Form 10-Q

(Mark One)

For the quarterly period ended March 31, 2004

OR

[  ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 000-25120

RSA Security Inc.

174 Middlesex Turnpike
Bedford, Massachusetts 01730
(Address of Principal Executive Offices)

Registrant’s Telephone Number, Including Area Code: (781) 515-5000

Indicate by 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 12 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 [  ]

As of April 22, 2004, there were outstanding 61,760,258 shares of the Registrant’s Common Stock, $0.01 par value per share.

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

RSA SECURITY INC.
FORM 10-Q
For the Quarter Ended March 31, 2004

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

RSA SECURITY INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In thousands, except share data)

See notes to condensed consolidated financial statements.

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RSA SECURITY INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
(In thousands, except per share data)

See notes to condensed consolidated financial statements.

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RSA SECURITY INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)

Cash payments for income taxes were $361 and $316 for the three months ended March 31, 2004 and 2003, respectively.
Cash payments for interest expense were $2,873 for the three months ended March 31, 2004 and 2003.

See notes to condensed consolidated financial statements.

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RSA SECURITY INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands, except share and per share data)

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include the accounts of RSA Security Inc. and its wholly owned subsidiaries and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements and should be read in conjunction with the audited consolidated financial statements included in our Annual Report on Form 10-K filed for the year ended December 31, 2003.

In the opinion of our management, the accompanying unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements, and reflect all adjustments of a normal recurring nature considered necessary to present fairly results of the interim periods presented. The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year. We have reclassified certain prior period amounts to conform to the current period presentation.

Use of Estimates – The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires our management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. Our actual results could differ from those estimates.

Cash Equivalents – All highly liquid investments purchased with a remaining maturity of three months or less are considered cash equivalents.

Marketable Securities – Marketable securities are classified as “available for sale” and recorded at market using the specific identification method. Unrealized gains and losses are included in accumulated other comprehensive income, net of tax effects. Realized gains are determined based on the specific identified cost of the securities.

Revenue Recognition – Revenue is recognized when earned. Our revenue recognition policies are in compliance with all applicable accounting principles generally accepted in the United States of America, including the American Institute of Certified Public Accountants Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” and SOP 98-9, “Modification of SOP 97-2 With Respect to Certain Transactions.” We recognize revenue from the sale of products when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is considered probable. We recognize revenue from licensing other intellectual property when evidence of an arrangement exists, the fee is fixed or determinable and collection is considered probable. We reduce revenue by provisions for estimated returns. When arrangements contain multiple elements and vendor specific objective evidence of fair value exists for all undelivered elements, we recognize revenue for the delivered elements using the residual method. For arrangements containing multiple elements where vendor specific objective evidence of fair value does not exist for all undelivered elements, we defer revenue for the delivered and undelivered elements until vendor specific objective evidence of fair value exists or all elements have been delivered. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 48, “Revenue Recognition when Right of Return Exists,” we recognize revenue upon shipment of product to our stocking distributors, net of estimated returns. We defer maintenance services revenue, whether sold separately or as part of a multiple element arrangement, and recognize it ratably over the term of the maintenance contract, generally twelve months.

Some of our arrangements contain bundled products which include a term software license, an RSA SecurID® authenticator and support for the term of the license. As these arrangements contain multiple elements where vendor specific objective evidence of fair value does not exist for all undelivered elements, we record these arrangements as deferred revenue and recognize revenue ratably on a monthly basis over the term of the license agreement.

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For arrangements that contain an initial prepaid license fee with the payment of ongoing royalties, we recognize revenue on the initial prepaid license fee when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collection is considered probable. We recognize the ongoing royalties at the time we can make a reliable estimate of the actual usage that has occurred, provided collection is probable. Annual license fees or one time license fee arrangements typically contain non-refundable terms; therefore we recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collection is considered probable.

We recognize revenue allocated to professional service elements as the services are performed. When customization is essential to the functionality of the licensed software, then both the software license and professional services revenue are recognized under the percentage of completion method, which requires revenue to be recognized as a percentage of the project completed. We recognize revenue and gross profit using labor hours as an input measure of progress to completion on these arrangements.

Allowance for Sales Returns – We record allowances for estimated sales returns and allowances on products and maintenance and professional service revenue in the same period as we record the related revenue. We base these estimates on historical sales returns, analysis of credit memo data, current economic trends, product line and customer industry and other known factors.

Allowance for Doubtful Accounts – We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We analyze accounts receivable and the composition of the accounts receivable aging, historical bad debts, customer creditworthiness, current economic trends, foreign currency exchange rate fluctuations, and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Bad debt expense, if any, is included in marketing and selling expenses in the condensed consolidated statements of income. The allowance for doubtful accounts is included in accounts receivable in the condensed consolidated balance sheets and was as follows:

Allowance for Warranty Obligations – Our standard practice is to provide a warranty on all RSA SecurID hardware authenticators for the customer selected programmed life of the authenticator (generally three to five years) and to replace any defective authenticators (other than authenticators damaged by a user’s abuse or alteration) free of charge. We sell our other products to customers with a warranty for product defects for a specified period, generally ninety days. Reserves are provided for warranty expenses based upon historical experience and estimates of future liabilities. We provide reserves for warranty obligations based on historical failure and defective return rates and include these costs as a component of product cost of revenue. We reevaluate the estimate of warranty and defective return obligations, including the assumptions about estimated failure and return rates, each quarter.

During 2002 and 2003, our quarterly analysis of historical failure and defective return rates indicated that certain authenticators produced between 2000 and 2002 were subject to higher defect and failure rates. We increased our provisions for warranty expense accordingly. We will continue to monitor warranty claims and reevaluate our estimate of warranty and defective return obligations in future periods, which may result in our recording additional warranty expense.

We monitor warranty claims and address defects through our quality and design processes, which are managed by our product engineering, quality control and technical support organizations. During the last several years, we have increased resources and initiated new programs to build an expanded family of high performance authentication solutions. These programs have resulted in the redesign and re-engineering of authenticator products to improve performance and reliability by incorporating new microprocessors, electronics, firmware and batteries with longer life.

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Accrued warranty reserve is included in accrued expenses and other liabilities in the condensed consolidated balance sheet and was as follows:

Financial Instruments — The carrying amounts of cash and cash equivalents, marketable securities, accounts receivable and accounts payable approximate fair value due to the short-term nature of these instruments. The carrying value of the convertible debentures is the principal balance of the debentures outstanding less the fair value of the warrants outstanding, net of accumulated accretion of the warrants’ fair value. We believe the carrying value of the convertible debentures approximates their fair value.

We account for our investment in Crosby Finance, LLC (“Crosby”) under Emerging Issues Task Force (“EITF”) Issue No. 96-12, “Recognition of Interest Income and Balance Sheet Classification of Structured Notes.” We are carrying our interest in Crosby at fair value with all changes in fair value included in income (loss) from investing activities in the consolidated statements of income. We determine the fair value based on the fair value of Crosby’s right to potentially receive additional cash proceeds under a variable delivery forward contract that Crosby holds.

Investments where ownership is less than 20% and we do not have significant influence on the operating or financial decisions of the investee are accounted for using the cost method. The carrying value of investments is equal to cost less investment valuation impairment charges. We regularly consider available evidence in evaluating our investments for potential impairment. Certain events, such as an initial public offering, could result in the reclassification of an investment to an available for sale marketable security.

Impairment of Long-lived Assets - We test long-lived assets for recoverability whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. The recoverability of long-lived assets is assessed by comparing the undiscounted cash flows expected to be generated to the carrying value of the assets. If the sum of the undiscounted cash flows is less than the carrying value of the assets, we recognize an impairment charge. The amount of an impairment charge is determined by comparing the carrying amount of the long-lived asset to its fair value. Fair value is determined based on estimated discounted cash flows.

Income Taxes - We provide for income taxes for interim periods based on the estimated effective tax rate for the full year. We record cumulative adjustments to tax provisions in the interim period in which a change in the estimated annual effective rate is determined.

Earnings Per Share — We compute basic earnings per share using the weighted average number of common shares outstanding. We compute diluted earnings per share using the weighted average number of common shares outstanding plus the effect of potential outstanding shares, including options and warrants, using the “treasury stock” method. Diluted loss per share excludes the effect of equity instruments including convertible debentures, options and warrants, as such instruments are antidilutive.

Concentration of Credit Risk — We provide e-security solutions to various customers in diverse industries. We perform ongoing credit evaluations of our customers and maintain allowances for potential credit losses. We had two significant customers who are resellers, which accounted for approximately 23% and 21% of total accounts receivable as of March 31, 2004 and December 31, 2003, respectively.

Stock-Based Compensation Plans - We account for stock-based compensation cost using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, no accounting recognition is given to stock options granted at fair market value until they are exercised. Upon exercise, net proceeds, including the tax benefits realized, if any, are credited to shareholders’ equity.

Stock-Based Compensation Plans Pro Forma Disclosure — Had we recognized compensation expense for our stock option and purchase plans based on the fair value for awards under our plans in accordance with SFAS No. 123, “Accounting for Stock Based Compensation,” pro forma net loss and pro forma net loss per share would have been as follows:

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We estimate the fair values used to compute pro forma net loss and pro forma net loss per share as the fair value at grant date using the Black-Scholes option-pricing model with the following weighted average assumptions:

New Accounting Pronouncements Adopted — Interpretation No. 46 — In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, “Consolidation of Variable Interest Entities,” which was revised by FIN 46R issued in December 2003 (“FIN 46”). This interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” addresses consolidation by business enterprises of variable interest entities (“VIE”) that either: do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or for which the equity investors lack an essential characteristic of a controlling financial interest. FIN 46 also sets forth certain disclosure requirements regarding interests in VIE that are deemed significant, even if consolidation is not required. FIN 46 applies to interim periods ending after March 15, 2004. The adoption of FIN 46 did not require the consolidation of our investment in Crosby and therefore did not have a significant impact on our consolidated financial position or results of operations.

2. Investments and Financial Instruments

Our marketable securities were as follows:

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(Loss) income from investing activities includes the following (losses) gains:

We hold a 99% interest in Crosby Finance, LLC, a bankruptcy-remote, qualified special purpose entity, established specifically to securitize shares of VeriSign, Inc. (“VeriSign”) common stock. At March 31, 2004, Crosby held 2,027,325 shares of VeriSign common stock and a variable delivery forward contract (“VDF”). The VDF contract entitles Crosby to receive cash proceeds of up to $35,336 if the market price of VeriSign common stock on January 3, 2006 is at least $87.16. The closing price of VeriSign’s common stock on The NASDAQ National Market on March 31, 2004 was $16.59 per share.

The carrying amount of our 99% interest in Crosby was $89 and $208 at March 31, 2004 and December 31, 2003, respectively, and is included in other assets on the condensed consolidated balance sheets. We are carrying our interest at fair value with all changes in fair value reported in income from investing activities in the condensed consolidated statements of income. We determine the fair value of our interest in Crosby based on the fair value of Crosby’s right to potentially receive additional cash proceeds upon maturity of the VDF.

Crosby has no liability or obligation to its members or to the counterparty to the VDF contract other than to deliver the shares of VeriSign common stock to the counterparty upon maturity of the VDF contract and to distribute the cash proceeds, if any, to its members. After settlement of the VDF in January 2006, Crosby will dissolve.

3. Comprehensive Income

Comprehensive income was as follows:

The tax effects of unrealized holding gains on marketable securities were $8 for the three months ended March 31, 2004.

4. Earnings Per Share

Equity instruments that were considered antidilutive and therefore were not included in the computation of diluted earnings per share include the following shares of our common stock:

5. Restructurings

During 2002 and 2001, we evaluated and initiated restructuring actions in order to consolidate some of our operations, enhance operational efficiency and reduce expenses. These actions resulted in total restructuring charges of $56,036 and $19,956 for the years ended December 31, 2002 and 2001, respectively. We continue to monitor and assess our facility obligations, the real estate market and our operating expenses. Restructuring charges were zero for the three months ended March 31, 2004 and 2003.

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Restructuring charges recorded during 2002 and 2001 consist of facility exit costs, costs associated with the sale and liquidation of our Swedish development operations, and severance and other costs associated with the reduction of employee headcount.

Restructuring charges accrued and unpaid at March 31, 2004 were as follows:

We expect to pay the remaining restructuring costs accrued at March 31, 2004 as follows:

6. Segments

We have one reportable segment, e-Security Solutions. The operations of the e-Security Solutions segment consist of the sale of software licenses, hardware, maintenance and professional services through two product groups, Enterprise solutions and Developer solutions. Enterprise solutions include sales of RSA SecurID® authenticators, RSA ACE/Server® software, RSA Keon® software, RSA ClearTrust® software, and maintenance and professional services associated with these products. Developer solutions include sales of RSA BSAFE® encryption software and protocol products, RSA Keon components, and maintenance and professional services associated with these products. The segment was determined primarily on how management views and evaluates our operations.

Our operations are conducted throughout the world. Operations in the United States represent approximately 56% of revenue. Our operations in other countries have been grouped by regional area below. The following tables present information about e-Security Solutions revenue:

Except for Tech Data Corporation (a reseller), no single customer accounted for more than 10% of our total revenue for the three months ended March 31, 2004 and 2003. Revenue from Tech Data Corporation accounted for 10.6% of total revenue for the three months ended March 31, 2004. During 2003, Tech Data Corporation merged with Azlan Group Plc (also a reseller). Had this merger been completed as of January 1, 2003, revenue from the combined entity, on a pro forma basis, would have accounted for 10.8% of our total revenue for the three months ended March 31, 2003.

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The tables below present information about our long lived assets by region:

7. Litigation

On or about February 2, 2001, Leon Stambler filed a complaint for patent infringement in U.S. District Court for the District of Delaware against RSA Security, VeriSign, Inc., First Data Corporation, Openwave Systems Inc., and Omnisky Corporation, Case Number 01-0065. In his complaint, Mr. Stambler alleged that certain products marketed by each of the defendants infringed various patents that he owns, and he sought unspecified damages as well as a preliminary and permanent injunction enjoining the defendants from infringing the claims asserted. The trial took place in March 2003, and the jury determined that our products did not infringe Mr. Stambler’s patents. On April 17, 2003, the court entered final judgment in our favor on all claims of non-infringement. On or about December 8, 2003, Mr. Stambler filed a notice of appeal to the United States Court of Appeals. We plan to vigorously defend the appeal, and we believe that the final disposition of this matter will not have a material adverse effect on our continuing operations and consolidated financial position.

On or about December 20, 2001, France Telecom and Telediffusion de France (“FT”) filed a Request for Arbitration with the International Court of Arbitration. FT claimed that we breached a license agreement with FT and sought unspecified damages including a payment in excess of $110,000 plus the legal fees and other costs associated with the arbitration. The arbitration took place in June 2003. On March 27, 2004, the arbitrator ruled in our favor, denying all of FT’s claims, and ordered FT to pay us approximately $1,600 in reimbursement of our legal fees and other expenses associated with the arbitration. Due to FT’s many procedural objections, we believed that FT might contest the ruling. To eliminate this uncertainty, in April 2004, we requested that FT confirm to us in writing that they intended to comply with the arbitrator’s ruling. On April 15, 2004, FT confirmed to us in writing that it would accept the arbitrator’s ruling. In April, we received cash payment. We will record this $1,600 gain in the second quarter of 2004.

In a related matter, FT had also filed a patent infringement suit in Delaware against Novell, Inc., one of our licensees. On or about April 22, 2004, the court dismissed the case at the joint request of FT and Novell.

From time to time, we have been named as a defendant in other legal actions arising from our normal business activities, which we believe will not have a material adverse effect on us or our business.

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

We make statements in this Report that are forward looking, that is, statements that are not historical facts but that convey projections about the future. For example, statements containing the words “believes,” “anticipates,” “plans,” “expects,” “estimates,” “intends,” “may,” “projects,” “will,” “would,” and similar expressions may be forward-looking statements. However, we caution investors not to place undue reliance on any forward-looking statements in this Report because these statements speak only as of the date when made. Furthermore, we are not obligated to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. There are a number of factors that could cause our actual results to differ materially from those indicated by these forward-looking statements, including without limitation the factors described below under the caption “Certain Factors That May Affect Future Results.”

Overview

RSA Security Inc. helps organizations protect private information and manage the identities of people and applications accessing and exchanging that information. With thousands of customers around the globe, RSA Security’s portfolio of solutions — including identity & access management, secure mobile & remote access, secure enterprise access and secure transactions — are all designed to provide seamless e-security. We sell our two factor user authentication, certificate processing, Web access management and encryption products and solutions to corporate enterprise users seeking turnkey security solutions, and to original equipment manufacturers, developers and corporate enterprise users seeking software development components for embedding security in a range of software applications or hardware devices.

We derive our operating revenue primarily from two distinct product groups: Enterprise solutions, which includes RSA SecurID® authenticators, RSA ACE/Server® software, RSA ClearTrust® software, RSA Keon® software, and maintenance and professional services associated with those products; and Developer solutions, which includes RSA BSAFE® encryption software and protocol products, RSA Keon components, and maintenance and professional services associated with those products.

We believe sales of our products will be driven by the trend of enterprises permitting remote access to internal resources and Web-enabling of existing applications, as well as a desire for strong authentication within the enterprise. Sales of our RSA SecurID authenticator products continue to generate substantial revenue for us, while our less mature Enterprise software products are building revenue. We believe the decrease in the number of technology companies funding development and the availability of free, “open source” products that compete with our RSA BSAFE product line continue to put pressure on our Developer solutions revenue. We believe our product line synergies and strength of our customer base create opportunities to sell additional products to existing customers. However, we have observed that information technology budgets remain constrained, which has had and could continue to have a direct effect on the sale of our products.

We continue to explore opportunities to sell our products into new markets. Today the majority of our customers utilize our products to secure and to manage network and application access for their employees and partners. Increasingly, however, our customers are also using our products to secure and manage access for their customers, including consumer customers. We have seen increased interest in financial institutions and other companies seeking to provide security to consumers. Today we see interest in consumer authentication broadening to many more types of consumer-facing organizations, which we believe is driven by concerns about identity theft and privacy, and the desire to comply with information protection regulations. While still early, we believe that this expanded market has the potential to drive strong incremental demand for our products.

Our Enterprise solutions customers typically place an initial order for a limited number of users, for either our RSA SecurID authenticators or any of our software products, and deploy additional authenticators or software licenses as their need for our products within their enterprise increases. Authenticators have a programmed life of two to five years, and as they expire, our customers typically place additional orders for replacement authenticators. We typically base our RSA ACE/Server, RSA Keon and RSA ClearTrust software license fees on the number of users authorized under each customer’s license. In most cases, customers will also enter into an annual customer support agreement for their software license at the time of initial purchase and renew this support agreement annually. Our support agreement entitles our customers to license software upgrades and telephone support.

Our Developer solutions software licensing terms vary by product and customer. Typical licensing terms may include an initial prepaid license fee and ongoing royalties paid as a percentage of the developer’s product or service revenue, or payment of annual license fees, or a single fully paid-up license fee. Often, our existing developer customers go on to license new software or technology from us or wish to increase the field of use rights for the technology they have already licensed. In such a case, we amend our license agreement with the customer and charge additional licensing fees, thus deriving additional revenue.

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Our professional services group provides customers with project management, architecture and design, physical deployment, custom development, education and practitioner certification services. Customers typically pay for professional services either at a fixed price or at hourly or daily rates for the time it takes us to complete the project.

We have contracted with outside manufacturing organizations to produce our RSA SecurID authenticators, and some of our products contain technology that is licensed from third parties. Our cost of revenue consists primarily of costs associated with the manufacture and delivery of RSA SecurID authenticators and royalty fees that we pay for the licensed technology. Cost of revenue also includes warranty obligation expense and labor and overhead costs associated with professional services, customer support, and production activities. Production costs include the programming labor, shipping, inspection and quality control functions associated with the RSA SecurID authenticators. We are currently working to establish new supplier relationships in order to increase the number of vendors from which we buy our authenticators and authenticator components, in order to reduce our vulnerability to potential supply problems.

We distribute our products through direct sales to end user customers, and through indirect sales, including sales to resellers and distributors that we ship directly to the end user customer and sales to distributors for stocking purposes. For the three months ended March 31, 2004, approximately 58% of our revenue was from sales to distributors shipped directly to the end user and resellers, approximately 33% of our revenue was from direct sales to end user customers, and approximately 9% of our revenue was from sales to stocking distributors. Our stocking distributors provide us with inventory level and point of sale reports on a monthly basis. Based upon these reports, we estimate that our stocking distributors typically hold approximately four weeks of inventory on hand in the distribution channel.

Our direct sales to our customers in countries outside of the United States are denominated in U.S. dollars and local currency, with the majority of our sales denominated in U.S. dollars. Our sales through indirect distribution channels are generally denominated in U.S. dollars. For countries outside the United States, we generally pay our operating expenses in local currency. Where we do invoice customers in local currency, we are exposed to foreign exchange rate fluctuations from the time of invoice until collection occurs. We are also exposed to foreign currency fluctuations between the time we collect in U.S. dollars and the time we pay our operating expenses in local currency. Fluctuations in currency exchange rates could affect the profitability and cash flows in U.S. dollars of our products sold in international markets.

Application of Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these condensed consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expense during the reporting period. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, sales returns, allowance for doubtful accounts, intangible assets, income taxes, financing operations, warranty obligations, restructurings, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. However, our actual results could differ from those estimates.

We believe the following critical accounting policies affect our significant estimates and assumptions used in the preparation of our condensed consolidated financial statements.

Revenue Recognition — We derive our revenue primarily from two sources: sales of products, including hardware and software licenses, and services, including maintenance, support and professional services. Our management must make and use judgments and estimates in connection with the revenue recognized in any reporting period. We recognize revenue from the sale of products when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is considered probable. We reduce revenue by provisions for estimated sales returns. The amount and timing of our revenue for any period may materially differ if our management made different judgments or utilized different estimates in establishing our allowance for sales returns. An increase in our allowance for sales returns would reduce our revenue in the period for which the increase is recorded.

For all sales, we use a binding contract, purchase order or another form of documented agreement as evidence of an arrangement with the customer. Sales to our distributors are evidenced by a master agreement governing the relationship, together with binding purchase

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orders on a transaction-by-transaction basis. We consider delivery to occur when we ship the product, so long as title and risk of loss have passed to the customer.

At the time of a transaction, we assess whether the sale amount is fixed or determinable based upon the terms of the documented agreement. If we determine the fee is not fixed or determinable, we recognize revenue when the fee is fixed. We assess if collection is probable based on a number of factors, including past transaction history with the customer and the creditworthiness of the customer. If we determine that collection is not probable, we do not record revenue until such time as collection becomes probable, which is generally upon the receipt of cash.

We do not generally include acceptance provisions in arrangements with our customers; however, if an arrangement includes an acceptance provision, we recognize revenue upon the customer’s acceptance of the product, which occurs upon the earlier of receipt of a written customer acceptance or expiration of the acceptance period.

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 48, “Revenue Recognition when Right of Return Exists,” we recognize revenue upon shipment of product to stocking distributors who have only limited return rights, and record a sales return reserve to provide for estimated product returns. We estimate product returns from distributors based upon historical experience.

When arrangements contain multiple elements and vendor specific objective evidence (“VSOE”) of fair value exists for all undelivered elements, we recognize revenue for the delivered elements using the residual method. We base our determination of VSOE of fair value of each of the undelivered elements in multi-element arrangements on either the price we charge when the same element is sold separately or the price established by the members of our management, who have the relevant authority to set prices, for an element not yet sold separately. For arrangements containing multiple elements where VSOE of fair value does not exist for all undelivered elements, we defer revenue for the delivered and undelivered elements until VSOE of fair value exists or all elements have been delivered.

Some of our arrangements contain bundled products which include a term software license, an RSA SecurID® authenticator and support for the term of the license. As these arrangements contain multiple elements where vendor specific objective evidence of fair value does not exist for all undelivered elements, we record these arrangements as deferred revenue and recognize revenue ratably on a monthly basis over the term of the license agreement.

We defer maintenance service revenue, whether sold separately or as part of a multiple element arrangement, and recognize it ratably over the term of the maintenance contract, generally twelve months.

We recognize revenue allocated to professional service elements as the services are performed. When the customization is essential to the functionality of the licensed software, then both the software license and professional services revenue are recognized under the percentage of completion method, which requires revenue to be recognized as a percentage of the project completed. We recognize revenue and gross profit using labor hours as an input measure of progress to completion on these arrangements.

Allowance for Sales Returns - We record allowances for estimated sales returns and allowances on products and maintenance and professional service related revenue in the same period as the related revenue is recorded. We base these estimates on historical sales returns, analysis of credit memo data, current economic trends, product line and customer industry data and other known factors. Our historical experience with sales returns varies by product line depending on the customer, industry and market. We must make judgments and estimates in connection with establishing the allowances for estimated sales returns in any reporting period. The amount and timing of our revenue for any reporting period may materially differ if actual sales returns and allowances differ from our estimates.

Allowance for Doubtful Accounts - We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We analyze accounts receivable and the composition of the accounts receivable aging, historical bad debts, and current economic trends, regional factors and other known factors when evaluating the adequacy of the allowance for doubtful accounts. Based upon the analysis and estimates of the uncollectibility of our accounts receivable, we record an increase in the allowance for doubtful accounts when the prospect of collecting a specific account receivable becomes doubtful. Actual results could differ from the allowances for doubtful accounts recorded, and this difference may have a material effect on our financial position and results of operations. We record recoveries of accounts previously written off as uncollectible as increases to the allowance for doubtful accounts.

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Allowance for Warranty Obligations - Our standard practice is to provide a warranty on all RSA SecurID hardware authenticators for the customer selected programmed life of the authenticator (generally three to five years) and to replace any defective authenticators (other than authenticators damaged by a user’s abuse or alteration) free of charge. We sell our other products to customers with a warranty for product defects for a specified period, generally ninety days. We provide reserves for warranty obligations based on historical failure and defective return rates, and include these costs as a component of product cost of revenue. We reevaluate the estimate of warranty and defective return obligations, including the assumptions about estimated failure and return rates, each quarter.

During 2002 and 2003, our analysis of historical failure and defective return rates indicated that certain authenticators produced between 2000 and 2002 were subject to higher defect and failure rates than we had previously experienced. Accordingly, we increased our provisions for warranty obligations by $4.6 million and $2.8 million for the years ended December 31, 2003 and 2002, respectively. We increased our provisions for warranty obligations by $0.2 million and $0.9 million for the three months ended March 31, 2004 and 2003, respectively. We will continue to monitor warranty claims and reevaluate our estimate of warranty and defective return obligations in future periods, which may result in our recording additional warranty expense. Actual warranty returns could differ from the allowance for warranty obligations recorded.

We monitor warranty claims and address defects through our quality and design processes, which are managed by our product engineering, quality control and technical support organizations. During the last several years, we have increased programs and initiated new programs to build an expanded family of high performance authentication solutions. These programs have resulted in the redesign and re-engineering of authenticator products to improve performance and reliability by incorporating new microprocessors, electronics, firmware and batteries with longer life.

Income Taxes - The preparation of our consolidated financial statements requires us to estimate our income taxes in each of the jurisdictions in which we operate, including those outside the United States, which may be subject to certain risks that ordinarily would not be expected in the United States. A change in our estimate of income by jurisdiction could cause a change in our annual effective tax rate. The income tax accounting process involves our estimating our actual current exposure together with assessing temporary differences resulting from differing treatment of certain items for tax and accounting purposes. These differences result in the recognition of deferred tax assets and liabilities. We must then record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized.

Management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against deferred tax assets. We have recorded a valuation allowance of $25.4 million as of March 31, 2004 due to uncertainties related to our ability to utilize some of our deferred tax assets, primarily consisting of acquisition related net operating losses carried forward. We base the valuation allowance on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. If actual results differ from these estimates or we adjust these estimates in future periods, we may need to adjust our valuation allowance, which could materially impact our consolidated financial position and results of operations.

Valuation of Goodwill and Other Intangible Assets - In assessing the recoverability of our intangible assets, we must make assumptions regarding estimated future cash flows and earnings and other factors used to determine the fair value of the respective assets. We will record an impairment charge in the amount by which the carrying value of the assets exceeds their fair value. We generally determine fair value based on estimated discounted future cash flows. If these estimates or their related assumptions change in the future, we may be required to record impairment charges against these assets in the reporting period in which the impairment is determined. Any such impairment charge could be significant and could have a material adverse effect on our consolidated financial position and results of operations. We perform an annual test for impairment of our goodwill as of November 30 of each year, and if events or circumstances occur that would more likely than not reduce the fair value of the goodwill below its carrying amount, will perform an interim impairment test. We completed the required annual goodwill impairment test as of November 30, 2003, by comparing the carrying amount of the enterprise to the estimated fair value of the enterprise. Estimated fair value of the enterprise was determined based upon the market multiple valuation method, which requires that we utilize estimates of future cash flows, revenue and earnings. As of November 30, 2003, the fair value of the enterprise was greater than the carrying amount of the enterprise. Therefore, our annual goodwill impairment test performed as of November 30, 2003 did not result in an impairment of our goodwill. At March 31, 2004, we had approximately $189.3 million of goodwill, which accounted for approximately 35% of our total assets. Any goodwill impairment test could result in a decrease to the carrying value of goodwill and could have a material effect on our results of operations and consolidated financial position.

Restructurings - During 2002 and 2001, we initiated consolidation of certain operations in order to enhance operational efficiency and reduce expenses, and recorded significant restructuring charges in connection with these actions. Restructuring charges totaled $56.0

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million in 2002 and $20.0 million in 2001. These restructuring charges and our continued analysis of our facilities require us to make estimates based upon real estate market conditions, rental rates, future corporate requirements, general economic conditions and future estimated cash flows. Included in the restructuring charges recorded in 2002 are facility exit costs of $44.0 million, which represents estimated shortfalls of sublease rental income compared to lease payments due through 2009 under certain exited facilities lease agreements, impaired leasehold improvements and furniture and fixtures, and other associated facilities expenses. We base estimates related to anticipated sublease market rates for excess facilities on assumptions regarding the time period required to locate and contract with suitable subtenants and base these assumptions on market trend information analysis.

We will continue to monitor and assess our facility obligations, real estate markets and our operating expenses. If the assumptions for the estimates used in our restructuring reserve change due to changes in the real estate and sublease markets, or due to the terms of sublease agreements that we have obtained, the ultimate restructuring expenses for these facilities could vary by material amounts, and could cause us to record additional or revise previously recorded restructuring charges in future reporting periods which could have a material effect on our results of operations and consolidated position.

New Accounting Pronouncements Adopted - Interpretation No. 46 – In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, “Consolidation of Variable Interest Entities,” which was revised by FIN 46R issued in December 2003 (“FIN 46”). This interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” addresses consolidation by business enterprises of variable interest entities (“VIE”) that either: do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or for which the equity investors lack an essential characteristic of a controlling financial interest. FIN 46 also sets forth certain disclosure requirements regarding interests in VIE that are deemed significant, even if consolidation is not required. FIN 46 applies to interim periods ending after March 15, 2004. The adoption of FIN 46 did not require the consolidation of our investment in Crosby and therefore did not have a significant impact on our consolidated financial position or results of operations.

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Results of Operations

The following table sets forth certain consolidated financial data as a percentage of our total revenue:

Revenue

The following tables set forth the amount, percentage of total revenue and percentage increase (decrease) of our revenue by product group, product type and product line:

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The following tables set forth the amount, percentage of total revenue and percentage increase of revenue by regional area:

We believe the increase in total revenue in the first quarter of 2004, as compared to the first quarter of 2003, was primarily attributable to businesses continuing the trend toward permitting remote access to internal resources and Web-enabling existing applications. We believe our identity and access management solutions promote our product synergies and enable us to generate additional revenue by selling additional products to existing customers. We also believe that as new, lower cost remote access technologies become available and as employment rates increase, we will benefit with increased total product revenue. We believe that governmental regulations regarding access and distribution of private information will drive demand for our products. However, information technology budgets continue to be constrained, and the continued uncertainty in the economy and global affairs may affect revenue generated from the sales of our products in future quarters.

Our RSA SecurID authentication product line generates a substantial portion of our revenue. Authenticator units sold, in thousands of units, were as follows:

The increase in number of units sold, partially offset by a decrease in the average selling price in the three months ended March 31, 2004 as compared to the comparable period in 2003, contributed to the increased revenue from our RSA SecurID authentication product line. The decrease in the average selling price can be attributed to an increase in the number of larger volume transactions during the three months ended March 31, 2004 as compared to the comparable period in 2003, because we tend to give larger discounts on larger volume transactions. We believe our RSA SecurID authentication products generate and will continue to generate substantial revenue for us.

We believe the increase in our total revenue can be attributed in part to the continued adoption of our authentication products by an increasing number of small and mid size businesses, as well as expanded deployments of our products by some of our existing larger customers.

Our sales to the financial services, technology and telecommunications vertical markets continue to provide increased revenue for us. We believe our revenue from the healthcare and financial services markets will continue to increase due to required compliance with industry specific privacy and security laws standards.

We believe the increase in our Web access management revenue is due in part to an increase in the number of companies allowing access of their information and applications by internal and external users. We believe that our Web access management revenue will continue to grow due to introductions of new enhancements to our products, including the Federal Identity Management Module, strong technology and strategic partnerships. In addition, we have changed our sales strategy to dedicate a portion of our sales force to focus on selling our emerging products, while selling our more mature products primarily through our resellers and distributors.

The decrease in Developer solutions and encryption revenue during the three months ended March 31, 2004 as compared to the comparable period in 2003, was primarily due to the decrease in the number of technology companies funding development of new information technology products, and the availability of free, “open source” products that compete with our RSA BSAFE product line, which continue to put pressure on our Developer solutions revenue. We believe that our Developer solutions revenue may benefit from companies’ needs to secure their transactions due to various regulatory requirements. We currently believe our Developer solutions revenue will represent 8% to 10% of total revenue over the next twelve months.

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The increase in service revenue for the three months ended March 31, 2004 as compared to the comparable period in 2003 can primarily be attributed to purchases by new customers coupled with high renewals of annual maintenance contracts from sale of products in prior periods.

We believe that as the United States government proceeds with its agenda of increasing awareness and funding of cyber-security issues and its focus on homeland security, we will benefit with increased revenue. We believe the government sector of our business may increase in the future as government agencies seek e-security partners in order to execute their cyber-security agenda. However, revenue from the government sector of our business was consistent during the three months ended March 31, 2004 as compared to the comparable period in 2003, as the United States government continued to defer its information technology spending.

Gross Profit

The following tables set forth the gross profit and gross margin for products and maintenance and professional services:

We believe the increase in total gross margin for the first quarter of 2004, as compared to the first quarter of 2003, was primarily attributable to our efforts to reduce costs and improve operating efficiencies, combined with an increase in total revenue. We believe the increase in gross margin for products for the first quarter of 2004, as compared to the same period of 2003, was primarily attributable to decreases in hardware component prices combined with a decrease of $0.8 million in our warranty obligation expense in the first quarter of 2004, as compared to the first quarter of 2003.

We believe the decrease in gross profit margin from maintenance and professional services in the first quarter of 2004, as compared to first quarter of 2003, was primarily attributable to increased professional services revenue, which typically have lower gross margins than our maintenance services.

We expect to maintain total gross margins of between 79% and 81% during the next twelve months.

Research and Development

Total research and development expenses increased 16.1% in the first quarter of 2004 to $14.7 million from $12.7 million in the first quarter of 2003, and represented 20.4% and 20.7% of total revenue for the first quarter of 2004 and 2003, respectively. The increase in research and development expenses of $2.0 million for the first quarter of 2004 as compared to the first quarter of 2003 resulted from increased payroll, overhead, and consulting expenses associated with our continued allocation of resources towards investing in our future product offerings. We believe research and development expenditures will be approximately 19% to 21% of total revenue during the next twelve months.

Marketing and Selling

Total marketing and selling expenses increased 15.0% in the first quarter of 2004 to $26.3 million from $22.9 million in the first quarter of 2003, and represented 36.6% and 37.4% of total revenue for the first quarter of 2004 and 2003, respectively. For the first quarter of 2004, as compared to the first quarter of 2003, approximately $2.9 million of the increase in marketing and selling expenses was due to increased labor and overhead costs, and approximately $0.5 million of the increase was associated with increased marketing programs. We believe marketing and selling expenditures will be approximately 32% to 35% of total revenue during the next twelve months.

General and Administrative

Total general and administrative expenses decreased 20.4% in the first quarter of 2004 to $7.6 million from $9.5 million in the first quarter of 2003, and represented 10.5% and 15.5% of total revenue for the first quarter of 2004 and 2003, respectively. Approximately $2.5 million of the decrease in general and administrative expenses in the first quarter of 2004, as compared to the first quarter of

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2003, was due to a decrease in legal expenses. In 2003, we had legal expenses associated with the successful defense of the Stambler patent infringement lawsuit. This decrease in legal expenses was partially offset by an increase of $0.6 million due to increased payroll and overhead costs. We believe general and administrative expenditures will be approximately 10% to 12% of total revenue during the next twelve months.

Restructurings

During 2002 and 2001, we evaluated and initiated restructuring actions in order to consolidate some of our operations, enhance operational efficiency and reduce expenses. These actions resulted in total restructuring charges of $56.0 million and $20.0 million for the years ended December 31, 2002 and 2001, respectively. We continue to monitor and assess our facility obligations, the real estate market and our operating expenses. Based upon our ongoing assessments of our facility obligations and the rental real estate market, or if we are successful in obtaining sublease tenants for our excess facilities, we may have to record additional restructuring charges or revise previously recorded restructuring charges in future reporting periods. Restructuring charges were zero for the three months ended March 31, 2004 and 2003.

Restructuring charges recorded during 2002 and 2001 consist of facility exit costs, costs associated with the sale and liquidation of our Swedish development operations, and severance and other costs associated with the reduction of employee headcount.

Restructuring charges accrued and unpaid at March 31, 2004 were as follows:

We expect to pay the remaining restructuring costs accrued at March 31, 2004 as follows:

Interest Expense and Other

Interest expense and other includes the following:

Interest expense, non cash amortization of deferred financing costs and non cash accretion of warrant value included in interest expense and other were incurred in connection with our 7% convertible debentures, which were issued in October and November of 2001. The increase in interest income in the three months ended March 31, 2004 as compared to the comparable period in 2003 was primarily due to higher interest rates earned on higher average cash and marketable securities balances.

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(Loss) income from Investing Activities

(Loss) income from investing activities includes the following (losses) gains:

We sold substantially all of our remaining private equity investments during 2003, received cash proceeds of $3.0 million and recognized a gain from the sales of $1.5 million during the three months ended March 31, 2003.

Provision for Income Taxes

The provision for income taxes was $1.6 million during the first quarter of 2004 compared to $0.9 million during the first quarter of 2003. Our effective tax rate decreased to 20.0% for the first quarter of 2004 from 34.7% for the first quarter of 2003. The decrease in our effective tax rate was primarily attributable to the increased profitability of our international operations where the effective tax rates are generally lower than the United States statutory rate. We currently expect our tax rate to be approximately 20% for 2004.

Liquidity and Capital Resources

We had $186.1 million in cash and cash equivalents at March 31, 2004, consisting primarily of operating cash and short-term investments. This represents a decrease of $21.2 million in cash and cash equivalents during the three months ended March 31, 2004. The major changes in cash during the three months ended March 31, 2004 include cash used for investing activities of $34.7 million, cash provided by financing activities of $7.2 million and cash provided by operations of $6.9 million.

Cash used for investing activities of $34.7 million during the first quarter of 2004 consisted primarily of $32.9 million of cash used for the purchase of marketable securities and $1.5 million of cash used for property and equipment purchases.

Cash provided by financing activities of $7.2 million during the first quarter of 2004 consisted of proceeds from employee exercises and purchases under our stock option and employee stock purchase plans.

We have commitments for various operating leases worldwide that expire at various times through 2017. These commitments are shown below net of existing sublease agreements, excluding facility exit costs included in restructuring charges. The lease commitments of $129.8 million shown below include lease commitments of $8.7 million related to certain exited facilities that have not been reserved for in restructuring charges. In addition, lease commitments and restructuring obligations shown below are net of estimated sublease income of $10.4 million related to existing sublease agreements. Restructuring commitments shown below are primarily for facility exit costs of up to 72 months of minimum lease payments due under certain excess facilities lease agreements, net of related sublease agreements. The following are our contractual commitments associated with our lease obligations, restructurings and convertible debentures:

During October and November 2001, we issued 7% convertible subordinated debentures with an aggregate principal amount of $80.0 million, together with warrants to purchase an aggregate of 873,045 shares of our common stock. Interest on these debentures is payable in cash semi-annually on January 1 and July 1, at a fixed rate of 7% per annum. We expect to make interest payments of

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approximately $4.5 million during the remainder of the year ending December 31, 2004. The debentures mature on October 17, 2004, unless redeemed earlier by us or converted into shares of our common stock at the holder’s option. At any time and at their option, each holder may convert any outstanding debentures into shares of our common stock at a conversion price of $13.745 per share. Conversion of all of the outstanding debentures would result in the issuance of approximately 5.8 million shares of our common stock. We can redeem all or a portion of the 7% convertible debentures for cash as long as the arithmetic average of the weighted average price of our common stock on each trading day during the fifteen trading day period immediately prior to the election to redeem is 150% of the conversion price. This redemption feature was not exercisable at March 31, 2004. The debentures are unsecured and are subordinated to all existing and future senior indebtedness. The agreements governing the convertible debentures contain covenants restricting our ability to incur and guarantee additional debt. The covenants limit the amount of additional debt we may incur to the lesser of 30% of our consolidated stockholders’ equity, which was approximately $97.5 million at March 31, 2004, or a total of $180.0 million including the balance of the 7% convertible debentures outstanding.

Any increase or decrease in our accounts receivable balance and accounts receivable days outstanding (calculated as net accounts receivable divided by revenue per day) will affect our cash flow from operations and liquidity. Our accounts receivable and accounts receivable days outstanding may increase due to changes in factors such as the amount of international sales and length of customer’s payment cycle. We also record deferred maintenance billings as accounts receivable, and the timing of these billings affects the accounts receivable days outstanding. Historically, international and indirect customers pay at a slower rate than domestic and direct customers. An increase in revenue generated from international and indirect customers may increase our accounts receivable days outstanding and accounts receivable balance. Due to the current economic climate, we may observe an increase in the length of our customers’ payment cycle. To address increases in our accounts receivable balance and to improve cash flow, we may from time to time take actions to encourage earlier payment of receivables. Discounts offered to customers to encourage payment are deducted from revenue. To the extent that our accounts receivable balance increases, we may incur increased bad debt expense and increased estimates for reserves against revenue and will be subject to greater general credit risks.

We provide e-security solutions to various customers in diverse industries. We perform ongoing credit evaluations of our customers and maintain allowances for potential credit losses. We had two significant customers who are resellers, which accounted for approximately 23% and 21% of total accounts receivable as of March 31, 2004 and December 31, 2003, respectively.

We currently expect to receive additional tax refunds of approximately $6.0 million during the second half of 2004. These tax refunds are attributable to the recovery of income taxes paid in prior years and are available to us due to the carryback of capital losses incurred in 2003. These capital losses resulted from the sale in 2003 of a significant portion of our remaining equity investments. The refunds are subject to Internal Revenue Service review.

Crosby Finance, LLC (“Crosby”) held approximately 2.0 million shares of VeriSign common stock and a variable delivery forward contract, or VDF, at March 31, 2004. The gain recorded for financial reporting purposes upon execution of the VDF contract in 2000 has not been recognized for tax purposes, and accordingly we recorded a $26.6 million deferred tax liability in 2000. This deferred tax liability will reverse upon maturity of the VDF contract in 2006 and the gain will be included in the calculation of our taxable income for 2006. The recognition of that gain would result in a tax liability to us and may require the payment of cash to settle such tax liability.

Our plans for future uses of cash may include additional acquisitions of other entities or technologies, retirement of outstanding debt and additional purchases of property and equipment, and inventory. We anticipate capital expenditures for the remainder of 2004 will be primarily for purchases of property and equipment and will aggregate up to approximately $7 million. In addition, if our 7% debentures are not converted to common stock before October 17, 2004, then we will have to pay the principal amount of the notes, which is $80 million, to the note holders. We expect to fund our capital expenditures from cash on hand and cash generated from operations.

We believe that cash generated from our operating activities will be sufficient to fund our working capital requirements through at least the next twelve months. We anticipate that current cash on hand, cash generated from operations, and cash generated from the exercise of employee options and employee stock purchase plans will be adequate to fund our planned capital and financing expenditures for at least the next twelve months.

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New Accounting Pronouncements Adopted

Interpretation No. 46 – In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, “Consolidation of Variable Interest Entities,” which was revised by FIN 46R issued in December 2003 (“FIN 46”). This interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” addresses consolidation by business enterprises of variable interest entities (“VIE”) that either: do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or for which the equity investors lack an essential characteristic of a controlling financial interest. FIN 46 also sets forth certain disclosure requirements regarding interests in VIE that are deemed significant, even if consolidation is not required. FIN 46 applies to interim periods ending after March 15, 2004. The adoption of FIN 46 did not require the consolidation of our investment in Crosby and therefore did not have a significant impact on our consolidated financial position or results of operations.

Certain Factors That May Affect Future Results

Our quarterly operating results have fluctuated in the past and may fluctuate significantly in the future. A variety of factors, many of which are outside of our control, can cause these fluctuations, including, among others:

•		the size, timing and shipment of individual orders for our products;
•		changes in our operating expenses;
•		the timing of the introduction or enhancement of our products and our competitors’ products;
•		customers deferring their orders in anticipation of the introduction of new products by us or our competitors;
•		market acceptance of new products;
•		changes in the mix of products sold;
•		changes in product pricing, including changes in competitors’ pricing policies;
•		development and performance of our direct and indirect distribution channels and changes in the mix of vertical markets to which we sell our products;
•		the amount and timing of charges relating to the impairment or loss of value of some of our assets, especially goodwill and intangible assets;
•		the timing of personnel departures and new hires and the rate at which new personnel become productive; and
•		general economic conditions.

We may not be able to achieve, sustain or grow our profitability from quarter to quarter. Because our operating expenses are based on anticipated revenue levels and a high percentage of our expenses are fixed, a small variation in when revenue is recognized can cause significant variations in operating results from quarter to quarter.

The global economy, especially the technology sector, is still weak and may recover slowly or not at all during the foreseeable future. The general economic slowdown has had and may continue to have serious negative consequences for our business and operating results. We believe that the economic slowdown is causing some current or potential customers to defer purchases, to go out of business or to have insufficient capital to buy or pay for our products. In response to the current economic conditions, many companies have reduced their budgets for information technology products and services, which could reduce or eliminate some potential sales of our products and services. In addition, some of our resellers and distributors are experiencing financial difficulties due to the weak economy, which affects our ability to sell to and collect money from those resellers and distributors.

We currently lease a number of excess, unused or under-used facilities that we are trying to sublet, and our lease commitments for some of these facilities will not expire for several years. Even if we find sublessees for these facilities, the monthly rent we receive from the sublessees will likely be significantly less than the monthly rent we owe to the landlords, which means that we will be responsible for paying the difference.

Our stock price has been volatile and is likely to remain volatile. From March 31, 2003 through April 22, 2004 our stock price has ranged from a per share high of $19.48 to a low of $6.60. A number of factors may contribute to the volatility of our stock price, including:

•		our ability to meet the expectations of brokerage firms, industry analysts and investors with respect to our operating and financial results;
•		our public announcements and our competitors’ public announcements;

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•		the public’s perception of the strength of the e-security solutions market and technology companies generally;
•		litigation developments;
•		the volatility of the stock market in general and of the technology sector in particular; and
•		general economic conditions.

If the market for e-security solutions does not continue to grow, then demand for our products may decrease. Demand for our products depends on, among other things:

•		the perceived ability of our products to address real customer problems;
•		the perceived quality, price, availability and interoperability of our products as compared to our competitors’ products;
•		the market’s perception of how easy or difficult it is to deploy our products, especially in complex, heterogeneous network environments;
•		the continued evolution of electronic commerce as a viable means of conducting business;
•		market acceptance and use of digital signatures and digital certificates in business applications;
•		the ability of network infrastructures to support an increasing number of users and services;
•		the public’s perception of the need for secure electronic commerce and communications over both wired and wireless computer networks;
•		the U.S. government’s continued focus on e-security as a means to counteract terrorism and other hostile acts;
•		the pace of technological change and our ability to keep up with these changes;
•		the market’s perception of our products’ ability to address the e-security aspects of privacy and security legislation; and
•		general economic conditions, which, among other things, influence how much money our customers and potential customers are willing to allocate to their information technology budgets.

Unless we keep up with the ongoing changes in e-security technology, such as our competitors’ introduction of new products, the development of new standards and changes in our customers’ requirements, our products could become obsolete and difficult to sell. Our future success will depend in part upon our ability to enhance our existing products and to introduce new, competitively priced products and solutions with features that meet changing market requirements, all in a timely and cost-effective manner. A number of factors, including the following, could have a negative impact on the success of our products:

•		quality, reliability or security failures, which could result in product returns, delays in collecting accounts receivable, unexpected service or warranty expenses, reduced orders and a decline in our competitive position;
•		delays or difficulties in product development;
•		our competitors’ introduction of new products ahead of our new products, or their introduction of superior or cheaper products;
•		the availability of free, unpatented implementations of encryption algorithms and security protocols;
•		the market’s failure to accept new technologies, including smart cards and Web access management, Web services, digital certificate and public and private key management technologies;
•		our failure to include features in our products, or obtain industry and governmental certifications, that our customers or U.S. or foreign government regulators may require;
•		our failure to anticipate changes in customers’ requirements; and
•		the implementation of industry or government standards that are inconsistent with the technology embodied in our products.

We may need to purchase or license technology from third parties in order to introduce new products or enhance our existing products. We may not be able to find businesses that have the technology we need and, if we find such businesses, may not be able to purchase or license the technology on commercially favorable terms or at all.

Transactions for some of our products, especially our digital certificate management and Web access management products, often involve large expenditures by our customers. The sales cycles for these transactions can be long and unpredictable due to a number of uncertainties such as:

•		customers’ budgetary constraints;
•		the need to educate potential customers about our products’ capabilities;
•		customers’ willingness to invest potentially substantial resources and modify their network infrastructures to take advantage of our products;

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•		the timing of customers’ budget cycles;
•		delays caused by customers’ internal review processes; and
•		for sales to the federal government, federal regulatory, approval and purchasing requirements.

Problems with the availability or quality of our products could cause our revenue to decrease and our costs to increase, damage our reputation in the marketplace and subject us to damage claims from our customers. Examples of quality and possible availability problems include:

•		In 2002 and 2003, our quarterly analysis of historical failure and defective return rates indicated that certain RSA SecurID authenticators produced between 2000 and 2002 were subject to higher defect and failure rates.
•		Many of our suppliers are located outside of the United States. If political, economic or health-related events, such as the U.S. actions in Iraq or a major health crisis like the SARS epidemic in 2003, were to affect international trade, then we could experience difficulties in obtaining product components from our international suppliers.
•		We depend on a limited number of suppliers for some of our product components. If our existing suppliers were unable to provide us with a sufficient supply of quality components, then we would have to expend significant resources to find new suppliers, and it is possible that we would be unable to find new suppliers in a timely manner.

If we fail to remain competitive, then we could lose market share for our established products or fail to gain market share for our less mature products. A number of competitive factors could cause us to lose potential sales or to sell our products at lower prices or at reduced margins, including, among others:

•		Some of our competitors offer e-security products with features and functionality that our products do not currently offer.
•		Some computer and software companies that have not traditionally offered e-security products are now offering free or low-cost e-security products and functionality bundled with their own computer and software products.
•		Some of our current and potential competitors have greater financial, marketing and technical resources than we do, allowing them to leverage an installed customer base, adapt more quickly to new technologies and changes in customer requirements, or devote greater resources to the promotion and sale of their products than we can.
•		The expiration of some of our patents has permitted the use and distribution of “freeware,” free versions of some of our technology, and we believe that some potential customers may be choosing to use freeware instead of buying our products.
•		Many companies have reduced their information technology budgets due to the current economic conditions, which could make competition more intense because we are competing for fewer customer dollars.

International sales accounted for more than 40% of our total revenue in each of the years ended December 31, 2003, 2002 and 2001 and in the three months ended March 31, 2004. There are certain risks inherent in doing business internationally, including:

•		foreign regulatory requirements and the burdens of complying with a wide variety of foreign laws;
•		legal uncertainty regarding liability and the costs of resolving or litigating a dispute internationally;
•		difficulties in the enforcement of intellectual property rights;
•		export and import restrictions on cryptographic technology and products incorporating that technology;
•		difficulties and delays in establishing international distribution channels;
•		the need to tailor or “localize” our products in order to compete in particular international markets and to comply with foreign laws;
•		difficulties in collecting international accounts receivable;
•		fluctuations in currency exchange rates;
•		potentially adverse tax consequences, including restrictions on the repatriation of earnings;
•		tariffs and other trade barriers; and
•		political instability.

If we fail to protect our rights in our proprietary technology, competitors may use our technology, which could weaken our competitive position, reduce our revenue and increase our costs. We rely on a combination of patent, trade secret, copyright and trademark laws, software licenses, nondisclosure agreements and technical measures to protect our proprietary technology. However, despite our efforts to protect our proprietary rights, unauthorized third parties may nonetheless succeed at:

•

copying aspects of our products;

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•		obtaining and using information that we regard as proprietary; or
•		infringing upon our patents and other proprietary rights.

We rely on patents to protect our proprietary rights in our technology, but patents may not provide complete protection:

•		It is possible that any patent that we or our licensors hold might be invalidated, circumvented, challenged or terminated.
•		It is possible that patent examiners might reject the claims described in our pending or future patent applications.
•		The laws of some countries in which our products are now, or may in the future be, developed or sold may not protect our products and intellectual property rights to the same extent as the laws of the United States.
•		During the life of a patent, third parties may design and sell “work-around” solutions that accomplish the goals of our patented inventions but do not infringe the patents themselves.

Our issued U.S. patents expire at various dates ranging from 2005 to 2018. When each of our patents expires, competitors may develop and sell products based on the same or similar technologies as those covered by the expired patent, which could result in lower prices, reduced margins or the failure of our products to achieve or maintain market acceptance. In addition, when each of our patents expires, potential customers may choose to rely on “freeware,” free versions of our previously patented technology, rather than buying our products.

From time to time, we have been involved in disputes with third parties who allege that our products may infringe intellectual property rights held by the third parties. Any litigation carries a number of significant risks, including:

•		litigation is often very expensive, even if it is resolved in our favor; and
•		litigation diverts the attention of management and other resources.

Moreover, if a court or other government agency rules against us in any intellectual property litigation, we might be required to:

•		discontinue the use of certain processes;
•		cease the manufacture, use and sale of infringing products;
•		expend significant resources to develop non-infringing technology;
•		obtain licenses to the infringing technology; or
•		pay significant monetary damages.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We are exposed to a variety of risks, including changes in the market value of our marketable securities, investments, our common stock and foreign exchange rates. Market fluctuations could impact our results of operations and financial condition. In the normal course of business, we employ established policies and procedures to manage these risks.

Our marketable securities and cash equivalent investments are generally high credit quality instruments, primarily U.S. Treasury and government agency obligations, tax-exempt municipal obligations and money market investments with contractual maturities of two years or less. We do not expect any material loss from our marketable securities and cash equivalent investments and therefore believe that our potential interest rate exposure is not material. We evaluate the realizable value of these investments using qualitative and quantitative factors including discounted cash flow analysis and liquidation value assessments.

During 2001, we issued 7% convertible subordinated debentures due October 17, 2004 with an aggregate principal amount of $80.0 million, together with warrants to purchase an aggregate of approximately 0.9 million shares of our common stock. At any time and at their option, each holder may convert any outstanding debentures into shares of our common stock at a conversion price of $13.745 per share, which upon conversion of all of the outstanding debentures would result in the issuance of approximately 5.8 million shares of our common stock. The holders of the warrants issued with the debentures may exercise the warrants at any time until October 17, 2006 at an exercise price of $13.745 per share. The conversion price of the debentures and the exercise price of the warrants may be adjusted under certain circumstances, such as events that would cause dilution of the holder’s interest. We may redeem all or a portion of the debentures for cash as long as the arithmetic average of the weighted average price of our common stock on each trading day during the fifteen trading day period immediately prior to the election to redeem is at least 150% of the conversion price. This redemption feature was not exercisable at March 31, 2004. If the 7% convertible debentures are redeemed in part or total prior to their maturity date we will record a non cash charge for unamortized deferred financing costs and the unamortized value of the warrants.

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At March 31, 2004, unamortized deferred financing costs were $0.8 million and the unamortized value of the warrants was $0.8 million. Interest is payable in cash semi-annually at a fixed rate of 7% per annum, and therefore we believe we have no interest rate exposure with these debentures.

As a global concern, we face exposure to adverse movements in foreign currency exchange rates. These exposures may change over time as business practices evolve and could have a material adverse impact on our financial results. Historically, our primary exposures to fluctuations in foreign currency exchange rates related to sales and operating expenses denominated in local currencies. Our direct sales to our customers in countries outside of the United States are denominated in U.S. dollars and local currencies, with the majority of our direct sales denominated in U.S. dollars. Our sales through indirect distribution channels are generally denominated in U.S. dollars. For countries outside the United States, we generally pay our operating expenses in local currency. When we do invoice customers in local currency, we are exposed to foreign exchange rate fluctuations from the time of invoice until collection occurs. We are also exposed to foreign currency rate fluctuations between the time we collect in U.S. dollars and the time we pay our operating expenses in local currency. Fluctuations in foreign currency exchange rates could affect the profitability and cash flows in U.S. dollars of our products sold in international markets.

Item 4. Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in the SEC rules promulgated under the Securities Exchange Act of 1934, as amended) as of March 31, 2004. Based on this evaluation, our CEO and CFO concluded that, as of March 31, 2004, our disclosure controls and procedures were (1) designed to ensure that material information relating to RSA Security, including its consolidated subsidiaries, is made known to our CEO and CFO by others within RSA Security, particularly during the period in which this Report was being prepared, and (2) effective, in that they provide reasonable assurance that information that we are required to disclose in the reports we file under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

No change in our internal control over financial reporting (as defined in the SEC rules promulgated under the Securities Exchange Act) occurred during the quarter ended March 31, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

On or about February 2, 2001, Leon Stambler filed a complaint for patent infringement in U.S. District Court for the District of Delaware against RSA Security, VeriSign, Inc., First Data Corporation, Openwave Systems Inc., and Omnisky Corporation, Case Number 01-0065. In his complaint, Mr. Stambler alleged that certain products marketed by each of the defendants infringed various patents that he owns, and he sought unspecified damages as well as a preliminary and permanent injunction enjoining the defendants from infringing the claims asserted. The trial took place in March 2003, and the jury determined that our products did not infringe Mr. Stambler’s patents. On April 17, 2003, the court entered final judgment in our favor on all claims of non-infringement. On or about December 8, 2003, Mr. Stambler filed a notice of appeal to the United States Court of Appeals. We plan to vigorously defend the appeal. We believe that the final disposition of this matter will not have a material adverse effect on our continuing operations and consolidated financial position.

On or about December 20, 2001, France Telecom and Telediffusion de France (“FT”) filed a Request for Arbitration with the International Court of Arbitration. FT claimed that we breached a license agreement with FT and sought unspecified damages including a payment in excess of $110.0 million plus the legal fees and other costs associated with the arbitration. The arbitration took place in June 2003. On March 27, 2004, the arbitrator ruled in our favor, denying all of FT’s claims, and ordered FT to pay us approximately $1.6 million in reimbursement of our legal fees and other expenses associated with the arbitration. Due to FT’s many procedural objections, we believed that FT might contest the ruling. To eliminate this uncertainty, in April 2004, we requested that FT confirm to us in writing that they intended to comply with the arbitrator’s ruling. On April 15, 2004, FT confirmed to us in writing that it would accept the arbitrator’s ruling. In April, we received cash payment. We will record this $1.6 million gain in the second quarter of 2004.

In a related matter, FT had also filed a patent infringement suit in Delaware against Novell, Inc., one of our licensees. . On or about April 22, 2004, the court dismissed the case at the joint request of FT and Novell.

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From time to time, we have been named as a defendant in other legal actions arising from our normal business activities, which we believe will not have a material adverse effect on us or our business.

Item 6. Exhibits and Reports on Form 8-K

a) Exhibits

See the Exhibit Index attached to this Report.

(b) Reports on Form 8-K:

On January 9, 2004, we filed a Current Report on Form 8-K announcing our preliminary financial results for the fourth quarter ended December 31, 2003.

On January 29, 2004, we filed a Current Report on Form 8-K announcing our financial results for the fourth quarter and year ended December 31, 2003.

On February 10, 2004, we furnished a Current Report on Form 8-K containing our presentation entitled Inspiring Confidence in e-Business dated February 2004.

On February 24, 2004, we furnished a Current Report on Form 8-K containing our presentation entitled Inspiring Confidence in e-Business dated February 2004.

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SIGNATURE

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

Dated: May 6, 2004

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EXHIBIT INDEX

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