combined strengths of the two companies enable them to compete more effectively than SafeNet could alone, the belief that the merger allows the combined company 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, and the impact of anticipated operating efficiencies.

     The following unaudited consolidated pro forma results of operations of the Company for the three month period ended June 30, 2003 and the six-month periods ended June, 2003 and 2004, give effect to the March 15, 2004 acquisition of Rainbow and the February 6, 2003 acquisition of Cylink as though they had both occurred on January 1, 2003 (in thousands, except per share amounts):

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     The November 2003 acquisition of SSH would not have materially affected the reported results of operations for the six months ended June 30, 2003 had the acquisition occurred on January 1, 2003.

     The pro forma results include the estimated amortization of intangibles subject to amortization. The Company does not record amortization expense related to goodwill, but rather reviews the carrying value of the asset for impairment at least annually in accordance with its stated accounting policy. 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, 2003, nor are they necessarily indicative of future consolidated results.

(5) RESTRUCTURING CHARGE

     In connection with the acquisition and integration of Rainbow on March 15, 2004, the Company reevaluated all of its current leased and owned facilities to determine whether any were duplicative and where new needs for expansion should be directed. Based on the amount of available leased and owned property acquired in connection with Rainbow, the Company determined that it would cease use of certain existing leased facilities that were obtained in connection with the acquisition of Cylink. In accordance with FASB Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities, a liability for costs that will continue to be incurred under a contract for its remaining term without economic benefit should be recognized and measured at its fair value when the company ceases using the right conveyed by the contract. The fair value of the liability at the cease-use date was determined based on the remaining lease rentals, reduced by estimated sublease rentals that could be reasonably obtained for the property, and included common area maintenance costs, real estate taxes and other costs that the Company is contractually obligated to pay over the remaining lease term under the provisions of the lease contact. The Company calculated an estimated liability of $6,190 as of March 16, 2004 based on current expectations of market rates for subleasing the property and the anticipated amount of time required to sublease the property. This amount was reduced by the remaining unfavorable lease liability of $4,705 recorded by the Company for this property in connection with Cylink purchase accounting, yielding a net charge during the six months ending June 30, 2004 of $1,485 which is included in the results of operations of the Enterprise division. As of June 30, 2004, the liability is classified as an unfavorable lease liability in the accompanying consolidated balance sheet, including the current portion of $1,206 that is included in other accrued expenses.

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(6) INVENTORIES

     Inventories consisted of the following:

(7) PROPERTY AND EQUIPMENT

     Property and equipment consisted of the following:

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(8) GOODWILL

     The changes in the carrying amount of goodwill for the six-month period ended June 30, 2004 and year ended December 31, 2003 are as follows:

(9) ACQUIRED INTANGIBLE ASSETS

     Acquired intangible assets consisted of the following at June 30, 2004, of which $54,878 related to the Enterprise Security Division, and $91,161 related to the Embedded Security Division:

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     Acquired intangible assets consisted of the following at December 31, 2003, of which $10,900 related to the Enterprise Security Division, and $12,699 related to the Embedded Security Division:

     The estimated amortization expense for each of the fiscal years subsequent to December 31, 2003 is as follows:

(10) INCOME TAXES

     The tax provisions for the three and six-month periods ended June 30, 2004 and 2003 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 59% for the six months ended June 30, 2004, which is the rate the Company anticipates for the full year ending December 31, 2004. This rate differs from the 54% rate estimated at the end of the first quarter, due to a change in the expected mix of net income between U.S. and foreign jurisdictions. The estimated effective tax rate differs from the U.S. statutory rate of 35% due primarily to the impact of certain acquisitions and related costs that are not expected to be deductible for tax purposes, as well as the impact of income earned in foreign jurisdictions that will be taxed at different rates.

     Deferred tax assets, net of valuation allowance, and deferred tax liabilities arising from continuing operations as of June 30, 2004 are
$4,182 and $55,931, respectively. The deferred tax liabilities at June 30, 2004 include $49,703 of deferred tax liabilities that relate to the acquisition of certain intangibles assets that are not deductible for tax purposes, related to the Rainbow acquisition.

(11) SEGMENTS OF THE COMPANY AND RELATED INFORMATION

     The Company has two reportable segments. The Embedded Security Division designs and sells a broad range of security products, including silicon chips, accelerator cards, licensed intellectual property and software products to original equipment manufacturers (“OEMs”) that embed them into their own network and wireless products. The Enterprise Security Division sells high-performance security solutions, including software and appliances, to address the needs of the U.S. government, financial institutions and other security-sensitive commercial companies. The reportable segments are strategic business units that offer different products. The segments are managed separately because each segment requires different technology and marketing strategies. The Embedded Security Division and Enterprise Security Division include some international sales mainly to South America, Europe and Asia.

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     The following table sets forth information about the Company’s reportable segments for the three and six months ended June 30, 2004 and 2003:

     Significant non-cash items excluding depreciation and amortization was comprised of $2,158 and $2,519 of unearned compensation for the three and six months ended June 30, 2004, respectively, as well as $1,485 of restructuring charges for the six months ended June 30, 2004. There were no restructuring charges for the three months ended June 30, 2004 or either period in 2003. There were no unearned compensation charges in 2003. The items related to 2003 were the write-off of in-process research and development projects, which represented $1,781 and $9,681 for the three and six months ended June 30, 2003, respectively.

(12) SIGNIFICANT CUSTOMERS AND CONCENTRATIONS OF CREDIT RISK

     Financial instruments that potentially subject the Company to significant concentrations of credit risk consist primarily of accounts receivable. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. Sales terms with customers, including distributors, do not provide for right of return privileges for credit, refund or other products. The Company’s payment terms are generally 30-60 days from delivery of products, but could fluctuate depending on the terms of each specific contract. The Company’s customers, who include both commercial companies and governmental agencies, are in various industries, including banking, security, communications and distributors of electronic products.

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     For the three months ended June 30, 2004, a major U.S. government agency customer of the Enterprise Security Division accounted for 27% of the Company’s consolidated revenues. For the three months ended June 30, 2003, Cisco Systems, a commercial client of the Embedded Security Division, accounted for 19% of the Company’s consolidated revenues and one U.S. government systems integrator customer of the Enterprise Security Division accounted for 12% of the Company’s consolidated revenues.

     For the six months ended June 30, 2004, a major U.S. government agency customer of the Enterprise Security Division accounted for 25% of the Company’s consolidated revenues. For the six months ended June 30, 2003, Cisco Systems, a commercial client of the Embedded Security Division accounted for 24% of the Company’s consolidated revenues and one U.S. government systems integrator customer of the Enterprise Security Division accounted for 12% of the Company’s consolidated revenues.

     As of June 30, 2004, a major U.S. government agency customer of the Enterprise Security Division accounted for 37% of consolidated accounts receivable. As of June 30, 2003, Cisco Systems, a commercial client of the Embedded Security Division accounted for 14% of consolidated accounts receivable and one U.S. government systems integrator customer of the Enterprise Security Division accounted for 13% of the consolidated accounts receivable.

(13) INCOME (LOSS) PER SHARE

     For the three months ended June 30, 2003, and the six months ended June 30, 2004 and 2003 presented in the accompanying financial statements, 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 securities consist of outstanding options and warrants to purchase 839 shares and 539 shares of the Company’s common stock as of June 30, 2004 and 2003, respectively.

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

Forward-Looking Statements

     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, among others, the risks described in Item 1 – Business in the Company’s 2003 Form 10-K. 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.

Critical Accounting Policies and Estimates

     Management’s Discussion and Analysis of Financial Condition and Results of Operations discuss our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to intangible assets and contingencies and litigation. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

     We identified our most critical accounting policies to be those related to revenue recognition for our software contracts with multiple elements, contracts accounted for using the percentage of completion method, the relevant accounting related to valuation allowances, accounts receivable, inventory, capitalized software, and other acquired intangible assets. We describe these accounting policies in relevant sections of this discussion and analysis. This discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included in our 2003 Annual Report on Form 10-K.

     As a result of the acquisition of Rainbow in March 2004, the portion of our revenues earned under long-term contracts has increased significantly from fiscal year 2003. Accordingly, we have updated our critical accounting policies in light of this new concentration.

     We recognize revenue and profit as work on long-term contracts progresses using the percentage of completion method of accounting, which relies on estimates of total expected contract revenues and costs. We follow this method since reasonably dependable estimates of the revenue and costs applicable to various stages of a contract can be made. Since the financial reporting of these contracts depends on estimates, which are assessed continually during the term of the contract, recognized revenues and profit are subject to revisions as the contract progresses to completion. Revisions in profit estimates are reflected in the period in which the facts that give rise to the revision become known. Accordingly, favorable changes in estimates result in additional profit recognition, and unfavorable changes in estimates result in the reversal of previously recognized revenue and profits. When estimates indicate a loss under a contract, cost of revenue is charged with a provision for such loss. As work progresses under a loss contract, revenue continues to be recognized, and a portion of the contract costs incurred in each period is charged to the contract loss reserve.

Overview

     SafeNet develops, markets, and supports a portfolio of hardware and software network security products and solutions. Our products and solutions are used to encrypt secure wide area networks (WANs) and virtual private networks (VPNs) for the public and private sector to prevent security breaches that could result in unauthorized access to confidential data, invasion of privacy and financial loss.

     SafeNet has two reportable business segments: the Enterprise Security Division and the Embedded Security Division. Through our Enterprise Security Division, we sell high-performance security solutions to address the needs of the Federal government, financial institutions 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.

     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.

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     In February 2003, we acquired Cylink, 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.

     In February 2003, we also acquired the assets of Raqia, a development stage company that was developing content inspection technology. This transaction consisted primarily of technology-related intangible assets.

     In November 2003, we acquired substantially all of the assets and properties used in connection with the toolkit, IPVia VPN and VPN client businesses of SSH Communications Security Corp. (“SSH”). SSH is a world-leading supplier of managed security middleware.

     On March 15, 2004 the Company completed the acquisition of Rainbow Technologies, Inc. (“Rainbow”). Rainbow provided information security solutions for mission-critical data and applications used in business, organization and government computing environments. This merger with Rainbow will have a significant impact on our operations going forward. While the impact of the merger on our future results of operations and liquidity is still somewhat uncertain at this time, the combined company has added approximately 4,000 new customers to SafeNet’s existing customer base, distribution channels in over 100 countries, and up to 535 employees to SafeNet’s approximately 215 employees.

     In addition, we anticipate this merger will result in cost savings as a result of cost synergies and operating efficiencies after the integration of our businesses. While the magnitude and timing of those benefits is uncertain, we currently anticipate pre-tax annual cost savings of at least $10.0 million to $13.0 million, including anticipated savings of $7.0 million to $8.0 million in personnel costs, $1.8 million to $2.5 million in professional fees and insurance costs, $1.8 million to $2.5 million in marketing costs, and $0.5 million to $1.0 million in management and board of directors expenses.

     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, the timing of development and introduction of new products and the timing of significant acquisitions. 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.

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RESULTS OF OPERATIONS

Three Months ended June 30, 2004 Compared to Three Months ended June 30, 2003

Revenues and Gross Margins (dollars in thousands)

(1) Includes amortization of acquired intangible assets of $3.3 and $0.8 million for three months ended June 30, 2004 and 2003, respectively.

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     Revenues increased $37.8 million primarily due to the acquisition of Rainbow on March 15, 2004, which generated product revenue ($40.8 million) and service and maintenance revenue ($1.1 million) for the three months ended June 30, 2004. This increase was offset by the loss of Cisco product revenue in the amount of $3.2 million as well as a single sale to a major U.S. government system integrator in the second quarter of 2003 for $1.9 million, neither of which was repeated in the same period of 2004. Additionally, the acquisition of SSH’s OEM product line added $0.7 million of service and maintenance revenue for the three months ended June 30, 2004. Neither the SSH nor Rainbow acquisitions are reflected in the revenues for the three months ended June 30, 2003.

     Revenue for the Embedded Security Division increased by $11.8 million for the three months ended June 30, 2004 over the three months ended June 30, 2003, due to increased revenues of $13.3 million from the Rainbow acquisition, $0.9 million from licenses of intellectual property (IP) and $0.7 million from SSH maintenance revenue, offset by the loss of $3.2 million in Cisco product sales. Revenue for the Enterprise Security Division increased by $26.1 million for the three months ended June 30, 2004, over the three months ended June 30, 2003, due to increased revenues of $28.6 million from the Rainbow acquisition, offset by a single sale to a major U.S. government system integrator in the second quarter of 2003 for $1.9 million that did not recur in the 2004 period.

     The revenue mix by type has changed significantly as the Rainbow acquisition was a product focused acquisition. The Rainbow revenue stream is approximately 97% product and 3% service and maintenance. Our integrated product and service offerings will continue to offer growth in all three revenue types but we will remain a product based company. These products include hardware, software, IP, and development. The revenue mix by segment should continue to be materially consistent with the most recent quarter, with the Embedded Security Division representing 30% to 35% of total revenues and the Enterprise Security Division representing the remainder.

     Gross margins for each type of revenue fluctuated for the three months ended June 30, 2004 as compared to the three months ended June 30, 2003. The fluctuation in product margin was due to the secure communications business, which carries margins in the 20% to 25% range and represents over 44% of the revenues for the three months ended June 30, 2004. The products comprising the remaining portion of the revenue base earn average margins from 70% to over 90%. The decrease in service and maintenance margin was due to increased headcount to support and maintain the additional products we offer.

     The gross margins by segment are reflective of changes within each division. The Embedded Security Division’s gross margins were the same for each period reported. The Enterprise Security Division’s gross margins decreased because of the addition of the secure communications business from the Rainbow acquisition. The secure communications business functions primarily as a government contractor and direct provider to the U.S. Government, with products that typically earn lower gross margins. The Enterprise Security Division’s gross margins will fluctuate based on the mix of revenues from sales of secure communications products during the applicable reporting period.

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Operating Expenses

     Research and development expenses rose due to the increase in the number of ongoing technology projects within the Company as well as the increase in the number of research and development team employees. The Company has added personnel through several acquisitions in the last 12 to 18 months, including Cylink, Raqia, SSH, and Rainbow. For the three months ended June 30, 2003, the Company had only added personnel from Cylink and Raqia. As a percentage of revenue, research and development expenses have decreased from 25% to 11%. The Company has been able to leverage its many research and development resources into multiple projects that have resulted in increased and continuously improving product offerings of both hardware and software.

     Sales and marketing expenses increased due to two factors. The first factor is additional headcount added throughout the year, due primarily to the Rainbow acquisition. The second factor is increased sales, which incrementally increases selling costs, including commissions. As a percentage of revenue, sales and marketing expenses decreased from 23% for the three months ended June 30, 2003 to 13% for the same period in 2004. The decrease in the percentage of total sales was expected as the Company continues to leverage its current product offerings and sales force to handle the additional demand and markets that the Company is moving into throughout the world.

     General and administrative expenses increased due to additional legal and professional fees, as well as increased headcount. As a percentage of revenue, general and administrative expenses increased from 9% for the three months ended June 30, 2003 to 10% for the same period in 2004.

     In the three month period ended June 30, 2003, the Company’s acquisitions of Cylink and Raqia assets necessitated the write-off of in-process research and development costs totaling $1.8 million. There were no such charges in the second quarter of 2004 associated with the Rainbow acquisition.

     Costs of integration of acquired companies were higher by $1.4 million from the three months ended June 30, 2004 compared to the same period in 2003. The costs for the 2003 period reflect significant integration and professional fees related to the Cylink acquisition. The costs in 2004 reflect Rainbow integration costs.

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     Amortization of intangible assets increased from $1.3 million for the three months ended June 30, 2003 to $2.3 million for the same period in 2004. The amortization for the 2004 period includes amortization from multiple acquisitions — Cylink, Raqia, SSH, and Rainbow. For the same period in 2003, amortization of intangible assets did not include amortization related to the acquisitions of SSH or Rainbow. This will continue to be a significant cost to the Company throughout 2004. See Note 9 of the consolidated financial statements as of and for the period ended June 30, 2004.

     Amortization of unearned compensation is a cost specific to the Rainbow acquisition and reflects the amortization of the fair value of the unvested portion of common stock options assumed by us in the Rainbow acquisition. We did not assume any unvested options during 2003.

Interest and Other Income, Net

     The increase in interest and other income is due primarily to increased cash and investment balances and investment that increased interest earned over the prior period as well as gains on our foreign currency transactions during the current quarter.

Income Tax Expense

     The tax provisions for the three month periods ended June 30, 2004 and 2003 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 currently estimates that the effective income tax rate for the year ending December 31, 2004 will be approximately 59%. This rate differs from the 53% rate estimated at the end of the first quarter due to a change in the expected mix of net income between U.S. and foreign jurisdictions and differs from the U.S. statutory rate of 35% due primarily to the impact of certain acquisitions and related costs that are not expected to be deductible for tax purposes, as well as the impact of income earned in foreign jurisdictions that will be taxed at different rates.

     During the second quarter of fiscal year 2003, the Company estimated that the effective income tax rate for the year ended December 31, 2003 would be approximately <10%>. This overall effective tax rate reflects the non-deductible write-off of in-process research and development costs related to the Cylink acquisition partly offset by the recognition of a tax benefit related to the reduction in deferred tax liabilities established in purchase accounting for non-deductible intangible assets.

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Six Months ended June 30, 2004 Compared to Six Months ended June 30, 2003

Revenues and Gross Margins (dollars in thousands)