UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2005

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 May 5, 2005, was 24,590,796.

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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)

See accompanying notes to consolidated financial statements.

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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.

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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
Three Months Ended March 31, 2005
(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
March 31, 2005

(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, 2004. The results of operations for the interim period are not necessarily indicative of results to be expected in future periods.

(2) BUSINESS

     SafeNet, Inc. (“SafeNet” or the “Company”) develops, markets, sells, and supports a portfolio of hardware and software information security products and services that protect and secure digital identities, communications and applications, offering both Original Equipment Manufacturer (“OEM”) technology and end-user products. The Company provides its network security solutions worldwide for financial, enterprise, telecommunications and government use. The Company’s technology is sold and licensed in various formats, including software, hardware, silicon chips, and intellectual property.

     In March 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. This merger with Rainbow has had and will continue to have a significant impact on operations going forward.

     In December 2004, the Company completed its acquisition of Datakey, Inc., which expanded the customer base and product offerings to include token-based solutions that simplify enterprise-wide access and identity management.

(3) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Revenue Recognition

     The Company derives revenue from software and technology licenses, product sales, maintenance (post-contract customer support), and services. Software and technology licenses typically contain multiple elements, including the product license, maintenance, and/or other services. The Company allocates the total arrangement fee among each deliverable based on the fair value of each of the deliverables determined based on vendor-specific objective evidence.

License and Royalties

     License revenue is comprised of perpetual and time-based license fees, which are derived from arrangements with end-users, original equipment manufacturers and resellers. For each license arrangement, the Company defers revenue recognition until: (a) persuasive evidence of an arrangement exists; (b) delivery

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of the software or technology has occurred and there are no remaining obligations or substantive customer acceptance provisions; (c) the fee is fixed or determinable; and (d) collection of the fee is probable. For both perpetual and time-based licenses, once all of these conditions are satisfied, the Company recognizes license revenue based on the residual method after all elements other than maintenance have been delivered as prescribed by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions. Royalties are recognized as they are earned.

     Revenues that are earned under long-term contracts to develop high assurance encryption technology are recognized using contract accounting. Under contract accounting, revenue from these arrangements is recognized using the percentage-of-completion method. Progress to completion is measured using contract milestones. Management considers contract milestones to be the best available measure of progress on these contracts since each milestone contains customer-specified acceptance criteria. Any estimated losses are provided for in their entirety in the period they are first determined. Actual remaining costs under fixed price contracts could vary significantly from the Company’s estimates, and such differences could be material to the financial statements.

Products

     The Company also sells hardware and related encryption products. For each product sale, the Company defers revenue recognition until: (a) persuasive evidence of an arrangement exists; (b) delivery has occurred and there are no remaining obligations or substantive customer acceptance provisions; (c) the selling price to the customer is fixed or determinable; and (d) collectibility of the selling price is reasonably assured.

     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, cost-plus-fee type contracts, and customized development 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.

Maintenance and Other Services

     Maintenance revenue is derived from support arrangements. Maintenance arrangements provide technical customer support and the right to unspecified upgrades on an if-and-when-available basis. In accordance with SOP 97-2, Software Revenue Recognition, vendor specific objective evidence of fair value of maintenance is determined based on the price charged for the maintenance element when sold separately. The maintenance term is typically one year in duration and maintenance revenue is recognized ratably over the maintenance term. Unrecognized maintenance fees are included in deferred revenue.

     Other service revenue is comprised of revenue from consulting fees and training. Service revenue is recognized when the services are provided to the customer. The Company’s policy is to recognize software license revenue when these associated services are not essential to the functionality of the product. To date, these services have not been essential to the functionality of the products. Vendor specific objective evidence of fair value of these services is determined by reference to the price that a customer will be required to pay when the services are sold separately, which is based on the price history that the Company has developed for separate sales of these services.

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Shipping and Handling Costs

     All shipping and handling costs incurred in connection with the sale of products to customers is included in cost of product revenues.

Use of Estimates

     The Company regularly reviews its estimates related to ongoing long term development contracts. For the three months ended March 31, 2005, revisions to these estimates resulted in an increase in net income of approximately $0.5 million or $0.02 per diluted share.

Product Warranties

     The changes in the carrying amount of accrued warranty costs from December 31, 2004 to March 31, 2005 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 March 31, 2005, 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.

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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 three months ended March 31, 2005, the Company did not grant options to the Board of Directors and granted 156 options to employees.

Reclassifications

     Where appropriate, certain amounts in the prior year consolidated financial statements have been reclassified to conform to the 2005 presentation.

     On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The Company expects to adopt Statement 123(R) on January 1, 2006.

     As permitted by Statement 123, the Company currently accounts for share-based payments to employees using Opinion 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of Statement 123(R)’s fair value method could have a significant impact on our results of operations, although it will have no impact on our overall financial position. The impact of adoption of Statement 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future as well as the option pricing model that is selected by

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the Company. However, had we adopted Statement 123(R) in prior periods and utilized the Black-Scholes option pricing model, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net loss and loss per share disclosed above. Statement 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. Statement 123(R) allows for either a modified retrospective or modified prospective method of adoption. The Company is currently evaluating each method and assessing the potential impact of each.

(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 for an aggregate purchase price of $412,225. 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.

DataKey, Inc.

On December 15, 2004, SafeNet, Inc. completed the merger of Snowflake Acquisition Corp., a Minnesota corporation and wholly-owned subsidiary of SafeNet, with and into Datakey, Inc., a Minnesota corporation, pursuant to the terms and conditions of the Agreement and Plan of Merger dated September 9, 2004 by and among SafeNet, Datakey, and Snowflake Acquisition Corp. As a result of the merger, Datakey has become a wholly-owned subsidiary of SafeNet and 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, have been converted into the right to receive $0.65 net per share in cash. The aggregate purchase price was $11,505. The Company is finalizing its estimates of the direct costs of the acquisition, and thus, the allocation of the purchase price is subject to refinement, although any modifications are not expected to be material.

     The following unaudited consolidated pro forma results of operations of the Company for the three month period ended March 31, 2004, gives effect to the March 15, 2004 acquisition of Rainbow and the December 15, 2004 acquisition of Datakey as though they had both occurred on January 1, 2004 (in thousands, except per share amounts):

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(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 then remaining unfavorable lease liability of $4,805 recorded by the Company for this property in connection with Cylink purchase accounting, yielding a net charge during the period of $1,485 which is included in the results of operations of the Enterprise division. As of March 31, 2005, the liability is classified as an unfavorable lease liability in the accompanying consolidated balance sheet, including the current portion of $1,052 that is included in other accrued expenses. There were no such restructuring charges for the three months ending March 31, 2005.

(6) INVENTORIES

     Inventories consisted of the following:

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(7) PROPERTY AND EQUIPMENT

     Property and equipment consisted of the following:

(8) GOODWILL

     The changes in the carrying amount of goodwill for the three month period ended March 31, 2005 are as follows:

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(9) ACQUIRED INTANGIBLE ASSETS

     Acquired intangible assets consisted of the following at March 31, 2005, of which $49,574 related to the Enterprise Security Division, and $83,942 related to the Embedded Security Division:

     The estimated amortization expense for each of the fiscal years subsequent to December 31, 2004 is as follows:

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(10) INCOME TAXES

     The tax provisions for the three months ended March 31, 2005 and 2004 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 was 36% for the three months ended March 31, 2005, which is the rate the Company anticipates for the full year ending December 31, 2005. 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.

     Significant components of the Company’s income tax (benefit) expense from continuing operations for the three month periods ended March 31 are as follows:

     Deferred tax assets, net of valuation allowance, and deferred tax liabilities as of March 31, 2005 are $9,694 and $48,872, respectively. The deferred tax liabilities at March 31, 2005 include $46,032 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.

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     The following table sets forth information about the Company’s reportable segments for the three months ended March 31, 2005 and 2004:

     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 $1,454 of amortization of unearned compensation for the three months ended March 31, 2005. Significant non-cash items excluding depreciation and amortization were comprised of $1,485 of restructuring charges and $361 of amortization of unearned compensation for the three months ended March 31, 2004. There were no restructuring charges for the three months ended March 31, 2005.

(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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     As of March 31, no customers comprised 10% or greater of consolidated accounts receivable. As of December 31, 2004 one client of the Enterprise Security Division accounted for 22% of consolidated accounts receivable.

     For the three months ended March 31, 2005, one customer of the Enterprise Security Division accounted for 39% of the Company’s consolidated revenues. For the three months ended March 31, 2004, one customer of the Enterprise Security Division, accounted for 22% of the Company’s consolidated revenues.

(13) INCOME (LOSS) PER SHARE

     For the three months ended March 31, 2004, 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 809 shares of the Company’s common stock as of March 31, 2004, respectively.

(14) SUBSEQUENT EVENTS

     On April 4, 2005, the Company completed the acquisition of DMDsecure.com B.V., (“DMD”), a global leader in digital rights management (DRM) software. The acquisition will expand SafeNet’s DRM business growth into the electronic content protection market. Under the terms of the definitive purchase agreement, SafeNet will pay cash consideration of 7.5 million euros with additional cash consideration pursuant to an earn out schedule based on performance thresholds.

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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 Form 10-K for the year ended December 31, 2004. 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 and technology arrangements 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 2004 Annual Report on Form 10-K.

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Overview

     We develop, market, sell, and support a portfolio of hardware and software information security products and services that protect and secure digital identities, communications, and applications. Our products and services are used to create secure wide area networks (WANs) including ATM, Frame, Link, and SONET, virtual private networks over the Internet (VPNs), wireless networks, security management, intrusion prevention, software anti-piracy and revenue protection, and identity management to prevent security breaches that could result in unauthorized access to confidential data, invasion of privacy and financial loss. Our information security solutions allow our customers to lower the cost of deploying and managing secure, reliable private networks and enable the use of the Internet and wireless networks for secure business communications and transactions with customers, suppliers, and employees.

     Our products are based on industry standard encryption algorithms and communication protocols that allow for integration into large networks and interoperability with other market-leading network devices and applications. Our solutions incorporate our security technologies, including our silicon chips, smart cards, USB tokens, network appliances, client software, and management software, to provide a vertically integrated solution that addresses the stringent security needs of our customers. Our products enable our customers to expand their existing networks efficiently and to integrate these networks with lower-cost VPNs. Our security products are centrally managed with our management software, which enables policy management and the secure, scalable monitoring of network devices, applications, network traffic, and security events.

     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.

     On March 15, 2004, we completed the acquisition of Rainbow Technologies, Inc. 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.

     On December 15, 2004, we completed the acquisition of Datakey, Inc., which expanded our customer base and product offerings to include token-based solutions that simplify enterprise-wide access and identity management. Operations of Datakey are in the process of being integrated into our Enterprise Security Division.

     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 March 31, 2005 Compared to Three Months Ended March 31, 2004

Revenues and Gross Margins

(1) Includes amortization of acquired intangible assets of $3,491 and $1,129 for three months ended March 31, 2005 and 2004, respectively. Also, amortization of unearned compensation of $110 and $30 is included for the three months ended March 31, 2005 and 2004, respectively.

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     Revenues increased $35.8 million primarily due to the increased product revenue from our government business of $16.6 million, and our rights management products of $8.9 million for the three months ended March 31, 2005. These increases in product revenue were due primarily to the acquisition of Rainbow. In addition, we experienced increased revenues from license and royalties and increased service and maintenance revenue, related to increased product offerings attributable to acquisitions.

     Revenue for the Embedded Security Division increased by $7.9 million for the three months ended March 31, 2005 over the three months ended March 31, 2004, due primarily to increased revenues from the rights management products that were acquired in the Rainbow acquisition. Revenue for the Enterprise Security Division increased by $27.9 million for the three months ended March 31, 2005, over the three months ended March 31, 2004, due primarily to increased revenues of $16.6 million for product sales from the government business, and $3.4 million increase in other product revenue acquired in the Rainbow acquisition that closed on March 15, 2004.

     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 other developed technolgies. 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 March 31, 2005 as compared to the three months ended March 31, 2004. The fluctuation in product margin was due to the secure communications business, which carries margins in the 20% to 25% range and represents approximately 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 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.

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Operating Expenses

     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 primarily through acquisitions with some increase relating to additional hires. For the three months ended March 31, 2004, the Company had only added personnel from a few smaller acquisitions. As a percentage of revenue, research and development expenses have decreased from 20% to 14%. 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 17.5% for the three months ended March 31, 2004 to 15.9% for the same period in 2005. The decrease in the percentage of total sales was expected as the Company continues to leverage its product offerings and global sales force for increased demand and new market opportunities.

     General and administrative expenses increased due to additional legal and professional fees related to a larger global presence and additional costs relating to ongoing compliance efforts with the provisions of the Sarbanes-Oxley Act of 2002, as well as increased headcount. As a percentage of revenue, general and administrative expenses decreased from 11.4% for the three months ended March 31, 2004 to 8.7% for the same period in 2005.

     Restructuring charges for the three months ended March 31, 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 2005.

     Costs of integration of acquired companies were higher by $2.7 million during the three months ended March 31, 2005 compared to the same period in 2004. The costs for the 2004 period reflect initial integration and professional fees related to the Rainbow acquisition. The costs in 2005 reflect the ending portion of integration costs related to the Rainbow acquisition.

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     Amortization of intangible assets increased from $1.5 million for the three months ended March 31, 2004 to $2.3 million for the same period in 2005. The amortization for the 2004 period primarily includes amortization from multiple acquisitions — Cylink, Raqia, and SSH. For the same period in 2005, amortization of intangible assets included those same acquisitions plus the addition of Rainbow and Datakey. This will continue to be a significant expense to the Company throughout 2005 and future periods. See Note 9 of the consolidated financial statements as of and for the period ended March 31, 2005.

     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.

Interest and Other Income, Net

     The increase in interest and other income is due primarily to increased cash and investment balances that increased interest earned over the prior period.

Income Tax Expense

     The tax provisions for the three month periods ended March 31, 2005 and 2004 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, 2005 will be approximately 36%. 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.

     The effective tax rate for the three month periods ended March 31, 2005 and 2004 are 36% and 54%, respectively. The effective rate decreased as a result of lower non-deductible acquisition related expenses relative to pre-tax earnings in addition to an increase in pre-tax earnings generated in foreign tax jurisdictions with lower associated tax rates.

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Liquidity and Capital Resources

     As of March 31, 2005, SafeNet had working capital of $208.0 million including unrestricted cash and short-term investments of $173.1 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 three month period ended March 31, 2005, compared to the same period in 2004, cash provided by operating activities increased by approximately $9.6 million. Cash from investing activities decreased by $54.9 million, primarily due to cash received from the Rainbow acquisition in 2004 of $60.3 million and the net effect of sales and purchases of securities, yielding a net usage of cash of $5.5 million. Cash provided by financing activities increased by $0.3 million, which is mainly attributed to the proceeds from stock options exercised under the Employee Stock Purchase Plans.

     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 three month period ended March 31, 2005, we spent $3.3 million for integration costs related to the Rainbow and Datakey acquisitions. We expect to continue to incur costs associated with the acquisitions. These costs relate to professional fees such as legal, due diligence, professional integration advisory services, financial advisory fees and other non-recurring costs of integrating companies. Additionally, we would expect that there may be additional cash obligations, including obligations resulting from future acquisitions that we may pursue.

     The following table sets forth, as of March 31, 2005, our commitments and contractual obligations for the years indicated (amounts in thousands):

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.

(2) The Company has a supply agreement with approximately 6,800 units remaining to be purchased by June, 2006. The financial obligation is approximately $5.4 million; however we can cancel on a 30 day notice and be obligated only for cost incurred. The contract and the need for the items on the contract are currently being evaluated for termination.

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.

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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 March 31, 2005. 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 three months ended March 31, 2005, a 10% change in average exchange rates would have changed our reported currency translation adjustment of $3.2 million by approximately $0.2 million. For the three months ended March 31, 2005, a 10% change in average exchange rates would have changed the Company’s foreign currency transaction earnings by approximately $0.1 million. We manage our exposure to market risks related to operations through regular operating and financing activities. All of the potential impacts noted above are based on a sensitivity analysis performed as of March 31, 2005. Actual results may differ materially.

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 three months ended March 31, 2005, we had net interest income of approximately $0.5 million. A 10% change in the average interest rate for the three months ended March 31, 2005 would have had a negligible effect on earnings.

     At March 31, 2005 and December 31, 2004, 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 March 31, 2005, 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 were no changes in our internal controls over financial reporting during the first quarter of 2005 that materially affected or are reasonably likely to materially affect our internal controls over financial reporting.

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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 2 — UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

     None.

ITEM 3 — DEFAULTS UPON SENIOR SECURITIES

     None.

ITEM 4 — SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     None.

ITEM 5 — OTHER INFORMATION

     None.

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ITEM 6 – EXHIBITS

Exhibits required by Item 601 of Regulation S-K:

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

	(1)	Filed as an exhibit to the Form 10-Q for the quarterly period ended June 30, 2002 and incorporated herein by reference.
	(2)	Filed as an exhibit to the Form 10-Q for the quarterly period ended September 30, 2004 and incorporated herein by reference.

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SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on behalf of the undersigned, thereunto duly authorized.

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