SAFENET INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


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

		For the quarterly period ended September 30, 2004

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

Commission File Number 0-20634

SAFENET, INC.

(Exact name of registrant as specified in its charter)


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

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 [X] No [ ]

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

APPLICABLE ONLY TO CORPORATE ISSUERS

The number of shares outstanding of the issuer’s Common Stock as of November 5, 2004, was 24,149,513.

PART I: FINANCIAL INFORMATION

Item 1: Financial Statements

SAFENET, INC.
AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share amounts)


	September 30,			December 31,
	2004			2003
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	80,672		$	21,651
Restricted cash		4,479			2,800
Short-term investments		93,313			92,280
Accounts receivable, net of allowance for doubtful accounts of $2,538 in 2004 and $940 in 2003		43,283			13,191
Inventories, net of reserve of $1,026 in 2004 and $1,275 in 2003		14,845			3,123
Unbilled costs and fees		957			—
Deferred income taxes		3,293			—
Prepaid expenses and other current assets		4,814			1,414

Total current assets		245,656			134,459
Property and equipment, net of accumulated depreciation and amortization of $5,472 in 2004 and $6,875 in 2003		15,737			3,809
Computer software development costs, net of accumulated amortization of $2,156 in 2004 and $1,696 in 2003		2,600			1,982
Goodwill		308,240			42,407
Other intangible assets, net of accumulated amortization of $23,047 in 2004 and $9,280 in 2003		140,477			23,599
Other assets		3,627			1,900

Total assets	$	716,337		$	208,156

Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	11,416		$	3,799
Accrued salaries and commissions		11,661			3,770
Advance payments and deferred revenue		9,236			4,791
Accrued income taxes		9,907			2,294
Other accrued expenses		7,781			2,509
Deferred income taxes		7,538			2,607
Due to former owners of acquired companies		3,850			2,800
Accrued warranty costs		3,296			259
Accrued severance and related acquisition costs		593			—

Total current liabilities		65,278			22,829
Unfavorable lease liability		4,559			4,149
Deferred income taxes		46,532			2,181
Other liabilities		2,813			—

Total liabilities		119,182			29,159

Commitments and contingencies		—			—
Stockholders’ equity:
Preferred stock, $.01 par value per share, authorized 500 shares, no shares issued and outstanding		—			—
Common stock, $.01 par value per share, authorized 50,000 shares, issued and outstanding shares of 24,111 in 2004 and 13,286 in 2003		241			133
Additional paid-in capital		625,572			199,783
Unearned compensation		(8,613	)		—
Accumulated other comprehensive income		5,321			5,394
Accumulated deficit		(25,366	)		(26,313	)

Total stockholders’ equity		597,155			178,997

Total liabilities and stockholders’ equity	$	716,337		$	208,156

See accompanying notes to consolidated financial statements.

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


	Three Months ended September 30,				Nine Months ended September 30,
	2004		2003		2004		2003
			(Restated - Note 1)				(Restated - Note 1)
Revenues:
Licenses and royalties	$	2,449	$	3,131	$	7,300	$	7,702
Products		51,892		11,071		116,563		32,079
Service and maintenance		5,109		3,183		13,948		7,678

		59,450		17,385		137,811		47,459
Cost of revenues:
Licenses and royalties		126		79		196		203
Products ⁽¹⁾		26,426		3,537		58,869		10,226
Service and maintenance		62		320		1,327		959
Amortization of acquired intangible assets		3,287		353		7,674		2,243

		29,901		4,289		68,066		13,631

Gross profit		29,549		13,096		69,745		33,828

Operating expenses:
Research and development expenses		6,179		3,777		17,180		11,182
Sales and marketing expenses		8,414		3,956		19,723		10,835
General and administrative expenses		4,309		1,729		12,300		4,852
Costs of integration of acquired companies		4,573		138		7,935		3,127
Amortization of acquired intangible assets		2,304		1,313		6,173		3,349
Amortization of unearned compensation (*see detail below)		2,028		—		4,547		—
Write-off of acquired in-process research and development costs		—		—		—		9,681
Restructuring charge		100		—		1,585		—

Total operating expenses		27,907		10,913		69,443		43,026

Operating income (loss)		1,642		2,183		302		(9,198	)
Interest and other income, net		825		207		2,049		449

Income (loss) before income taxes		2,467		2,390		2,351		(8,749	)
Income tax expense		1,471		569		1,404		1,607

Net income (loss)	$	996	$	1,821	$	947	$	(10,356	)

Net income (loss) per common share:
Basic	$	0.04	$	0.14	$	0.05	$	(0.97	)

Diluted	$	0.04	$	0.13	$	0.04	$	(0.97	)

Shares used in computation:
Basic		23,976		12,769		20,998		10,700
Diluted		24,558		13,546		21,686		10,700

*Composition of stock compensation
Cost of revenues	$	160	$	—	$	374	$	—
Research and development		387		—		892		—
Sales and marketing		347		—		774		—
General and administrative		408		—		906		—
Integration		726		—		1,601		—

Total	$	2,028	$	—	$	4,547	$	—


⁽¹⁾	Excludes amortization of earned compensation of $160, $0, $374, $0

See accompanying notes to consolidated financial statements.

SAFENET, INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

Nine Months Ended September 30, 2004

(Unaudited, in thousands)



											Accumulated
	Common stock				Additional paid-in			Unearned			other comprehensive			Accumulated			Total stockholders’
	Shares		Amount		capital			compensation			income (loss)			deficit			equity
Balance as of January 1, 2004		13,286	$	133	$	199,783		$	—		$	5,394		$	(26,313	)	$	178,997
Costs incurred in connection with the registration of common stock issued for the asset acquisitions of Raqia Networks, Inc. and Rainbow Technologies, Inc.		—		—		(1,034	)		—			—			—			(1,034	)
Issuance of common stock in connection with the acquisition of Rainbow Technologies, Inc.		10,306		103		375,025			—			—			—			375,128
Assumption of stock options in connection with the acquisition of Rainbow Technologies, Inc.		—		—		44,600			(13,160	)		—			—			31,440
Amortization of unearned compensation		—		—		—			4,547			—			—			4,547
Issuance of common stock under Employee Stock Purchase Plan		23		—		552			—			—			—			552
Issuance of common stock for stock option exercises		476		5		6,646			—			—			—			6,651
Issuance of common stock for stock warrants exercised		20		—		—			—			—			—			—
Foreign currency translation adjustment		—		—		—			—			(73	)		—			(73	)
Net income		—		—		—			—			—			947			947

Balance as of September 30, 2004		24,111	$	241	$	625,572		$	(8,613	)	$	5,321		$	(25,366	)	$	597,155

See accompanying notes to consolidated financial statements.

SAFENET, INC
AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)


	Nine Months Ended September 30,
	2004			2003
				(Restated - Note 1)
Cash flows from operating activities:
Net income (loss)	$	947		$	(10,356	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Write-off of acquired in-process research and development costs		—			9,681
Depreciation and amortization of property and equipment		2,237			892
Amortization of computer software development costs		458			207
Amortization of other intangible assets		13,919			5,576
Amortization of unearned compensation		4,547			—
Income tax benefit related to stock option exercises		—			2,458
Restructuring charge		1,585			—
Deferred income taxes		(3,726	)		(1,506	)
Amortization of unfavorable lease liability		(1,174	)		(532	)
Changes in operating assets and liabilities:
Accounts receivable, net		(11,815	)		(739	)
Inventories, net		(1,737	)		1,811
Prepaid expenses and other current assets		(559	)		547
Accounts payable		(1,416	)		785
Accrued salaries and commissions		1,006			(4,253	)
Accrued income taxes		5,788			1,038
Other accrued expenses		(4,161	)		(1,970	)
Advance payments and deferred revenue		807			(358	)

Net cash provided by operating activities		6,706			3,281

Cash flows from investing activities:
Sales of available for sale securities		53,267			48,078
Purchases of available for sale securities		(53,983	)		(36,181	)
Purchases of property and equipment		(4,267	)		(1,474	)
Expenditures for computer software development		(1,078	)		(1,245	)
Cash received upon acquisition of Rainbow, net of cash paid		54,174			—
Cash received upon acquisition of Cylink and SSH, net of cash paid		(474	)		703
Cash paid for Raqia, net of cash acquired		—			(1,390	)
Change in other assets		(1,219	)		791

Net cash provided by investing activities		46,420			9,282

Cash flows from financing activities:
Proceeds from stock options exercised and issuance of stock under Employee Stock Purchase Plan		7,203			8,637
Costs incurred in connection with the registration of common stock issued for the Rainbow, Cylink, SSH, and Raqia acquisitions		(1,034	)		—
Proceeds from public offering, net of costs		—			83,920

Net cash provided by financing activities		6,169			92,557

Effect of exchange rate changes on cash		(274	)		(388	)

Net increase in cash and cash equivalents		59,021			104,732
Cash and cash equivalents at beginning of period		21,651			3,399

Cash and cash equivalents at end of period	$	80,672		$	108,131

See accompanying notes to consolidated financial statements.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 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.

(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 accrued warranty costs from December 31, 2003 to September 30, 2004 are as follows:


Balance as of December 31, 2003	$	259
Balance acquired from Rainbow		3,423
Cash payments made		(386	)

Balance as of September 30, 2004	$	3,296

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 September 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.

The following table illustrates the effect on net income 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.


	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
				(Restated - Note 1)						(Restated - Note 1)
Net income (loss), as reported	$	996		$	1,821		$	947		$	(10,356	)
Add: Stock-based employee compensation expense included in net income, net of taxes		831			—			1,864			—
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of taxes		(4,558	)		(1,243	)		(7,725	)		(2,981	)

Pro forma net (loss) income	$	(2,731	)	$	578		$	(4,914	)	$	(13,337	)

Income (loss) per share:
Basic - as reported	$	0.04		$	0.14		$	0.05		$	(0.97	)

Diluted - as reported	$	0.04		$	0.13		$	0.04		$	(0.97	)

Basic - pro forma	$	(0.11	)	$	0.05		$	(0.23	)	$	(1.25	)

Diluted - pro forma	$	(0.11	)	$	0.04		$	(0.23	)	$	(1.25	)

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 nine months ended September 30, 2004, the Company granted 140 options to the Board of Directors and 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 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 $412,123, consisting 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 $5,555. 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.

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.


Cash and cash equivalents	$	60,815
Short-term investments		319
Accounts receivable, net		16,862
Unbilled cost and fees		1,780
Inventories		9,980
Prepaid expenses		2,847
Deferred income taxes		4,182
Property and equipment		9,837
Goodwill		265,973
Intangible assets subject to amortization (8 year weighted average life)		117,277
Intangible assets not subject to amortization		13,520
Other assets		513

Total assets acquired		503,905

Accounts payable		9,022
Accrued salaries and commissions		9,905
Other accrued expenses		8,151
Other liabilities		3,187
Accrued income taxes		1,828
Deferred income taxes		53,885
Other current liabilities		1,945
Accrued warranty costs		3,423
Accrued restructuring costs		436

Total liabilities assumed		91,782

Net assets acquired	$	412,123

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 $166,765 of goodwill to the Embedded Security segment and $99,208 to the Enterprise Security segment. Of the $265,973 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 September 30, 2003 and the nine month periods ended September 30, 2004 and 2003,

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):


	Three Months Ended September 30,		Nine Months Ended September 30,
	2003		2004		2003
Revenues	$	52,826	$	165,979	$	152,277

Net income (loss)	$	1,170	$	430	$	(19,253	)

Income (loss) per common share — basic	$	0.08	$	0.02	$	(1.42	)

Income (loss) per common share — diluted	$	0.07	$	0.02	$	(1.42	)

The loss from discontinued operations during the three and nine months ended September 30, 2003 related to a discontinued business from the acquired Rainbow business, prior to the acquisition. The November 2003 acquisition of SSH would not have materially affected the reported results of operations for the nine months ended September 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 acquisitions 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 $6,290 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 nine months ended

September 30, 2004 of $1,585, which is included in the results of operations of the Enterprise division. As of September 30, 2004, the liability is classified as an unfavorable lease liability in the accompanying consolidated balance sheet, excluding the current portion of $1,225 that is included in other accrued expenses.

(6) INVENTORIES

Inventories consisted of the following:


	September 30,			December 31,
	2004			2003
Raw materials	$	5,024		$	2,158
Finished goods		5,034			2,240
Inventoried costs relating to long-term contracts, net of amounts attributable to revenues recognized to date		5,813			—

		15,871			4,398
Reserve for excess and obsolete inventory		(1,026	)		(1,275	)

	$	14,845		$	3,123

(7) PROPERTY AND EQUIPMENT

Property and equipment consisted of the following:


	September 30,			December 31,
	2004			2003
Furniture and equipment	$	11,934		$	7,442
Buildings		5,033			—
Computer software		2,985			2,501
Leasehold improvements		1,257			741

		21,209			10,684
Accumulated depreciation and amortization		(5,472	)		(6,875	)

	$	15,737		$	3,809

(8) GOODWILL

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


	Embedded			Enterprise
	Security			Security
	Division			Division			Total
Balance as of January 1, 2003	$	12,826		$	—		$	12,826
Goodwill recorded during the year:
Acquisition of Cylink		—			24,880			24,880
Acquisition of SSH		2,744			—			2,744
Foreign currency translation adjustments		2,535			—			2,535
Other adjustments		(19	)		(559	)		(578	)

Balance as of December 31, 2003		18,086			24,321			42,407
Goodwill recorded during the year:
Acquisition of Rainbow		166,765			99,208			265,973
Foreign currency translation adjustments		(301	)		—			(301	)
Other adjustments		253			(92	)		161

Balance as of September 30, 2004	$	184,803		$	123,437		$	308,240

(9) ACQUIRED INTANGIBLE ASSETS

Acquired intangible assets consisted of the following at September 30, 2004, of which $66,342 related to the Enterprise Security Division, and $97,182 related to the Embedded Security Division:


	Weighted							Net
	Average Useful		Gross Carrying		Accumulated			Carrying
	Life in Years		Amount		Amortization			Amount
Intangible assets subject to amortization:
Customer contracts / relationships		7.4	$	27,821	$	(5,530	)	$	22,291
Developed technology		8.2		98,847		(10,577	)		88,270
Patents		7.2		16,085		(3,766	)		12,319
Non-compete agreements		2.0		2,066		(1,722	)		344
Key account list		5.0		1,140		(124	)		1,016
Purchase orders and contract backlog		1.0		1,328		(1,328	)		—

Total		7.8		147,287		(23,047	)		124,240

Intangible assets not subject to amortization:
Domain names		N/A		2,717		—			2,717
Trademarks		N/A		13,520		—			13,520

Total acquired intangible assets			$	163,524	$	(23,047	)	$	140,477

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:


	Weighted		Gross					Net
	Average Useful		Carrying		Accumulated			Carrying
	Life in Years		Amount		Amortization			Amount
Intangible assets subject to amortization:
Customer contracts/relationships		3.4	$	10,947	$	(2,151	)	$	8,796
Developed technology		3.5		9,426		(2,469	)		6,957
Patents		3.2		6,385		(2,385	)		4,000
Non-compete agreements		2.0		2,066		(947	)		1,119
Purchase orders and contract backlog		1.0		1,328		(1,328	)		—

Total		2.9		30,152		(9,280	)		20,872

Intangible assets not subject to amortization:
Domain names		N/A		2,727		—			2,727

Total acquired intangible assets			$	32,879	$	(9,280	)	$	23,599

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


Remaining 2004	$	5,593
2005		21,425
2006		16,573
2007		15,743
2008		13,814
2009 and thereafter		51,092

(10) INCOME TAXES

The tax provisions for the three and nine month periods ended September 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 60% for the nine months ended September 30, 2004, which is the rate the Company anticipates for the full year ending December 31, 2004. 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 September 30, 2004 are $3,293 and $54,070, respectively. The deferred tax liabilities at September 30, 2004 include $46,873 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 international sales mainly to South America, Europe and Asia.

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


	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Revenue from external customers:
Embedded security	$	15,003		$	3,252		$	39,809		$	14,304
Enterprise security		44,447			14,133			98,002			33,155

Consolidated revenues	$	59,450		$	17,385		$	137,811		$	47,459

Significant non-cash items other than depreciation and amortization expense
Embedded security	$	669		$	—		$	1,450		$	6,330
Enterprise security		1,459			—			4,682			3,351

Consolidated significant non-cash items other than depreciation and amortization expense	$	2,128		$	—		$	6,132		$	9,681

Operating (loss) income:
Embedded security	$	(5,933	)	$	(1,115	)	$	(11,086	)	$	(7,802	)
Enterprise security		7,575			3,298			11,388			(1,396	)

Consolidated operating income (loss)	$	1,642		$	2,183		$	302		$	(9,198	)

(Loss) income before income taxes:
Embedded security	$	(1,771	)	$	(1,036	)	$	(6,574	)	$	(7,666	)
Enterprise security		4,238			3,426			8,925			(1,083	)

Consolidated income (loss) before income taxes	$	2,467		$	2,390		$	2,351		$	(8,749	)

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. Where the underlying assets can be specifically attributed to a segment, the related depreciation and amortization have been classified accordingly. The remaining depreciation is allocated based on a percentage of revenue.

Significant non-cash items excluding depreciation and amortization were comprised of $2,028 and $4,547 of unearned compensation for the three and nine months ended September 30, 2004, respectively, as well as $100 and $1,585 of restructuring charges for the three and nine months ended September 30, 2004, respectively. There were no restructuring charges for the three and nine months ended September 30, 2003. There were no unearned compensation charges in 2003. Non-cash items in 2003 were the write-off of in-process research and development projects from the 2003 Cylink and Raqia acquisitions.

(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.

For the three months ended September 30, 2004, a major U.S. government agency customer of the Enterprise Security Division accounted for 43% of the Company’s consolidated revenues. For the three months ended September 30, 2003, a major U.S. government agency customer of the Enterprise Security Division, accounted for 16% of the Company’s consolidated revenues.

For the nine months ended September 30, 2004, a major U.S. government agency customer of the Enterprise Security Division accounted for 41% of the Company’s consolidated revenues. For the nine months ended September 30, 2003, a commercial client of the Embedded Security Division accounted for 18% of the Company’s consolidated revenues and one U.S. government systems integrator customer of the Enterprise Security Division accounted for 13% of the Company’s consolidated revenues.

As of September 30, 2004, a major U.S. government agency customer of the Enterprise Security Division accounted for 28% of consolidated accounts receivable. As of September 30, 2003, we had no customers comprised 10% or greater of accounts receivable.

(13) INCOME (LOSS) PER SHARE


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2004		2003		2004		2003
Net income (loss)	$	996	$	1,821	$	947	$	(10,356	)

Weighted average common shares outstanding — basic		23,976		12,769		20,998		10,700
Effect of dilutive securities – options		582		777		688		—

Adjusted weighted average common shares outstanding — diluted		24,558		13,546		21,686		10,700

Basic net income (loss) per share	$	0.04	$	0.14	$	0.05	$	(0.97	)

Diluted net income (loss) per share	$	0.04	$	0.13	$	0.04	$	(0.97	)

For the nine months ended September 30, 2003 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 653 shares of the Company’s common stock as of September 30, 2003.

(14) SUBSEQUENT EVENTS

On September 9, 2004, the Company entered into an agreement to acquire Datakey Inc., (“Datakey”) pursuant to a cash tender offer to acquire all of the common stock of Datakey for $0.65 per share and all of the outstanding convertible preferred stock of Datakey for $2.50 per share. Upon the closing of the tender offer on October 26, 2004, the Company acquired approximately 8.8 million shares of Datakey’s common stock (including the associated preferred stock purchase and other rights), representing approximately 75% of Datakey’s outstanding common stock, and 150,000 shares of Datakey’s convertible preferred stock, representing all of Datakey’s outstanding convertible preferred stock. The Company will acquire the remaining common stock of Datakey in a merger pursuant to which all remaining shares of

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 Form 10-K for the year ended December 31, 2003. 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 because reasonably dependable estimates of the revenue and costs applicable to various stages of a contract can be made. Because 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.

In certain circumstances, we enter into “bill-and-hold” arrangements with our customers, under which our customer agrees to purchase our products, but we retain physical possession until our customer requests shipment to designated locations. Typically, we recognize revenue from the sale of our products on the date of delivery to customers assuming title has passed and all of the other basic criteria for revenue recognition have been met. However, the recognition of revenue under bill-and-hold transactions is a departure from this general policy and therefore requires that the underlying facts at the time the transaction is recorded are evaluated to support revenue recognition. All of the following conditions must be met before our bill-and-hold transactions are recorded as a sale: (1) the risks of ownership have passed to the customer; (2) the buyer must have made a fixed commitment to purchase the goods, as reflected in written documentation; (3) the customer must request that the transaction be on a bill-and-hold basis; (4) a fixed schedule for delivery of the goods must exist; (5) we have retained any specific performance obligations such that the earnings process is not complete; (6) the ordered goods have been segregated from our inventory and are not to be subject to being used to fill other orders; and, (7) the goods are complete and ready for shipment. If any of these criteria are not met, we will defer revenue recognition until they are all met.

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.

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, we completed the acquisition of Rainbow. Rainbow provided information security solutions for mission-critical data and applications used in business, organization and government computing environments. This merger with Rainbow has had and will continue to have a significant impact on our operations going forward.

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.

On September 9, 2004, we entered into an agreement to acquire Datakey pursuant to a cash tender offer to acquire all of the common stock of Datakey for $0.65 per share and all of the outstanding convertible preferred stock of Datakey for $2.50 per share. Upon the closing of the tender offer on October 26, 2004, the Company acquired approximately 8.8 million shares of Datakey’s common stock (including the associated preferred stock purchase and other rights), representing approximately 75% of Datakey’s outstanding common stock, and 150,000 shares of Datakey’s convertible preferred stock, representing all of Datakey’s outstanding convertible preferred stock. We will acquire the remaining common stock of Datakey in a merger pursuant to which all remaining shares of Datakey common stock that were not validly tendered and purchased in the tender offer, except those shares for which appraisal rights under applicable law have been properly exercised, will be converted into the right to receive $0.65 net per share in cash. We expect the merger to close during the fourth quarter of 2004. The aggregate consideration for acquiring the shares of Datakey will be approximately $8.0 million. In addition, on September 9, 2004, we loaned Datakey approximately $2.2 million to pay off certain convertible notes of Datakey. Datakey is a provider of token-based solutions that simplify enterprise-wide access and identity management. Its business will be integrated into our Enterprise Security Division.

RESULTS OF OPERATIONS

Three Months Ended September 30, 2004 Compared to Three Months Ended September 30, 2003

Revenues and Gross Margins


	Three Months Ended September 30,						Variance
	2004			2003			$			%
	(dollars in thousands)
Revenues by type
License and royalties	$	2,449		$	3,131		$	(682	)		(22	%)
Products		51,892			11,071			40,821			369	%
Service and maintenance		5,109			3,183			1,926			61	%

Total	$	59,450		$	17,385		$	42,065			242	%

Revenues by segment
Embedded Security Division	$	15,003		$	3,252		$	11,751			361	%
Enterprise Security Division		44,447			14,133			30,314			214	%

Total	$	59,450		$	17,385		$	42,065			242	%

Revenue mix by type
License and royalties		4	%		18	%		(14	%)
Products		87	%		64	%		23	%
Service and maintenance		9	%		18	%		(9	%)

Total		100	%		100	%		0	%

Revenue mix by segment
Embedded Security Division		25	%		19	%		6	%
Enterprise Security Division		75	%		81	%		(6	%)

Total		100	%		100	%		0	%

Gross margins by type
License and royalties		95	%		97	%		(2	%)
Products (1)		43	%		65	%		(22	%)
Service and maintenance		99	%		90	%		9	%

Total		50	%		75	%		(25	%)

Gross margins by segment
Embedded Security Division		57	%		77	%		(20	%)
Enterprise Security Division		47	%		75	%		(28	%)

Total		50	%		75	%		(25	%)

(1) Includes amortization of acquired intangible assets of $3.3 and $0.4 million for three months ended September 30, 2004 and 2003, respectively.

Revenues increased $42.1 million primarily due to the increased product revenue from our government and commercial businesses of $25.6 million, commercial business of $4.2 million as well as our rights management products of $11.0 million for the three months ended September 30, 2004. These increases in product revenue were due primarily to the acquisition of Rainbow. In addition, we experienced increased service and maintenance revenue from maintenance contracts acquired between October 2003 and September 2004. These contracts were not present for the three months ended September 30, 2003. The offset to these increases was the loss of some chip royalties earned for the three months ended September 30, 2003 of $0.5 million that were not repeated in the same period of 2004.

Revenue for the Embedded Security Division increased by $11.8 million for the three months ended September 30, 2004 over the three months ended September 30, 2003, due primarily to increased revenues of $11.0 million from the rights management products that were acquired in the Rainbow acquisition. Revenue for the Enterprise Security Division increased by $30.3 million for the three months ended September 30, 2004, over the three months ended September 30, 2003, due primarily to increased revenues of $29.8 million for product sales from products acquired in the Rainbow and SSH acquisitions that were not part of the Company’s revenue stream in the 2003 period.

The revenue mix by type has changed significantly as the Company’s acquisitions were product-based companies, particularly Rainbow Technologies with a 97% product and 3% service mix, historically. 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, appliances, and development. The revenue mix by segment should continue to be materially consistent with the most recent quarter, with the Embedded Security Division representing 25% to 30% of total revenues and the Enterprise Security Division representing the remainder.

Gross margins for each type of revenue fluctuated for the three months ended September 30, 2004 as compared to the three months ended September 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 40% of the consolidated revenues for the current period. The products and services comprising the remaining portion of the revenue base earn average margins from 70% to over 90%. The increase in service and maintenance margin was due to higher contract revenue versus repair revenue (which is a lower margin service).

The gross margins by segment are reflective of changes within each division. The Embedded Security Division’s gross margins as well as the Enterprise Security Division’s gross margins decreased because of the increase in product revenues over other revenue streams. Product revenues are much lower margin sales than service and maintenance, licenses, or royalties. Both divisions have become primarily product based business driving down 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.

Operating Expenses


	Three Months Ended September 30,				Variance
	2004		2003		$		%
	(dollars in thousands)
Operating expenses
Research and development	$	6,179	$	3,777	$	2,402		64	%
Sales and marketing		8,414		3,956		4,458		113	%
General and administrative		4,309		1,729		2,580		149	%
Restructuring charges		100		—		100		100	%
Cost of integration of acquired companies		4,573		138		4,435		3214	%
Amortization of acquired intangible assets		2,304		1,313		991		75	%
Amortization of unearned compensation		2,028		—		2,028		100	%

Total	$	27,907	$	10,913	$	16,994		156	%

Research and development expenses increased due to 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 September 30, 2003, the Company had only added personnel from Cylink and Raqia. As a percentage of revenue, research and development expenses have decreased from 22% to 10%. 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 September 30, 2003 to 14% 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 decreased from 10% for the three months ended September 30, 2003 to 7% for the same period in 2004.

Restructuring charges for the three months ended September 30, 2004 are related to a change in the estimates made related to properties acquired during the Cylink acquisition. There were no such costs in the same period in 2003.

Costs of integration of acquired companies were higher by $4.4 million from the three months ended September 30, 2004 compared to the same period in 2003. The costs for the 2003 period reflect integration and professional fees related to the Cylink acquisition. The costs in 2004 reflect Rainbow integration costs.

Amortization of intangible assets increased from $1.3 million for the three months ended September 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 expense to the Company throughout 2004 and future periods. See Note 9 of the consolidated financial statements as of and for the period ended September 30, 2004.

Amortization of unearned compensation is an expense specific to the Rainbow acquisition and reflects the amortization of the intrinsic 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


	Three Months Ended September 30,				Variance
	2004		2003		$		%
	(dollars in thousands)
Interest and other income, net	$	825	$	207	$	618		299	%

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

Income Tax Expense


	Three Months Ended September 30,				Variance
	2004		2003		$		%
	(dollars in thousands)
Income tax expense	$	1,471	$	569	$	902		159	%

The tax provisions for the three month periods ended September 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 60%. 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.

During the third quarter of fiscal year 2003, the Company estimated that the effective income tax rate for the year ended December 31, 2003 would be approximately (18.7%). This overall effective tax rate reflected the non-deductible write-off of in-process research and development costs related to the Cylink acquisition partially 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.

Nine Months ended September 30, 2004 Compared to Nine Months ended September 30, 2003

Revenues and Gross Margins


	Nine Months ended September 30,						Variance
	2004			2003			$			%
	(dollars in thousands)
Revenues by type
License and royalties	$	7,300		$	7,702		$	(402	)		(5	%)
Products		116,563			32,079			84,484			263	%
Service and maintenance		13,948			7,678			6,270			82	%

Total	$	137,811		$	47,459		$	90,352			190	%

Revenues by segment
Embedded Security Division	$	39,809		$	14,304		$	25,505			178	%
Enterprise Security Division		98,002			33,155			64,847			196	%

Total	$	137,811		$	47,459		$	90,352			190	%

Revenue mix by type
License and royalties		5	%		16	%		(11	%)
Products		85	%		68	%		17	%
Service and maintenance		10	%		16	%		(6	%)

Total		100	%		100	%		0	%

Revenue mix by segment
Embedded Security Division		29	%		30	%		(1	%)
Enterprise Security Division		71	%		70	%		1	%

Total		100	%		100	%		0	%

Gross margins by type
License and royalties		97	%		97	%		0	%
Products (1)		43	%		61	%		(18	%)
Service and maintenance		90	%		88	%		2	%

Total		51	%		71	%		(20	%)

Gross margins by segment
Embedded Security Division		61	%		66	%		(5	%)
Enterprise Security Division		46	%		74	%		(28	%)

Total		51	%		71	%		(20	%)

(1) Includes amortization of acquired intangible assets of $7.7 and $2.2 million for the nine months ended September 30, 2004 and 2003, respectively.

Revenues increased $90.4 million primarily due to increased product offerings that stemmed from acquisitions, primarily the Rainbow acquisition. Revenue from those product offerings accounted for $96.2 million of the increased revenue, including the related service and maintenance revenue. This was offset by a decrease in our OEM product revenue of about $7.7 million, which is due primarily to the decline in the Cisco business from the related period in 2003 compared to the same period 2004.

Revenue increases by segment for the nine months ended September 30, 2004 over the nine months ended September 30, 2003 are reflective of several factors. The Embedded Security Division added $28.1 million of revenue from product offerings acquired in business combinations during the nine months ended September 30, 2004 that were not available in 2003 as well as increased service and maintenance revenue of $2.0 million. This was offset by a decline in Cisco revenue of $7.7 million. Revenues earned by the Enterprise Security Division increased $64.8 million, due primarily to acquired product offerings offset by a decrease in our WAN and VPN product revenues of $4.2 million from the 2003 to 2004 period.

The revenue mix by type has changed significantly as the Company’s acquisitions were product-based companies, particularly Rainbow Technologies with a 97% product and 3% service mix, historically. 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, appliances, 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 nine months ended September 30, 2004 as compared to the nine months ended September 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 40% of the revenues for the current period. The products and services comprising the remaining portion of the revenue base earn average margins from 70% to over 90%.

Operating Expenses


	Nine Months Ended September 30,				Variance
	2004		2003		$			%
	(dollars in thousands)
Operating expenses
Research and development	$	17,180	$	11,182	$	5,998			54	%
Sales and marketing		19,723		10,835		8,888			82	%
General and administrative		12,300		4,852		7,448			154	%
Write-off of acquired in-process research and development costs		—		9,681		(9,681	)		(100	%)
Restructuring charges		1,585		—		1,585			100	%
Cost of integration of acquired companies		7,935		3,127		4,808			154	%
Amortization of acquired intangible assets		6,173		3,349		2,824			84	%
Amortization of unearned compensation		4,547		—		4,547			100	%

Total	$	69,443	$	43,026	$	26,417			61	%

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 nine months ended September 30, 2003, the Company had only added personnel from Cylink and Raqia. As a percentage of revenue, research and development expenses have decreased from 24% to 12%. 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 nine months ended September 30, 2003 to 14% for the same period in 2004. The decrease in the percentage of total revenue 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 were 10% for the nine months ended September 30, 2003 and 9% for the nine months ended September 30, 2004.

In 2003, the Company’s acquisitions of Cylink and the Raqia assets necessitated the write-off of in-process research and development costs totaling $9.7 million in the aggregate (Cylink-$3.3 million; Raqia-$6.4 million). There were no such charges in 2004 associated with the Rainbow acquisition.

The restructuring charges for the nine months ended September 30, 2004 of $1.6 million ($0 for the nine months ended September 30, 2003) represents an estimated liability related to the abandonment of one of our leased facilities. We have been able to consolidate leased facilities as we continue to integrate the businesses we acquired in 2003 and 2004. This restructuring charge may change during the remaining term of the lease as we update our estimates of likely sublease income.

Costs of integration of acquired companies increased $4.8 million from the nine months ended September 30, 2003 to the same period in 2004. 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. These costs will remain significant throughout 2004 as we continue to integrate people, systems, products and cultures into the combined company.

Amortization of intangible assets increased from $3.3 million for the nine months ended September 30, 2003 to $6.2 million for the same period in 2004. The amortization for the 2004 period includes amortization from multiple acquisitions including a full nine months of Cylink, Raqia, SSH and six and a half months of amortization related to the Rainbow acquisition. For the same period in 2003, amortization of intangible assets includes eight months of amortization related to the Cylink acquisition, seven months of amortization related to the Raqia acquisition and none related to the SSH or Rainbow acquisitions. This will continue to be a significant cost to the Company throughout 2004 and future periods. See Note 9 of the consolidated financial statements as of and for the period ended September 30, 2004.

Amortization of unearned compensation is a cost specific to the Rainbow acquisition. It reflects the amortization of the intrinsic 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


	Nine Months Ended September 30,				Variance
	2004		2003		$		%
	(dollars in thousands)
Interest and other income, net	$	2,049	$	449	$	1,600		356	%

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

Income Tax (Benefit) Expense


	Nine Months Ended September 30,				Variance
	2004		2003		$			%
	(dollars in thousands)
Income tax (benefit) expense	$	1,404	$	1,607	$	(203	)		(13%)

The tax provisions for the nine month periods ended September 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 60% for the nine months ended September 30, 2004, which is the rate the Company anticipates for the full year ending December 31, 2004. This 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.

acquisition partially 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.

Liquidity and Capital Resources

As of September 30, 2004, SafeNet had working capital of $182.3 million including unrestricted cash and short-term investments of $174.0 million and restricted cash of $4.5 million. SafeNet believes that its current cash resources and future cash flows from operations will be sufficient to meet its anticipated short-term and long-term needs.

For the nine month period ended September 30, 2004, compared to the same period in 2003, cash provided by operating activities increased by $3.2 million. Cash provided by investing activities increased $37.1 million, primarily due to cash received from the Rainbow acquisition of $54.2 million and the net effect of sales and purchases of securities, yielding a net usage of cash of $12.6 million. Cash provided by financing activities decreased by $86.4 million, which is mainly attributed to our July 2003 secondary stock offering which yielded net cash of $83.9 million. There was no such cash inflow in 2004.

Material recurring uses of working capital include salaries and other compensation, which accounted for approximately $11.4 million for the nine months ended September 30, 2004, sales and marketing expenses, which accounted for approximately $14.9 million for the nine months ended September 30, 2004, and research and development projects, which accounted for approximately $10.6 million for the nine months ended September 30, 2004.

We have expended, and will continue to expend, significant amounts of cash for acquisition and integration costs related to prior and future acquisitions. During the nine month period ended September 30, 2004, we spent $7.0 million for integration costs related to the Rainbow acquisition. We expect to incur costs associated with the acquisition, which may aggregate up to $12.0 million, related to professional fees such as legal, due diligence, professional integration advisory services and financial advisory fees. Additionally, we would expect that there may be additional cash obligations, including obligations related to severance for Rainbow employees and lease termination costs.

The following table sets forth, as of September 30, 2004, our commitments and contractual obligations for the years indicated (amounts in thousands):


			Less than		1-3		3-5		More than
	Total		One Year		Years		Years		5 Years
Operating leases (1)	$	24,838	$	5,720	$	8,052	$	6,843	$	4,223

SafeNet generally does not make unconditional, non-cancelable purchase commitments.

SafeNet enters into purchase orders in the normal course of business which are less than one year term.

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

Inflation and Seasonality

SafeNet does not believe that inflation will significantly impact its business. We do not believe our business is seasonal. However, because we generally recognize product revenues upon product shipment and software revenues upon meeting certain objective criteria in accordance with accounting principles generally accepted in the United States, recognition may be irregular and uneven, thereby disparately impacting quarterly operating results and balance sheet comparisons.

ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market Risk

Market risk is the risk of loss to future earnings, to fair values or to future cash flows that may result from changes in the price of financial instruments. SafeNet is exposed to financial market risks, primarily related to changes in foreign currency exchange rates. SafeNet currently does not have any derivative financial instruments to protect against adverse currency movements. SafeNet manages its exposure to market risks related to operations through regular operating and financing activities. All of the potential impacts noted below are based on a sensitivity analysis performed as of September 30, 2004. Actual results may differ materially.

Foreign Currency Risk

We are exposed to the fluctuations in foreign currency exchange rates. Such fluctuations impact the recorded values of our investments in foreign subsidiaries in our consolidated balance sheet, and our foreign currency translation adjustment, a component of other comprehensive income. For the nine months ended September 30, 2004, a 10% change in average exchange rates would have changed our reported currency translation adjustment of $0.07 million by approximately $0.2 million. For the nine months ended September 30, 2004, a 10% change in the average exchange rates would have changed the Company’s foreign currency transaction earnings by approximately $0.06 million.

Interest Rate Risk

We are exposed to investment risk to the extent we purchase short-term interest bearing investment securities, which are considered cash equivalents and short-term investments. For the nine months ended September 30, 2004, we had net interest income of approximately $1.3 million. A 10% change in the average interest rate for the nine months ended September 30, 2004 would have had a negligible effect on earnings.

At September 30, 2004 and December 31, 2003, SafeNet did not have any interest bearing obligations. In addition, SafeNet does not hold any derivative instruments and does not have any commodity market risk.

ITEM 4 – CONTROLS AND PROCEDURES

As of the end of the period ended September 30, 2004, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company required to be included in the Company’s periodic SEC filings. There have been no significant changes in the Company’s internal controls or in other factors which could significantly affect internal controls subsequent to the date the Company carried out its evaluation.

PART II

ITEM 1 – LEGAL PROCEEDINGS

The Company is not involved in any material pending legal proceedings, other than ordinary routine litigation incidental to the business and other nonmaterial proceedings, to which the Company or any of its subsidiaries is a party or of which any of their property is the subject.

ITEM 5 – OTHER INFORMATION

On September 1, 2004, the Company entered into a First Amendment to Employment Agreement with Anthony A. Caputo, its Chief Executive Officer (the “Caputo Amendment”). The Caputo Amendment extends the term of Mr. Caputo’s employment until September 1, 2011 and provides, among other things, the following:

• Mr. Caputo shall be entitled to annual incentive compensation of not less than 100% of his applicable base salary if the Company’s business objectives as set forth in its annual business plan and any other annual objectives specified by the Company’s compensation committee are achieved.

• Mr. Caputo shall be entitled to receive annual awards of stock options, or other equivalent long term compensation, as determined by the compensation committee, in order to provide him with total direct compensation that is competitive with CEO compensation levels at peer companies.

• The company will pay certain taxes payable by Mr. Caputo as a result of the $2 million dollar variable life insurance policy provided to Mr. Caputo by the Company.

• If the Company terminates Mr. Caputo’s employment without “cause” or if Mr. Caputo terminates for “good reason,” each as defined in Mr. Caputo’s employment agreement, he is entitled to salary and prorated incentive compensation and vacation accrued through the termination date plus the following: (i) his annual base salary in effect at the date of termination, multiplied by three; (ii) the amount of his target incentive compensation under the applicable executive bonus plan for the fiscal year in which the termination occurs, multiplied by three; and (iii) all unpaid premiums required to fully fund the $2 million variable life insurance policy. Additionally, all of the options granted to Mr. Caputo shall be fully vested and exercisable upon a “change in control,” as defined in the employment agreement, and termination of his employment.

• If Mr. Caputo is subject to an excise tax under Section 4999 of the Internal Revenue Code of 1986, as amended (the “Code”) with respect to the payments or distributions in the nature of compensation made to him by the Company in connection with a change in control, he will be entitled to receive an additional amount so as to place him in the same after-tax position he would have been in had the excise tax not applied.

The descriptions of the Caputo Amendment herein are qualified in their entirety by reference to the Caputo Amendment, which is filed as an exhibit to this Form 10-Q.

On June 28, 2004, the Company and Carole Argo entered into a five-year employment agreement (the “Argo Employment Agreement”). Pursuant to the terms of the Argo Employment Agreement, Ms. Argo is to receive an annual salary of $275,000, to be reviewed annually by the compensation committee. The Argo Employment Agreement further provides, among other things, the following:

• Ms. Argo shall be entitled to annual incentive compensation of not less than 100% of her applicable base salary if the Company’s business objectives as set forth in its annual business plan and any other annual objectives specified by the Company’s compensation committee are achieved.

• Ms. Argo was granted an incentive stock option award for 50,000 shares of the Company’s common stock.

• If the Company terminates Ms. Argo’s employment without “cause” or if Ms. Argo terminates for “good reason,” each as defined in the agreement, she is entitled to salary and target incentive compensation and vacation accrued through the termination date plus the lesser of (i) $550,000 or (ii) the balance of her compensation under the contract to the end of the agreement computed using the latest applicable salary rate.

• If Ms. Argo voluntarily terminates her employment without good reason, then she shall be entitled to receive salary, accrued vacation and six months severance pay.

• If Ms. Argo is subject to an excise tax under Section 4999 of the Internal Revenue Code of 1986, as amended (the “Code”) with respect to the payments or distributions in the nature of compensation made to her by the Company in connection with a change in control, she will be entitled to receive an additional amount so as to place her in the same after-tax position she would have been in had the excise tax not applied.

The descriptions of the Argo Employment Agreement herein are qualified in their entirety by reference to the Argo Employment Agreement, which is filed as an exhibit to this Form 10-Q.

On June 28, 2004, the Company and Kenneth Mueller entered into a five-year employment agreement (the “Mueller Employment Agreement”). Pursuant to the terms of the Mueller Employment Agreement, Mr. Mueller is to receive an annual salary of $275,000, to be reviewed annually by the compensation committee and increased at least 10% per annum. The Mueller Employment Agreement further provides, among other things, the following:

• Mr. Mueller shall be entitled to annual incentive compensation of not less than 50% of his applicable base salary if the Company’s business objectives as set forth in its annual business plan and any other annual objectives specified by the Company’s compensation committee are achieved.

• Mr. Mueller was granted an incentive stock option award for 100,000 shares of the Company’s common stock.

• If the Company terminates Mr. Mueller’s employment without “cause” or if Mr. Mueller terminates for “good reason,” each as defined in the agreement, he is entitled to salary and target incentive compensation and vacation accrued through the termination date plus the lesser of (i) $275,000 or (ii) the balance of his compensation under the contract to the end of the agreement computed using the latest applicable salary rate.

• If Mr. Mueller voluntarily terminates his employment without good reason, then he shall be entitled to receive salary, accrued vacation and six months severance pay.

• If Mr. Mueller is subject to an excise tax under Section 4999 of the Internal Revenue Code of 1986, as amended (the “Code”) with respect to the payments or distributions in the nature of compensation made to him by the Company in connection with a change in control, he will be entitled to receive an additional amount so as to place him in the same after-tax position he would have been in had the excise tax not applied.

The descriptions of the Mueller Employment Agreement herein are qualified in their entirety by reference to the Mueller Employment Agreement, which is filed as an exhibit to this Form 10-Q.

2.1		Agreement and Plan of Merger dated September 9, 2004 by and among the Registrant, Snowflake Acquisition Corp. and Datakey, Inc. I/B/R (1)

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 (2)

3.2		By-laws of Registrant, as amended and restated

10.1		Amendment to Employment Agreement between Anthony Caputo and the Company.

10.2		Employment Agreement between Carole Argo and the Company.

10.3		Employment Agreement between Kenneth Mueller and the Company.

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

(1)		Filed as an exhibit to the Schedule TO filed by the Registrant with the Securities and Exchange Commission on September 21, 2004 and incorporated herein by reference.

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

(b)

We filed Current Reports on Forms 8-K on July 29, 2004 under Items 7 and 12, August 4, 2004 under Items 7 and 12, September 15, 2004 under Item 1.01, and September 17, 2004 under Item 4.02.


	Page
PART I: FINANCIAL INFORMATION
Item 1: Financial Statements (Unaudited)
Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003		3
Consolidated Statements of Operations for the three and nine months ended September 30, 2004 and 2003		4
Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended September 30, 2004 and 2003		5
Consolidated Statements of Stockholders’ Equity for the nine months ended September 30, 2004		6
Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003		7
Notes to Consolidated Financial Statements - September 30, 2004		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		30
Item 4: Controls and Procedures		30
PART II: OTHER INFORMATION
Item 1: Legal Proceedings		31
Item 5: Other Information		31
Item 6: Exhibits and Reports on Form 8-K		33
SIGNATURES		34
EXHIBITS
31.1
31.2
32.1
32.2


		SAFENET INC.

November 9, 2004		/s/ Anthony A. Caputo


		ANTHONY A. CAPUTO

		Chairman and Chief Executive Officer

November 9, 2004		/s/ Ken Mueller


		KEN MUELLER

		Senior Vice President and Chief Financial Officer