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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004

COMMISSION FILE NUMBER 0-20270

SAFLINK CORPORATION

(Exact name of registrant as specified in its charter)

777 108th Ave NE, Suite 2100; Bellevue, Washington 98004

(Address of principal executive offices and zip code)

(425) 278-1100

(Registrant’s telephone number, including area code)

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  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).    Yes  ¨    No  x

There were 79,327,413 shares of SAFLINK Corporation’s common stock outstanding as of November 10, 2004.

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SAFLINK Corporation

FORM 10-Q

For the Quarter Ended September 30, 2004

INDEX

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PART I—FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SAFLINK CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(In thousands)

See accompanying notes to condensed consolidated financial statements.

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SAFLINK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share data)

See accompanying notes to condensed consolidated financial statements.

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SAFLINK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

See accompanying notes to condensed consolidated financial statements.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1. Description of Business and Basis of Presentation

Description of the Company

SAFLINK Corporation offers biometric security, smart card, and public key infrastructure (“PKI”) solutions that protect intellectual property, secure information assets, and eliminate passwords. SAFLINK’s software provides Identity Assurance Management^™, allowing administrators to verify identity and control access to computer networks, physical facilities, applications, and time and attendance systems. SAFLINK Corporation was incorporated in the State of Delaware on October 23, 1991, and maintains its headquarters in Bellevue, Washington.

Condensed Consolidated Financial Statements

The accompanying condensed consolidated financial statements present unaudited interim financial information and therefore do not contain certain information included in the annual consolidated financial statements of SAFLINK Corporation and its wholly-owned subsidiaries, SAFLINK International, Inc. and Litronic, Inc., (together, the “Company” or “SAFLINK”). The balance sheet at December 31, 2003, has been derived from SAFLINK Corporation’s audited financial statements as of that date. In the opinion of management, all adjustments (consisting only of normally recurring items) it considers necessary for a fair presentation have been included in the accompanying condensed consolidated financial statements. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in SAFLINK Corporation’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003, as filed with the Securities and Exchange Commission (the “SEC”) on March 30, 2004.

Merger with SSP Solutions, Inc.

On August 6, 2004, the Company completed its merger transaction with SSP Solutions, Inc., dba SSP-Litronic, following which SSP-Litronic became a wholly-owned subsidiary of SAFLINK. In the merger, SAFLINK acquired all of the outstanding shares of SSP-Litronic common stock in a stock-for-stock transaction where each outstanding share of SSP-Litronic common stock was converted into the right to receive 0.6 shares of SAFLINK common stock. The Company issued 40,137,148 shares of common stock in exchange for the outstanding shares of SSP-Litronic common stock.

In connection with the merger, the Company assumed each option, warrant and promissory note exercisable for or convertible into shares of SSP-Litronic common stock, and those securities are now exercisable for or convertible into shares of SAFLINK common stock, with appropriate adjustments to reflect the merger.

Litronic is a global provider of digital identity management and information assurance products for the government and enterprise markets. By facilitating the deployment, management, and use of digital certificates and smart cards, Litronic’s products provide strong authentication solutions to protect valuable information as it is transmitted electronically. The Company believes that its merger with Litronic will help it to broaden its customer base and will enable it to be able to offer an integrated smart card plus biometric solution to the government and commercial sectors.

The assets, liabilities, and operations of Litronic are included in the Company’s condensed consolidated financial statements since the August 6, 2004, acquisition date. See Note 3 “Business Combinations.”

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

2. Summary of Significant Accounting Policies

Basis of Financial Statement Presentation and Principles of Consolidation

The capital structure presented in these condensed consolidated financial statements is that of SAFLINK. The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

The condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. Preparation of the condensed consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the balance sheets and revenues and expenses for the periods. Actual results could differ from those estimates.

Revenue Recognition

The Company derives revenue from license fees for software products, selling and reselling of hardware, and fees for services related to the software products including maintenance services, installation and integration consulting services.

The Company recognizes revenue in accordance with the provisions of Statement of Position 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by SOP 98-9 and related interpretations, including Technical Practice Aids, which provides specific guidance and stipulates that revenue recognized from software arrangements is to be allocated to each element of the arrangement based on the relative fair values of the elements, such as software products, upgrades, enhancements, post-contract customer support, installation, integration and/or training. Under this guidance, the determination of fair value is based on objective evidence that is specific to the vendor. In multiple element arrangements in which fair value exists for undelivered elements, the fair value of the undelivered elements is deferred and the residual arrangement fee is assigned to the delivered elements. If evidence of fair value for any of the undelivered elements does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist, or until all elements of the arrangement are delivered.

Revenue from biometric software and data security license fees is recognized upon delivery, net of an allowance for estimated returns, provided persuasive evidence of an arrangement exists, collection is probable, the fee is fixed or determinable, and vendor-specific objective evidence exists to allocate the total fee to elements of the arrangement. If customers receive pilot or test versions of products, revenue from these arrangements is recognized upon customer acceptance of permanent license rights. If the Company’s software is sold through a reseller, revenue is recognized when the reseller delivers its product to the end-user. Certain software delivered under a license requires a separate annual maintenance contract that governs the conditions of post-contract customer support. Post-contract customer support services can be purchased under a separate contract on the same terms and at the same pricing, whether purchased at the time of sale or at a later date. Revenue from these separate maintenance support contracts is recognized ratably over the maintenance period. Other software delivered under a license includes a first year of maintenance, in which case the value of such maintenance is recognized ratably over the initial license period. The value of such deferred maintenance revenue is established by the price at which the customer may purchase a renewal maintenance contract.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

Revenue from some data security hardware products contains embedded software. However, the embedded software is incidental to the hardware product sale. The Company also acts as a reseller of third-party hardware and software applications. Such revenue is recognized upon delivery of the hardware, provided that all other conditions above have been met.

Service revenue includes payments under support and upgrade contracts and consulting fees. Support and upgrade revenue is recognized ratably over the term of the contract, which typically is twelve months. Consulting revenue primarily relates to installation, integration and training services performed on a time-and-materials or fixed-fee basis under separate service arrangements. Fees from consulting are recognized as services are performed. If a transaction includes both license and service elements, license fees are recognized separately upon delivery of the licensed software, provided services do not include significant customization or modification of the software product, the licenses are not subject to acceptance criteria, and vendor-specific objective evidence exists to allocate the total fee to elements of the arrangement. If the services do include significant customization or modification of the software product, the revenue is recognized in accordance with Accounting Research Bulletin No. 45, Long-Term Construction Type Contracts (ARB 45), using the relevant guidance from the American Institute of Certified Public Accountants Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts (SOP 81-1).

Stock-Based Compensation for Employees and Non-Employees

The Company applies the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, “Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25,” issued in March 2000, to account for its stock options. Under this method, compensation expense is recognized only if the current market price of the underlying stock exceeded the exercise price on the date of grant. SFAS No. 123, “Accounting for Stock-Based Compensation,” and SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure, an Amendment of SFAS Statement No. 123,” established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of SFAS No. 123, as amended. The following table illustrates the effect on net loss if the fair-value-based method had been applied to all outstanding and unvested awards in each period.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

The Company accounts for non-employee stock-based compensation in accordance with SFAS No. 123 and Emerging Issues Task Force (“EITF”) No. 96-18, “Accounting for Equity Instruments that are Issued to other than Employees for Acquiring, or in conjunction with Selling, Goods or Services.”

New Accounting Standards

In January 2003, the FASB issued Interpretation 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 addresses consolidation by business enterprises of variable interest entities which have one or both of the following characteristics: (1) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity; (2) the equity investors lack one or more of the following essential characteristics of a controlling financial interest: (a) the direct or indirect ability to make decisions about the entity’s activities through voting rights or similar rights, (b) the obligation to absorb the expected losses of the entity if they occur, which makes it possible for the entity to finance its activities, or (c) the right to receive the expected residual returns of the entity if they occur, which is the compensation for the risk of absorbing expected losses. FIN 46 does not require consolidation by transferors to qualifying special purpose entities. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003.

In December 2003, the FASB issued a revision to Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (“FIN 46R”). FIN 46R clarifies the application of ARB No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support provided by any parties, including the equity holders. FIN 46R requires the consolidation of these entities, known as variable interest entities (“VIE’s”), by the primary beneficiary of the entity. The primary beneficiary is the entity, if any, that will absorb a majority of the entity’s expected losses, receive a majority of the entity’s expected residual returns, or both.

Among other changes, the revisions of FIN 46R (a) clarified some requirements of the original FIN 46, which had been issued in January 2003, (b) eased some implementation problems, and (c) added new scope exceptions. FIN 46R deferred the effective date of the Interpretation for public companies to the end of the first reporting period ending after March 15, 2004, except that all public companies must, at a minimum, apply the unmodified provisions of the Interpretation to entities that were previously considered “special-purpose entities” in practice and under the FASB literature prior to the issuance of FIN 46R by the end of the first reporting period ending after December 15, 2003. As of September 30, 2003, and 2004, management believes that the Company is not the primary beneficiary of any VIE’s.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS 150 applies specifically to a number of financial instruments that companies have historically presented within their financial statements either as equity or between the liabilities section and the equity section, rather than as liabilities. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. During the nine months ended September 30, 2004, the company classified certain instruments containing both liability and equity characteristics as liabilities which is discussed further in Note 4.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

Reclassifications

Certain reclassifications were made to the 2003 condensed consolidated financial statements to conform to the 2004 presentation. The Company’s condensed consolidated interim financial statements are not necessarily indicative of results to be expected for a full fiscal year.

3. Business Combinations

SSP-Litronic Merger

On August 6, 2004, pursuant to an Agreement and Plan of Merger and Reorganization, dated as of March 22, 2004, by and among SAFLINK Corporation, a Delaware corporation, Spartan Acquisition Corporation (“Spartan”), a Delaware corporation and wholly-owned subsidiary of SAFLINK, and SSP Solutions, Inc., a Delaware corporation, dba SSP-Litronic, Spartan was merged with and into SSP-Litronic, with SSP-Litronic surviving as a wholly-owned subsidiary of SAFLINK. The effective date of the merger was August 6, 2004. Pursuant to the terms of the merger agreement, SAFLINK acquired all of the outstanding shares of SSP-Litronic common stock in a stock-for-stock transaction where each outstanding share of SSP-Litronic common stock was converted into the right to receive 0.6 shares of SAFLINK common stock. SAFLINK issued 40,137,148 shares of its common stock in exchange for the outstanding shares of SSP-Litronic common stock.

Pursuant to the merger agreement, SAFLINK assumed each option, warrant and promissory note exercisable for or convertible into shares of SSP-Litronic common stock, and those securities are now exercisable for or convertible into shares of SAFLINK common stock, with appropriate adjustments to reflect the merger. At the time of the merger, the approximate number of shares exercisable for or convertible into shares of SAFLINK common stock assumed in connection with the merger included 2,360,552 million shares issuable upon exercise of options, 889,335 shares issuable upon exercise of warrants, and 816,000 shares issuable upon conversion of convertible promissory notes.

The Company believes that its merger with Litronic will help broaden its customer base and will enable it to offer an integrated smart card plus biometric solution to the government and commercial sectors.

The acquisition is being accounted for under the purchase method of accounting, as of August 6, 2004, and the results of operations of Litronic Inc. from August 6, 2004 through September 30, 2004 have been included in the consolidated results of operations for SAFLINK for the three and nine months ended September 30, 2004. A summary of the components of the purchase price for the acquisition, in thousands, is as follows:

The fair value of the common stock issued by SAFLINK upon the acquisition was $2.90 per share based on the average closing price for a period before and after March 22, 2004, the date of the merger agreement. The number of shares issued by SAFLINK to holders of SSP-Litronic common stock in connection with the merger was 40,137,138. The estimated merger costs primarily consist of legal, financial advisory and accounting fees and other directly related costs.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

The fair value of options and warrants assumed was determined using the fair value of SAFLINK common stock of $2.90 per share, based on the average closing price for a period before and after March 22, 2004, the date of the merger agreement, and a Black-Scholes model with the following assumptions: Options—an expected dividend yield of 0.0%, a risk-free interest rate between 2%–5%, volatility of 140%, and an expected life between 1–6 years. Warrants—an expected dividend yield of 0.0%, a risk-free interest rate between 1%–3%, volatility of 140%, and a contractual life between 0–5 years.

The purchase price was allocated based on a determination of the value of the tangible and intangible assets acquired and liabilities assumed. The goodwill recorded as a result of the acquisition will not be amortized, but will be included in the Company’s annual review of goodwill for impairment. The purchase price allocation is subject to change based on the final valuation of tangible and intangible assets and liabilities assumed, which is expected to be completed in the fourth quarter of 2004.

The fair value of the conversion feature of the convertible debt assumed was determined using a Black-Scholes model with the following assumptions: an expected dividend yield of 0.0%, a risk-free interest rate of 2.1%, a volatility of 75%, and a remaining contractual life of 1.4 years. The value was estimated at approximately $1.2 million and classified in additional paid-in capital in stockholders’ equity.

The following represents the preliminary allocation of the purchase price to the acquired assets and liabilities of SSP-Litronic. This allocation was based on the fair value of the assets and liabilities of SSP-Litronic as of August 6, 2004. The excess of the purchase price over the fair value of net identifiable assets acquired is reflected as goodwill (in thousands):

The unaudited pro forma combined historical results of operations for the three and nine months ended September 30, 2003, assuming the Litronic merger had closed on January 1, 2003, are as follows (in thousands, except per share data):

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

The unaudited pro forma combined historical results of operations for the three and nine months ended September 30, 2004, assuming the Litronic merger had closed on January 1, 2004, are as follows (in thousands, except per share data):

The pro forma information does not purport to be indicative of the results that would have been attained had these events actually occurred at the beginning of the period presented and is not necessarily indicative of future results.

Amortization of identifiable intangible assets has been provided over the following estimated useful lives: patents—7 years; developed technology—7 to 10 years; customer relationships—8 years; and non-competition agreements—3 years. Tradenames have been determined to have an indefinite life. Amortization expense related to this acquisition for the three and nine months ended September 30, 2004, was approximately $432,000. Based on the balances of identified intangible assets as of September 30, 2004, and assuming no subsequent impairment of the underlying assets, the annual amortization expense for the last three months of 2004 and the five subsequent years is expected to be approximately as follows (in thousands):

Asset Purchase from BSG and ISS

On December 29, 2003, the Company acquired certain assets and rights used in connection with the digital identity and biometric-enhanced physical access security business of Information Systems Support, Inc., a Maryland corporation (“ISS”) and Biometric Solutions Group, Inc., a Delaware corporation (“BSG”), pursuant to the terms of an Asset Purchase Agreement, dated as of December 28, 2003, by and between the Company, ISS and BSG. The purchase arrangement has been accounted for as a business combination. The primary reason the Company made the purchase was to expand its market by entering the physical access market and to meld the physical access product into its existing logical access product. This technology also played a vital role in the Company’s entry into the manufacturing automation systems market.

The purchase price paid in the acquisition was approximately $3.9 million, which consisted of $500,000 in cash, 1,122,855 shares of the Company’s common stock and $262,000 in direct acquisition fees. The fair value of the common stock issued by the Company upon the acquisition was $2.76 per share, based on the average market price for a period before and after December 29, 2003, the date of the asset purchase agreement. ISS and BSG have agreed not to sell the shares of common stock received in the transaction for a period of three years. The accounting for the purchase price allocation is now final and there were no adjustments made after December 31, 2003.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

The Company acquired certain intellectual property, tangible assets and inventory in the transaction. In addition, certain employees of ISS were offered employment with the Company in connection with the acquisition, including Robert L. Turbeville, Jr., a former Senior Vice President for ISS. The Company did not assume any liabilities on behalf of BSG as part of this acquisition, other than to accept assignment of a facilities lease for the offices of BSG in Charleston, South Carolina.

Amortization expense related to this purchase for the three and nine months ended September 30, 2004, was approximately $61,000 and $182,000, respectively. Based on the balances of identified intangible assets as of September 30, 2004, and assuming no subsequent impairment of the underlying assets, the annual amortization expense for the last three months of 2004 and the five subsequent years is expected to be approximately as follows (in thousands):

4. Inventory

The following is a summary of inventory as of September 30, 2004, and December 31, 2003 (in thousands):

5. Long–Term Debt

As part of the merger with Litronic, the Company assumed three convertible promissory notes (“Convertible Notes”) with a combined face value of $1,360,000. These notes mature December 31, 2005, and bear interest at a rate of 10% per annum to be paid quarterly in cash, or at the Company’s discretion, in common shares based upon the trailing 30-day average prior to the interest due date. The notes are convertible, in whole or in part, at the option of the holder into shares of the Company’s common stock at any time prior to maturity, at a conversion price of $1.66 per share, subject to adjustment under certain conditions. The notes automatically convert prior to maturity if the Company’s common shares trade at or above $5.00 per share with average volume of 60,000 shares per day for 20 consecutive trading days. The Company is subject to restrictive covenants related to the notes that prevent the Company from pledging intellectual property as collateral.

The conversion feature embedded in the Convertible Notes was valued at $1.2 million on the date of the merger, and was classified into equity in the purchase price allocation (Note 3).

The Company’s Litronic subsidiary maintains a factoring agreement with Bay View Funding (“BVF”). The factoring agreement contains a maximum advance of $750,000 and provides for successive, renewable three-month terms. The agreement contains a factoring fee of 1.25% of the gross face value of each purchased

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

receivable covering the 30-day period from the date of purchase by BVF. For invoices outstanding more than the 30-day period, a finance fee is charged at the rate of .063% of the gross face value of the purchased receivable for each day beyond the 30th day from the original date of purchase. Under the agreement, BVF advances 85% of the gross receivable, with the balance remitted after collection of the invoice less the factoring and finance fee, if applicable. The agreement requires a monthly minimum fee, including the factoring and financing fees, of approximately $250 per month. There were no amounts outstanding under the BVF line at September 30, 2004.

6. Stockholders’ Equity

Increase in Authorized Common Shares

During the quarter ended September 30, 2004, the Company increased the number of common shares authorized for issuance from 100,000,000 to 500,000,000, which was approved by stockholders on August 5, 2004.

Warrant Amendments and Exercises

On July 20, 2004, certain holders of outstanding warrants to purchase shares of the Company’s common stock exercised warrants to purchase an aggregate of 4,473,806 shares of common stock for cash, resulting in net proceeds of approximately $10.8 million. In order to encourage early exercise of the warrants by the warrant holders, the Company agreed to reduce the exercise price with respect to the warrants from a weighted average exercise price of $3.36 per share to $2.50 per share. All other material terms of the warrants, including the number of shares issuable upon exercise of the warrants and their expiration date, remained unchanged. The proceeds from the warrant exercises were held in a third-party escrow account and, upon closing of the merger on August 6, 2004, the funds were released to the Company and the Company issued the shares of common stock to the warrant holders.

The fair value of this modification of warrants was determined by using a Black-Scholes model immediately before and after the modification date of July 20, 2004, with the following assumptions: an expected dividend yield of 0.0%, a risk-free interest rate 0.8%, volatility of 42.5%, and an expected term of 5 days, the period of time the warrant holders had to accept the reduced exercise price. The value was estimated to be approximately $2.2 million and was recorded as a modification of outstanding equity instruments. This charge increased net loss attributable to common stockholders.

Reclassification of warrants to long-term liability

The Company’s Series A warrants and the related placement agent warrants that were issued on June 5, 2001, contain a cash redemption provision that is triggered if the Company issues, in a business combination, capital stock that represents more than 40% of its outstanding common stock immediately prior to such issuance. The Litronic merger qualified as a triggering event because the Company issued more than 40% of its common stock in connection with the merger. The cash redemption value was measured as of August 2, 2004, the date the warrant holders were officially notified of the merger by the Company, and, in accordance with the warrant provisions, was determined using a Black-Scholes model with the following assumptions: an expected dividend yield of 0.0%, a risk-free interest rate of 2.5%, a volatility of 105%, and a remaining contractual life of 1.8 years, as the warrants expire on June 5, 2006. As of August 2, 2004, there were Series A warrants and placement agent warrants outstanding to purchase 244,224 and 192,124 shares of the Company’s common stock, respectively. Exercise prices of the warrants ranged from $1.30 to $3.06. The total cash redemption value was estimated to be $765,000 as of August 2, 2004, and is fixed as long as the warrants are outstanding.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

On August 6, 2004, the closing date of the merger, these warrants were reclassified as a long-term liability in accordance with SFAS 150 because the warrants now contain characteristics of a debt instrument. The outstanding warrants were valued as of September 30, 2004, using a Black-Scholes model with the following assumptions: an expected dividend yield of 0.0%, a risk-free interest rate of 2.5%, a volatility of 75%, and a remaining contractual life of 1.7 years. The value of the warrants includes the value of the cash redemption provision, which was determined using a Black-Scholes model with similar assumptions. The value of the warrants was estimated to be $937,000, as of September 30, 2004, and is classified as a long-term liability. At each interim period and year end, the remaining outstanding warrants will be revalued and any difference from the previous valuation date will be recognized as a change in fair value of outstanding warrants.

Options and warrants assumed in SSP-Litronic merger

Options

The unexercised options issued under SSP-Litronic option plans (“SSP Options”) were assumed as part of the merger. Effective with the closing of the merger, no additional options can be granted under those plans. The terms and conditions related to the SSP Options remain unchanged, with the exception of the adjustment required to reflect the affect of the merger conversion ratio on the number of shares exercisable and the exercise price. As of September 30, 2004, there were outstanding SSP Options to purchase approximately 2.3 million shares of Company common stock. Generally, SSP Options vested and became exercisable 25% upon the first anniversary of the grant issuance, and thereafter vested as to 1/48 of the total number of shares underlying the option each month until vested and exercisable in full.

Warrants

The unexercised warrants issued by SSP-Litronic were assumed effective with the closing of the merger and the number of shares issuable upon exercise and the exercise price has been adjusted to reflect the merger. Warrants assumed consisted of A-1 Warrants, A-2 Warrants, and Placement Agent Warrants to purchase 875,082 shares of SAFLINK common stock, together with a previously issued warrant for the purchase of 14,254 shares of SAFLINK common stock at an exercise price of $3.52 per share, which expires July 31, 2005.

A-1 and A-2 Warrants

The A-1 Warrants have an exercise price of $2.50 per share, and the A-2 Warrants have an exercise price of $2.92 per share. The A-1 and A-2 Warrants are subject to customary anti-dilution provisions and weighted average anti-dilution provisions if the Company issues shares of common stock or securities convertible into or exercisable for common stock, other than excluded securities, at per share prices less than the then effective exercise price.

Beginning January 23, 2007, and subject to a minimum average dollar trading volume, the Company may redeem the A-1 and A-2 Warrants for $.17 per Warrant if the Company’s stock closes above $5.00 relative to the A-1 Warrants and $5.83 relative to the A-2 Warrants for ten consecutive trading days.

From the time of the merger until November 19, 2004, a holder may exercise a Warrant on a cashless basis for a net number of common shares, provided that a registration statement covering the resale of those shares is not then effective. At September 30, 2004, a total 421,500 A-1 Warrants and 415,500 A-2 Warrants were outstanding.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

Placement Agent Warrants

The Placement Warrants are exercisable at $1.17 per share and expire five years from the issuance date. At September 30, 2004, a total 38,082 Placement Agent Warrants were outstanding.

Common Stock Issuance

In conjunction with the merger with SSP-Litronic (Note 3) that closed August 6, 2004, the Company issued 40,137,148 common shares.

On February 26, 2004, the Company entered into a common stock purchase agreement and registration rights agreement with certain accredited institutional investors, pursuant to which the Company agreed to issue and sell an aggregate of 3,080,000 shares of the Company’s common stock and warrants to purchase up to 1,232,000 shares of the Company’s common stock in a private placement, for an aggregate purchase price of approximately $9.2 million. The warrants have a 5-year term, an original exercise price of $3.97 per share, and a call feature which the Company is entitled to exercise after three years and ten trading days from the date of issuance, provided that the per share market value of the common stock has been equal to or greater than 200% of the warrant price for a period of ten consecutive trading days immediately prior to the date of delivery of the call notice. Due to anti-dilution provisions contained in these warrants, the exercise price was reduced to $2.50 per share related to the warrant amendments that occurred in July 2004. Per the original registration rights agreement, if the registration statement ceased to be effective prior to its expiration date of February 26, 2007, or if the Company’s common stock was suspended or delisted from both the Nasdaq SmallCap Market and the OTC Bulletin Board for any reason for more than five business days, the Company may have been required to pay an amount as liquidated damages to each stockholder equal to 2% for the first thirty day period and 1% per thirty day period thereafter or portion thereof of the stockholder’s initial investment in the shares from the event date until the applicable event is cured. The warrant value as of February 26, 2004, was $4,069,000 based on the estimated value of the warrants using the Black-Scholes model, with an expected dividend yield of 0.0%, a risk-free interest rate of 4.0%, volatility of 140% and an expected life of three to five years. During September 2004, the registration rights agreement was amended so that the company would remedy any of these situations with shares of the Company’s common stock rather than cash. Due to the amendment of the Company’s potential obligation to settle the warrants in common stock rather than cash if the terms of the registration rights agreement are not met, the fair value of the warrants on the modification date, estimated at $2.3 million, has been reclassified from a liability to additional paid-in capital in stockholders’ equity and was estimated using the Black-Scholes model, with an expected dividend yield of 0.0%, a risk-free interest rate of 3.0%, a volatility of 132% and an expected life of two to five years.

In connection with this financing, the Company issued placement agent warrants to purchase up to 184,800 shares of the Company’s common stock at an original exercise price of $3.97 per share. The warrants have a 5-year term but are not subject to the registration rights agreement. The value of these placement agent warrants was included in financing costs and was estimated at $663,000, based on the estimated value of the warrants using the Black-Scholes model with an expected dividend yield of 0.0%, a risk-free interest rate of 4.0%, volatility of 140% and an expected life of five years. Other costs associated with this financing include $691,000 in direct fees paid to various third parties. Due to anti-dilution provisions contained in these warrants, the exercise price was reduced to $2.50 per share related to the warrant amendments that occurred in July 2004.

On June 5, 2004, due to provisions in the Company’s Series E preferred stock, all outstanding shares of Series E preferred stock automatically converted into shares of the Company’s common stock. As of June 4, 2004, there were 15,166 shares of Series E preferred stock outstanding, which converted into 2,166,576 shares of the Company’s common stock on June 5, 2004.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

On June 23, 2004, under its 2000 Stock Incentive Plan, the Company granted a stock purchase right to Glenn Argenbright, the Company’s Chief Executive Officer, to acquire 301,928 shares of the Company’s common stock. The stock purchase right was exercised on June 23, 2004 through past service rendered, with the shares issued being subject to a three-year cliff vesting schedule and vest completely on June 23, 2007. In the event that Mr. Argenbright’s service is terminated for any reason or no reason, with or without cause, any unvested shares will be forfeited and reacquired by the Company. The Company valued the grant using the Company’s closing stock price of $2.51 on June 23, 2004, multiplied by the number of shares granted, resulting in a total value of $758,000, which is classified as deferred compensation and is being amortized on a straight-line basis over the three-year vesting period. Deferred compensation amortization related to this grant during the three months and nine months ended September 30, 2004, was $63,000 and $68,000, respectively.

On August 9, 2004, under its 2000 Stock Incentive Plan, the Company granted a stock purchase right to Kris Shah, the President of Litronic, to acquire 500,000 shares of the Company’s common stock. The stock purchase right was exercised on August 9, 2004, with 300,000 shares issued being subject to a one-year cliff vesting schedule and the remaining 200,000 shares vesting after two years. In the event (A) there is a change of control prior to the expiration of the two year term or while Mr. Shah otherwise remains employed by the Company, (B) Mr. Shah’s employment is terminated without cause, as defined in the restricted stock agreement, (C) Mr. Shah resigns from his employment for good reason, as defined in the restricted stock agreement, or (D) Mr. Shah dies or becomes disabled, Mr. Shah will receive full accelerated vesting upon any unvested portion of the restricted stock. The Company valued the grant using the Company’s closing stock price of $2.74 on August 9, 2004, multiplied by the number of shares granted, resulting in a total value of $822,000, which is classified as deferred compensation with each tranche being amortized straight-line over its respective vesting period. Deferred compensation amortization related to this grant during the three months ended September 30, 2004, was $117,000.

7. Concentration of Credit Risk and Significant Customers

One customer accounted for 15% of the Company’s revenue for the nine months ended September 30, 2004, while the same customer accounted for 17% and another customer 11% of the Company’s revenue for the three months ended September 30, 2004, respectively. Four customers accounted for 26%, 13%, 11%, and 10% of accounts receivable as of September 30, 2004, respectively. For the nine months ended September 30, 2003, two customers accounted for 29% and 11% of the Company’s revenue, respectively, while two customers accounted for 49% and 11% of the Company’s revenue for the three months ended September 30, 2003, respectively. Two customers accounted for 58% and 13% of accounts receivable as of September 30, 2003, respectively.

Government sales accounted for 89% and 71% of the Company’s revenue for the three and nine months ended September 30, 2004, respectively. Government sales accounted for 12% and 22% of the Company’s revenue for the three and nine months ended September 30, 2003, respectively. Government customers accounted for 90% and 8% of the Company’s accounts receivable as of September 30, 2004, and 2003, respectively.

8. Comprehensive Loss

For the three and nine months ended September 30, 2004, and 2003, the Company had no components of other comprehensive loss; accordingly, total comprehensive loss equaled the net loss for the respective periods.

9. Net Loss Per Share

In accordance with SFAS No. 128, “Earnings Per Share,” the Company has reported both basic and diluted net loss per common share for each period presented. Basic net loss per common share is computed on the basis

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

of the weighted-average number of common shares outstanding for the period. Diluted net loss per common share is computed on the basis of the weighted-average number of common shares plus dilutive potential common shares outstanding. Dilutive potential common shares are calculated under the treasury stock method. Securities that could potentially dilute basic income per share consist of outstanding stock options, warrants, convertible preferred stock and convertible promissory notes. As the Company had a net loss in each of the periods presented, basic and diluted net loss per common share are the same. All potentially dilutive securities were excluded from the calculation of dilutive net loss per share as their effect was anti-dilutive.

Potential common shares outstanding consisted of options, warrants, and convertible notes to purchase or convert 13,009,009 and 11,232,632 shares of common stock at September 30, 2004, and 2003, respectively, and zero and 2,166,576 shares of common stock issuable upon conversion of Series E preferred stock as of September 30, 2004, and 2003.

10. Segment Information

Operating segments are revenue-producing components of the enterprise for which separate financial information is produced internally for the Company’s management. Under this definition, the Company operated, for all periods presented, as a single segment.

11. Related-party Transactions

Revenue Recognized

During the three months ended September 30, 2004, ISS was no longer considered a related-party. For the nine months ended September 30, 2004, the Company recognized $231,000 in revenue through related-party sales to ISS. The Company purchased certain assets from ISS and BSG on December 29, 2003, in a cash and common stock transaction (see Note 3).

KRDS Real Property Lease

As a result of the merger with SSP-Litronic, the Company assumed the building lease for SSP-Litronic’s corporate offices in Irvine, California. The lessor is KRDS, Inc., which is majority-owned by three employees of SAFLINK’s subsidiary, Litronic. SAFLINK recognized rent expense of approximately $71,000 for the three months ended September 30, 2004. The lease expires in the year 2012.

12. Contingencies

On February 6, 2004, Litronic received notice from the Environmental Protection Agency (“EPA”) regarding the Omega Chemical Superfund Site (“Omega Site”). The notice states that Litronic is a potentially responsible party (“PRP”) that contributed to the waste at the Omega Site. The notice also states that the amount of waste contributed to the Omega Site was a comparatively small quantity, or a de minimis quantity. As such, the notice is intended to offer Litronic the opportunity to resolve its liability for waste disposed at the Omega Site. The notice also states that if Litronic accepts the settlement offer, it can be released from further liability from the United States regarding the Omega Site as well as gaining contribution protection against lawsuits by other PRP’s, who potentially have claims against Litronic. The settlement offer amount is $108,000 and Litronic accepted the EPA offer on September 24, 2004. Litronic has been advised by its legal counsel and believes that there will be no further liability regarding this claim from the EPA or other PRP’s. As such, Litronic accepted the settlement offer of $108,000, which Litronic previously recorded as an accrued expense.

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

The Company’s guaranteed minimum lease payments as of September 30, 2004, were as follows (in thousands):

13. Liquidity and Capital Resources

The Company had working capital of $25.7 million and $6.7 million at September 30, 2004, and December 31, 2003, respectively. At September 30, 2004, the Company’s balance of cash and cash equivalents totaled $26.6 million. However, the Company incurred losses from operations for both the year ended December 31, 2003, and the nine months ended September 30, 2004. The Company expects to incur additional losses in the remainder of 2004.

On February 26, 2004, the Company entered into a common stock purchase agreement and registration rights agreement with certain accredited institutional investors, pursuant to which the Company agreed to issue and sell an aggregate of 3,080,000 shares of the Company’s common stock and warrants to purchase up to 1,232,000 shares of the Company’s common stock in a private placement, for an aggregate purchase price of approximately $9.2 million (Note 4). As described more fully in Note 4, due to the Company’s potential obligation to settle the warrants in cash if the terms of the registration rights agreement were not met, the fair value of the warrants were originally recorded as a liability rather than an equity award. The terms of the registration rights agreement were amended in September 2004 and the warrant liability was removed from the liability section into equity.

On July 20, 2004, certain holders of outstanding warrants to purchase shares of the Company’s common stock exercised warrants to purchase an aggregate of 4,473,806 shares of common stock for cash, resulting in gross proceeds of approximately $11.2 million (Note 4). In order to encourage early exercise of the warrants by the warrant holders, the Company agreed to reduce the exercise price with respect to the warrants from a weighted average exercise price of $3.36 per share to $2.50 per share.

On August 6, 2004, the Company closed its merger with SSP-Litronic. At the time of the closing, SSP-Litronic, had $14.8 million in cash, cash equivalents and investment securities and the Company issued 40,137,148 common shares to acquire all of the outstanding common shares of SSP-Litronic. As part of the merger, the Company assumed convertible notes with a principal balance of approximately $1.4 million as of September 30, 2004, which are explained further in Note 6.

The private placement of the Company’s common stock, the reduced pricing for warrants exercised, and the merger with SSP-Litronic provided the Company with a substantial amount of capital, but was dilutive to

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SAFLINK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

stockholders. While the Company does not anticipate the need to raise additional capital after having closed the special warrant offering, future capital needs will depend on many factors including, but not limited to:

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

This discussion and analysis should be read in conjunction with our unaudited condensed consolidated financial statements and accompanying notes included in this document and our 2003 audited consolidated financial statements and notes thereto included in our annual report on Form 10-K, which was filed with the Securities and Exchange Commission on March 30, 2004.

This quarterly report on Form 10-Q contains statements and information about management’s view of our future expectations, plans and prospects that constitute forward-looking statements for purposes of the safe harbor provisions under the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties that could cause actual results and events to differ materially from those anticipated, including the factors described in the sections of this quarterly report on Form 10-Q entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Factors That May Affect Future Results.” We undertake no obligation to publicly release the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events, conditions or circumstances.

The following management’s discussion and analysis of financial condition and results of operations should be read in conjunction with management’s discussion and analysis of financial condition and results of operations included in our annual report on Form 10-K for the year ended December 31, 2003.

As used in this quarterly report on Form 10-Q, unless the context otherwise requires, the terms “we,” “us,” “our,” “the Company,” and “SAFLINK” refer to SAFLINK Corporation, a Delaware corporation, and its subsidiaries.

Overview

We offer biometric security, smart card, and public key infrastructure (“PKI”) solutions that protect intellectual property, secure information assets, and eliminate passwords. Our software provides Identity Assurance Management^™, allowing administrators to verify the identity and control access to computer networks, physical facilities, applications, and time and attendance systems.

Our products are designed to eliminate the problems associated with password management by measuring human characteristics such as voiceprint, fingerprint, iris pattern, and facial contours, which are virtually impossible to duplicate. This type of authentication makes it more convenient for end-users to access their computer accounts or facilities, while improving the security of these accounts and reducing the overhead costs of maintaining them.

Our products are designed for large-scale and complex computer networks, facilities, and manufacturing automation systems, and allow users seeking access or performing transactions to be identified using various biometric or smart card technologies. Our products comply with recognized industry standards, which allow us to integrate a large variety of technologies within a common application environment without costly development related to each technology. Our products also provide our customers with the flexibility to deploy a mixture of different biometric or smart card technologies within their network to meet specific user and environmental requirements while providing protection against technology obsolescence since new devices can be added to, or upgraded within, the system without replacing or modifying the underlying network support infrastructure.

We derive revenue from license fees for software products, manufactured hardware sales, the reselling of hardware and third-party software that is complimentary to our core products, and from fees for services relating to the software and hardware products including maintenance services, training, installation, and programming and integration consulting services.

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Merger with SSP Solutions, Inc.

On August 6, 2004, we completed our merger transaction with SSP Solutions, Inc., dba SSP-Litronic, following which SSP-Litronic became a wholly-owned subsidiary of SAFLINK. In the merger, we acquired all of the outstanding shares of SSP-Litronic common stock in a stock-for-stock transaction where each outstanding share of SSP-Litronic common stock was converted into the right to receive 0.6 shares of our common stock. We issued 40,137,148 shares of our common stock in exchange for the outstanding shares of SSP-Litronic common stock.

In connection with the merger, we assumed each option, warrant and promissory note exercisable for or convertible into shares of SSP-Litronic common stock, and those securities are now exercisable for or convertible into shares of our common stock, with appropriate adjustments to reflect the merger. We filed with the Securities and Exchange Commission (“SEC”) a registration statement on Form S-4, which became effective on June 28, 2004, with respect to the shares of our common stock issued in the merger. In addition, we filed with the SEC a registration statement on Form S-8 on August 13, 2004, to register the shares of our common stock issuable upon exercise of the assumed options held by then current employees and consultants of SSP-Litronic. On October 15, we filed a current report on Form 8-K that included; 1) the unaudited condensed consolidated financial statements of SSP Solutions, Inc. at and for the three and six month periods ended June 30, 2004 and 2003, 2) SAFLINK and SSP Solutions, Inc. unaudited pro forma condensed consolidated financial statements for the twelve month period ended December 31, 2003, and at and for the six month period ended June 30, 2004, and 3) consolidated financial statements of SSP Solutions, Inc. as of December 31, 2003, and 2002, and for each of the years in the two-year period ended December 31, 2003. Also on October 15, 2004, we filed a registration statement with the SEC on Form S-3 related to the resale of the shares of our common stock issuable upon exercise or conversion of warrants, promissory notes, and certain other options assumed by us in the merger.

Immediately following the effective time of the merger, our board of directors was reconstituted to consist of the following six directors: Glenn L. Argenbright, Gordon E. Fornell, Richard P. Kiphart, Steven M. Oyer, Kris Shah and Marvin J. Winkler. Since the closing of the merger, Lincoln D. Faurer and Frank J. Cillufo were elected to the board of directors on September 30, 2004 and October 25, 2004, respectively. In addition, on August 9, 2004, SSP-Litronic, changed its name to Litronic, Inc. (“Litronic”) following the filing of an amendment to its certificate of incorporation with the Secretary of State of the State of Delaware.

Litronic is a global provider of digital identity management and information assurance products for the government and enterprise markets. By facilitating the deployment, management, and use of digital certificates and smart cards, Litronic’s products provide strong authentication solutions to protect valuable information as it is transmitted electronically. We believe that our merger with Litronic will help us to broaden our customer base and will enable us to be able to offer an integrated smart card plus biometric solution to the government and commercial sectors.

Asset Purchase from BSG and ISS

On December 29, 2003, we acquired certain assets and rights used in connection with the digital identity and biometric-enhanced physical access security business of Information Systems Support, Inc., a Maryland corporation (“ISS”) and Biometric Solutions Group, Inc., a Delaware corporation (“BSG”). We accounted for the purchase arrangement as a business combination. The primary reason we made the purchase was to expand our market by entering the physical access market and to meld the physical access product into our existing logical access product. This technology also plays a vital role in the manufacturing automation systems market.

Critical Accounting Policies and Estimates

Our discussion and analysis of financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and

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judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of commitments and contingencies. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Revenue Recognition

We believe a critical accounting policy is revenue recognition and it affects the more significant judgments and estimates used in the preparation of our condensed consolidated financial statements. We derive revenue from license fees for software products, manufactured hardware sales, reselling of hardware and third-party software, and fees for services relating to the software products including maintenance services, technology and programming consulting services.

We recognize revenue in accordance with the provisions of Statement of Position 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by SOP 98-9 and related interpretations, including Technical Practice Aids, which provides specific guidance and stipulates that revenue recognized from software arrangements is to be allocated to each element of the arrangement based on the relative fair values of the elements, such as software products, upgrades, enhancements, post-contract customer support, installation, integration and/or training. Under this guidance, the determination of fair value is based on objective evidence that is specific to the vendor. In multiple element arrangements in which fair value exists for undelivered elements, the fair value of the undelivered elements is deferred and the residual arrangement fee is assigned to the delivered elements. If evidence of fair value for any of the undelivered elements does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist, or until all elements of the arrangement are delivered.

Revenue from software or data security license fees is recognized upon delivery, net of an allowance for estimated returns, provided persuasive evidence of an arrangement exists, collection is probable, the fee is fixed or determinable, and vendor-specific objective evidence exists to allocate the total fee to elements of the arrangement. If customers receive pilot or test versions of products, revenue from these arrangements is recognized upon customer acceptance of permanent license rights. If our software is sold through a reseller, revenue is recognized when the reseller delivers its product to the end-user. Certain software delivered under a license requires a separate annual maintenance contract that governs the conditions of post-contract customer support. Post-contract customer support services can be purchased under a separate contract on the same terms and at the same pricing, whether purchased at the time of sale or at a later date. Revenue from these separate maintenance support contracts is recognized ratably over the maintenance period. Other software delivered under a license includes a first year of maintenance, in which case the value of such maintenance is recognized ratably over the initial license period. The value of such deferred maintenance revenue is established by the price at which the customer may purchase a renewal maintenance contract.

Revenue from some data security hardware products contains embedded software. However, the embedded software is incidental to the hardware product sale. We also act as a reseller of third-party hardware and software applications. Such revenue is recognized upon delivery of the hardware, provided that all other conditions above have been met.

Service revenue includes payments under support and upgrade contracts and consulting fees. Support and upgrade revenue is recognized ratably over the term of the contract, which typically is twelve months. Consulting revenue primarily relates to installation, integration and training services performed on a time-and-materials or fixed-fee basis under separate service arrangements. Fees from consulting are recognized as services are performed. If a transaction includes both license and service elements, license fees are recognized separately upon delivery of the licensed software, provided services do not include significant customization or modification of the software

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product, the licenses are not subject to acceptance criteria, and vendor-specific objective evidence exists to allocate the total fee to elements of the arrangement. If the services do include significant customization or modification of the software product, the revenue is recognized in accordance with Accounting Research Bulletin No. 45, Long-Term Construction Type Contracts (ARB 45), using the relevant guidance from the American Institute of Certified Public Accountants Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts (SOP 81-1).

Our revenue recognition policies are in accordance with the Securities and Exchange Commission’s Staff Accounting Bulletin No. 101, as amended by Staff Accounting Bulletin No. 104.

Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter and could result in future operating losses.

Goodwill

Goodwill represents the excess of costs over fair value of assets of businesses acquired. We have applied the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), since adoption on January 1, 2002. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS No. 142.

We assess the impairment of goodwill on an annual basis or whenever events or changes in circumstances indicate that the fair value of the reporting unit to which goodwill relates is less than the carrying value. Factors we consider important which could trigger an impairment review include the following:

If we were to determine that the fair value of a reporting unit was less than its carrying value, including goodwill, based upon the annual test or the existence of one or more of the above indicators of impairment, we would measure impairment based on a comparison of the implied fair value of reporting unit goodwill with the carrying amount of goodwill. The implied fair value of goodwill is determined by allocating the fair value of a reporting unit to its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of reporting unit goodwill. To the extent the carrying amount of reporting unit goodwill is greater than the implied fair value of reporting unit goodwill, we would record an impairment charge for the difference.

Impairment of Long-Lived Assets

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Asset” (SFAS No. 144), long-lived assets, such as property, plant, and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset.

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Results of Operations

We believe that period-to-period comparisons of our operating results may not be a meaningful basis to predict our future performance. You should consider our prospects in light of the risks, expenses and difficulties frequently encountered by companies in new and rapidly evolving markets and those described in this quarterly report and in our annual report on Form 10-K for the year ended December 31, 2003. We may not be able to successfully address these risks and difficulties.

We incurred net losses attributable to common stockholders of $7.2 million and $11.6 million for the three and nine months ended September 30, 2004, respectively. These results include a non-cash charge of $2.2 million related to the modification of warrants in July 2004. This is compared to net losses attributable to common stockholders of $2.5 million and $7.9 million for the three and nine months ended September 30, 2003, respectively. The net losses attributable to common stockholders for the three and nine months ended September 30, 2004, included a non-cash loss of $29,000 and a non-cash gain of $1.8 million, respectively, from the change in valuation of warrants outstanding that were issued in connection with our February 2004 financing.

The following discussion presents certain changes in our revenue and expenses that have occurred during the three and nine months ended September 30, 2004, as compared to the three and nine months ended September 30, 2003.

Revenue and Cost of Revenue

We recorded revenue primarily from four sources during the three and nine months ended September 30, 2004, and 2003: software licenses, manufactured hardware, third party hardware and software, and services. Product revenue consisted of revenue from sales of licenses to use software produced by us, the sale of hardware produced by us, and from the re-sale of hardware and software applications purchased from third parties. Service revenue consisted of revenue from post-contract customer support, consulting and integration services, and training. During the three months ended September 30, 2004, software license sales were $199,000, sales of hardware and third party software were $1.7 million, while service revenue was $487,000. During the same period in 2003, software license sales were $169,000, while sales of hardware and services were $162,000 and $432,000, respectively. Total revenue of $2.4 million for the three months ended September 30, 2004, increased $1.6 million, or 216%, from revenue of $763,000 for the three months ended September 30, 2003. The increase in total revenue can primarily be attributed to the addition of Litronic sales, which were combined with ours beginning August 6, 2004. Revenue of $4.1 million for the nine months ended September 30, 2004, increased $2.6 million, or 171%, from revenue of $1.5 million for the nine months ended September 30, 2003. This increase for the nine months can also be primarily attributed to sales related to Litronic and a larger direct sales force when compared to the same period in 2003.

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Total cost of revenue included product cost of revenue and service cost of revenue. Product cost of revenue consisted of packaging and production costs for our software and manufactured hardware sales, and cost of hardware and software applications purchased from third parties. Service cost of revenue consisted of labor and expenses for post-contract customer support, consulting and integration services, and training. During the three months ended September 30, 2004, cost of revenue from software, hardware and third party software, and services were $1,000, $850,000 and $311,000, respectively. Cost of revenue also included amortization of intangibles of $463,000 for the three months ended September 30, 2004, which was related to the acquisition of assets from BSG and our merger with Litronic. During the same period in 2003, cost of revenue from software, hardware and services were $2,000, $123,000 and $175,000, respectively. There was no amortization of intangibles included in cost of revenue for three months ended September 30, 2003. Total cost of revenue for the three months ended September 30, 2004, of $1.6 million, increased $1.3 million, or 442%, from cost of revenue of $300,000 for the same period in 2003. This increase was primarily due to higher revenue in this period when compared to the same period in 2003, as well as the addition of intangible asset amortization to the cost of revenue related to the Litronic merger. Total cost of revenue of $2.8 million for the nine months ended September 30, 2004, increased $2.2 million, or 401%, from $554,000 during the same period in 2003. This increase can be attributed to the significantly higher revenue during the first nine months in 2004 when compared to the same period in 2003, as well as the added intangible asset amortization.

Our gross margins for the three months ended September 30, 2004, and 2003, were 33% and 61%, respectively. This decrease in gross margin was primarily due to the addition of intangible amortization related to the BSG acquisition and Litronic merger. Gross margins for the nine months ended September 30, 2004, and 2003, were 33% and 64%, respectively. This decrease was primarily due to the addition of intangible asset amortization in 2004 and the recognition of $110,000 in revenue during the first three months of 2003 from the expiration of a non-recurring service contract for which there were no direct costs of revenue recognized during that period.

With the closing of our merger with Litronic on August 6, 2004, our future gross margin results will be dependent upon revenue levels, since cost of revenue will now include amortization of intangible assets related to the Litronic merger, which will be approximately $671,000 next quarter and in all quarters of 2005, assuming no impairment to the intangible asset values.

Operating Expenses

Total operating expenses for the three months ended September 30, 2004, increased $2.8 million, or 96%, to $5.8 million from $3.0 million for the comparable period in 2003. This increase was largely due to the merger with Litronic which approximately doubled our headcount. From a functional operating expense perspective, this increase was primarily due to increased compensation and related benefits ($1.9 million), slightly increased travel and entertainment expenses ($59,000), increased advertising and promotion ($135,000), increased occupancy costs ($154,000), increased legal and professional services ($267,000), increased expense related to amortization and depreciation ($56,000), increased telephone and internet ($33,000), and other general costs ($242,000).

The following table provides a breakdown of the dollar and percentage changes in operating expenses for the three and nine months ended September 30, 2004, as compared to the same periods in 2003 (in thousands):

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Product Development—Product development expenses consist primarily of salaries, benefits, supplies and equipment for software developers, hardware engineers, product management and quality assurance personnel, as well as legal fees associated with protection and commercialization of our intellectual property. Product development expenses increased $970,000 during the three months ended September 30, 2004, compared to the same period in 2003. This increase was primarily due to increased headcount and facility costs in connection with our merger with Litronic. This overall net increase in product development expenses consisted of increases in the following functional categories: compensation and benefits ($703,000), occupancy ($62,000), travel and lodging ($51,000), legal and professional ($96,000), and a net increase in other general costs ($58,000).

For the nine months ended September 30, 2004, product development expenses increased $1.5 million compared to the same period in 2003. This increase was primarily due to increased in headcount, related to the acquisition of assets from BSG and the merger with Litronic, as well as the related benefits, travel expenses and occupancy costs for those employees.

With the closing of our Litronic merger, we expect that our product development expenses will increase slightly next quarter as we will include an entire three month period of Litronic operations in our consolidated results.

Sales and Marketing—Sales and marketing expenses consist primarily of salaries and commissions earned by sales and marketing personnel, trade show and promotional expenses, and travel and entertainment costs. Sales and marketing expenses increased $842,000 during the three months ended September 30, 2004, compared to the same period in 2003. This increase was primarily due to increased headcount and related benefits due to the Litronic merger. This overall net increase in sales and marketing expenses consisted of increases in the following functional categories: compensation and benefits ($509,000), occupancy ($42,000), advertising and promotion ($135,000), professional services ($107,000), and a net increase in other general expenses ($64,000), offset by a decrease in travel and lodging ($15,000).

For the nine months ended September 30, 2004, sales and marketing expenses increased $1.4 million compared to the same period in 2003. This increase was primarily due to increases in headcount and related benefits associated with the build out of our direct sales team and the additional headcount and occupancy costs related to the merger with Litronic.

With the closing of our merger with Litronic, we expect that our sales and marketing expenses will increase slightly next quarter as we will include an entire three month period of Litronic operations in our consolidated results. Commissions are a variable cost that will fluctuate with revenue and could substantially impact the operating expense results of sales and marketing.

General and Administrative—General and administrative expenses consist primarily of salaries, benefits and related costs for our executive, finance, human resource, information technology and administrative personnel, professional services fees and allowances for bad debts. General and administrative expenses increased $727,000, during the three months ended September 30, 2004, compared to the same period in 2003. This increase consisted primarily of increases in compensation and benefits ($370,000), legal and professional services ($105,000), occupancy ($50,000), depreciation and amortization ($17,000), and a net increase in insurance and other general expenses ($185,000). This overall net increase can be attributed to the merger with Litronic. The increase in professional services can be attributed to consulting fees paid to ex-SSP-Litronic executives assisting in the merger integration.

For the nine months ended September 30, 2004 general and administrative expenses increased $1.1 million compared to the same period in 2003. This increase was primarily due to increases in headcount and related benefits and legal and professional services related to the merger with Litronic.

With the closing of our merger with Litronic, we expect that our general and administrative expenses will increase slightly next quarter as we will include an entire three month period of Litronic operations in our

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consolidated results. In addition, we expect to incur increased spending on professional services, consulting and travel as we work to integrate the two companies and comply with certain provisions of the Sarbanes-Oxley Act of 2002.

Amortization of Intangibles—Amortization of intangibles comes from the assets created from non-competition agreements as a result of our acquisition of BSG in December 2003 and our merger with Litronic in August 2004. Amortization of intangibles, which relates to non-competition agreements, totaled $30,000 and $0, during the three months ended September 30, 2004, and 2003, respectively. Amortization of intangibles for the nine months ended September 2004, and 2003, was $58,000 and $0, respectively. Amortization of intangibles will increase in the next quarter and in 2005 because Litronic operations will be combined with our results going forward.

Stock-based Compensation—Stock-based compensation primarily consists of the amortization of deferred compensation related employee grants of options to purchase common stock or restricted stock and options to purchase common stock granted for professional services. Stock-based compensation increased $274,000, during the three months ended September 30, 2004, compared to the same period in 2003. This increase consisted of an increase in amortization related to employee deferred compensation ($315,000), offset by a decrease in stock-based compensation related to professional services ($41,000).

For the nine months ended September 30, 2004, stock-based compensation decreased $262,000 compared to the same period in 2003. This decrease was primarily due to a decrease in stock-based compensation for professional services ($595,000), offset by an increase in amortization related to employee deferred compensation ($333,000).

Interest expense

Interest expense for the three and nine months ended September 30, 2004, was $22,000, compared to $6,000 and $11,000, respectively, for the same periods in 2003. Interest expense during 2004 and 2003 consisted of interest accrued from the financing of certain insurance policies over a nine month period. Interest expense during the three and nine months ended September 30, 2004, also included expense related to convertible notes assumed in the Litronic merger.

Other income

Other income for the three and nine months ended September 30, 2004, was $73,000 and $107,000, respectively, compared to $20,000 and $51,000, respectively, for the same periods in 2003. Other income primarily consisted of interest earned on cash, money market balances and short-term certificates of deposit. The increase was due to increased cash balances during 2004 when compared to 2003.

Change in fair value of outstanding warrants

Change in fair value of outstanding warrants for the three and nine months ended September 30, 2004, resulted in a loss of $29,000 and a gain of $1.8 million, respectively. The non-cash loss for the three months ended September 30, 2004, is related to marking to market the warrants issued in connection with our February 2004 financing, and represents the change in estimated fair value between the last day of the previous reporting period, June 30, 2004, and the day in which the registration rights agreement was amended, September 28, 2004. We amended the registration rights agreement to substitute our cash obligation to remedy any conditions that were not met, with shares of common stock instead. The fair value of the outstanding warrants as of September 28, 2004, was reclassified to equity as the potential cash penalties related to not meeting certain criteria specified in these warrants were amended to be remedied in our common stock, thus eliminating the debt characteristics of these warrants.

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Our Series A warrants and the related placement agent warrants that were issued on June 5, 2001, contain a cash redemption provision that is triggered if we issue, in a business combination, capital stock that represents more than 40% of our outstanding common stock immediately prior to such issuance. The Litronic merger qualified as a triggering event because we issued more than 40% of its common stock in connection with the merger. The cash redemption value was measured as of August 2, 2004, the date the warrant holders were officially notified of the merger by us, and, in accordance with the warrant provisions, using a Black-Scholes model with the following assumptions: an expected dividend yield of 0.0%, a risk-free interest rate of 2.5%, a volatility of 105%, and a remaining contractual life of 1.8 years, as the warrants expire on June 5, 2006. As of August 2, 2004, there were Series A warrants and placement agent warrants outstanding to purchase 244,000 and 192,000 shares of our common stock, respectively. Exercise prices of the warrants ranged from $1.30 to $3.06. The total cash redemption value was estimated to be $765,000 as of August 2, 2004, and is fixed as long as the warrants are outstanding.

On August 6, 2004, the closing date of the merger, these warrants were reclassified as a long-term liability in accordance with SFAS 150 because the warrants now contain characteristics of a debt instrument. The outstanding warrants were valued as of September 30, 2004, using a Black-Scholes model with the following assumptions: an expected dividend yield of 0.0%, a risk-free interest rate of 2.5%, volatility of 75%, and a remaining contractual life of 1.7 years. The value of the warrants includes the value of the cash redemption provision, which was determined using a Black-Scholes model with similar assumptions. The value of the warrants was estimated to be $937,000, as of September 30, 2004, and is classified as a long-term liability. Each interim period and year end, the remaining outstanding warrants will be revalued and any difference from the previous valuation date will be recognized as a change in fair value of outstanding warrants.

Income tax provision

We recorded an income tax provision of $12,000 for the three months ended September 30, 2004, and have recorded a total of $38,000 in income tax provision for the nine months ended September 30, 2004. This represents the income tax effect of goodwill amortization created by the BSG asset purchase. For tax purposes the goodwill is amortized over 15 years whereas for book purposes the goodwill is not amortized, but instead tested at least annually for impairment. The effective tax rate applied to the goodwill amortization deductible for tax purposes was 36%. There was no tax provision or benefit recorded during the comparable periods in 2003.

Liquidity and Capital Resources

We financed our operations during the nine months ended September 30, 2004, primarily from our working capital. As of September 30, 2004, our principal source of liquidity largely consisted of $26.6 million of cash and cash equivalents.

We expended $12.9 million in operating activities during the first nine months of 2004, compared to $8.3 million for the same period in 2003. The net loss of $9.4 million for the nine months ended September 30, 2004, which was reduced by a non-cash warrant valuation gain of $1.8 million, represents the majority of the cash used in operations. Significant adjustments to the net loss were increases of $1.4 million and $751,000 in accrued liabilities and accounts payable, respectively, and an increase of $836,000 in other current assets.

Investing activities provided a net $12.8 million during the nine months ended September 30, 2004. We acquired $13.4 million in cash, net of transaction costs paid, as a result of the merger with Litronic. We used $539,000 for purchases of furniture, equipment and software to support our increased headcount and to increase operating efficiency, compared to $546,000 for the same period in 2003.

Net cash provided from financing activities was $19.6 million in the first nine months of 2004, compared to $11.4 million during the same period in 2003. During the first nine months of 2004, we received $8.6 million in net proceeds in connection with our February 2004 financing. We also received $10.8 million in exercises of

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warrants, primarily from the July special warrant offer, and $177,000 from options to purchase our common stock. During the first nine months of 2003, cash provided by financing activities included $9.9 million in net proceeds for various warrant exercises and $1.5 million from stock option exercises.

Cash and working capital as of September 30, 2004, were $26.6 million and $25.7 million, compared to $7.1 million and $6.7 million as of December 31, 2003, respectively. The increase in our cash and working capital as of September 30, 2004, compared to December 31, 2003, was primarily due to the net proceeds of $8.6 million from our February 2004 financing, net proceeds of $10.8 million from the July 2004 special warrant offering, and $13.4 million acquired in the Litronic merger, net of direct merger costs paid. These proceeds were offset by normal operating expenses and merger-related fees.

We have incurred significant costs to develop our technology, products and services and to hire employees in our sales, marketing and administration departments, in addition to incurring non-cash compensation costs. To date, we have not generated significant revenue from the sale of our products and services when compared to our operating expenses. As a result, we have incurred significant net losses since inception, significant negative cash flows from operations in the periods from inception through September 30, 2004, and as of September 30, 2004, we had an accumulated deficit of $107.5 million. These losses have been funded primarily through the issuance of convertible preferred stock, common stock and warrants to purchase common stock.

As a result of the $11.2 million in gross proceeds from warrant exercises in July 2004 and the closing of the Litronic merger, we have increased our cash and cash equivalents balance to $26.6 million as of September 30, 2004. We believe we have sufficient funds to continue our combined operations beyond December 31, 2005, assuming no significant and unexpected uses of cash. However, our forecast is based upon certain assumptions, which may differ from actual future outcomes. Additionally, without a substantial increase in sales or a reduction in expenses, we will continue to incur operating losses. Other than the $750,000 accounts receivable financing line maintained by Litronic, we currently do not have a credit line or other borrowing facility to fund our operations.

Our significant fixed commitments with respect to note obligations, leases and inventory purchases as of September 30, 2004, were as follows (in thousands):

Our February 2004 financing, the July 2004 reduced pricing for warrants exercised, and the Litronic merger provided us with a substantial amount of capital, but were dilutive to stockholders. While we do not anticipate the need to raise additional capital after having closed the February 2004 financing, the Litronic merger and the July 2004 special warrant offering, our future capital needs will depend on many factors including, but not limited, to:

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Changes in these factors, among others, may require us to raise additional capital in the future. We have funded our operations primarily through the issuance of equity securities to investors and may not be able to generate a positive cash flow in the future. If we are unable to generate sufficient cash flow from operations, we will need to seek additional funds through the issuance of additional equity or debt securities or other sources of financing. We may not be able to secure such additional financing on favorable terms, or at all. Any additional financings will likely cause substantial dilution to existing stockholders. If we are unable to obtain necessary additional financing, we may be required to reduce the scope of, or cease, our operations.

Factors That May Affect Future Results

This quarterly report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. Our business, operating results, financial performance, and share price may be materially adversely affected by a number of factors, including but not limited to the following risk factors, any one of which could cause actual results to vary materially from anticipated results or from those expressed in any forward-looking statements made by us in this quarterly report on Form 10-Q or in other reports, press releases or other statements issued from time to time. Additional factors that may cause such a difference are set forth elsewhere in this quarterly report on Form 10-Q.

In addition to other information contained in this quarterly report on Form 10-Q, the following factors, among others, sometimes have affected, and in the future could affect our actual results and could cause future results to differ materially from those in any forward looking statements made by us or on our behalf. Factors that could cause future results to differ from expectations include, but are not limited to the following:

Our ability to integrate successfully the business of Litronic with our own business is uncertain.

We completed our merger transaction with SSP-Litronic on August 6, 2004, and we are in the process of integrating our operations with the business of Litronic. The integration will require significant effort on our part, including the coordination of our research and development and sales and marketing efforts. We may find it difficult to integrate the operations of Litronic, and vice versa. We have a large number of employees in widely dispersed operations in California, Washington, Virginia and other locations, which increases the difficulty of integrating operations. Litronic personnel may leave Litronic because of the merger. Litronic customers, distributors or suppliers may terminate their arrangements with Litronic, or demand amended terms to these arrangements. The challenges involved in this integration include, but are not limited to, the following:

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We cannot be certain that we will successfully integrate the business of Litronic in a timely manner or at all, or that we will realize any of the anticipated benefits from the merger. Risks associated with the failure to integrate the business of Litronic in a timely manner, or at all, include:

We have accumulated significant losses and may not be able to generate significant revenue or any net income in the future, which would negatively impact our ability to run our business.

We have accumulated net losses of approximately $107.5 million from our inception through September 30, 2004. We have continued to accumulate losses after September 30, 2004, to date and we may be unable to generate significant revenue or any net income in the future. We have funded our operations primarily through the issuance of equity securities to investors and may not be able to generate a positive cash flow in the future. If we are unable to generate sufficient cash flow from operations, we will need to seek additional funds through the issuance of additional equity or debt securities or other sources of financing. We may not be able to secure such additional financing on favorable terms, or at all. Any additional financings will likely cause substantial dilution to existing stockholders. If we are unable to obtain necessary additional financing, we may be required to reduce the scope of, or cease, our operations.

We have not generated any significant sales of our products within the competitive commercial market, nor have we demonstrated sales techniques or promotional activities that have proven to be successful on a consistent basis, which makes it difficult to evaluate our business performance or our future prospects.

We are just beginning to enter the complex and competitive commercial market for digital commerce and communications security solutions. Potential customers in our target markets are becoming increasingly aware of the need for security products and services in the digital economy to conduct their business. Historically, only enterprises that had substantial resources developed or purchased security solutions for delivery of digital content over the Internet or through other means. Also, there is a perception that security in delivering digital content is costly and difficult to implement. Therefore, we will not succeed unless we can educate our target markets about the need for security in delivering digital content and convince potential customers of our ability to provide this security in a cost-effective and easy-to-use manner. Even if we convince our target markets about the importance of and need for such security, there can be no assurance that it will result in the sale of our products. We may be unable to establish sales and marketing operations at levels necessary for us to grow this portion of our business, especially if we are unsuccessful at selling our products into vertical markets. We may not be able to support the promotional programs required by selling simultaneously into several markets. If we are unable to develop an efficient sales system, or if our products or components do not achieve wide market acceptance, then our operating results will suffer and our earnings per share will be adversely affected.

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A significant number of shares of our common stock are or will be eligible for sale in the open market, which could reduce the market price for our common stock and make it difficult for us to raise capital.

In our merger transaction with Litronic we assumed options, warrants and convertible promissory notes of Litronic that, as of November 10, 2004, represented the right to acquire 3,409,427 shares of our common stock, 2,303,911 of which have exercise or conversion prices below the fair market value of our common stock of $2.34 as of November 10, 2004.

As of November 10, 2004, 79,327,413 shares of our common stock were outstanding. In addition, including the securities assumed in the Litronic merger, there were 13,009,009 million shares of our common stock issuable upon exercise or conversion of outstanding options, warrants, and convertible promissory notes. We have issued options and warrants to acquire shares of common stock to our employees and certain other persons at various prices, some of which have exercise prices below the current market price for our common stock. As of November 10, 2004, options to acquire 8,177,806 shares of our common stock were outstanding and our existing stock incentive plan had 3,972,749 shares available for future issuance.

The issuance of a large number of additional shares of our common stock upon the exercise or conversion of outstanding options, warrants or convertible promissory notes would cause substantial dilution to existing stockholders and could decrease the market price of our common stock due to the sale of a large number of shares of common stock in the market, or the perception that these sales could occur. These sales, or the perception of possible sales, could also impair our ability to raise capital in the future.

Because they own approximately 52% of our common stock, seven stockholders could significantly influence our affairs, which may preclude other stockholders from being able to influence stockholder votes or corporate actions.

Seven of our stockholders (together with their affiliates) beneficially own approximately 52% of our outstanding common stock as of November 10, 2004. Given this substantial ownership, if they decided to act together, they would be able to significantly influence the vote on those corporate matters to be decided by our stockholders. In addition, these stockholders hold options, warrants and convertible promissory notes representing the right to acquire an additional 1,362,404 shares of our common stock. If these stockholders exercised their options and warrants and converted their promissory notes in full, they would own approximately 53% of our outstanding common stock. Such concentrated ownership may decrease the value of our common stock and could significantly influence our affairs, which may preclude other stockholders from being able to influence stockholder votes.

If the market for our products and services does not experience significant growth or if our biometric and smart card products do not achieve broad acceptance in this market, our ability to generate significant revenue in the future would be limited and our business would suffer.

A substantial portion of our product revenue and a portion of our service revenue are derived from the sale of biometric and smart card products and services. Biometric and smart card solutions have not gained widespread acceptance. We cannot accurately predict the future growth rate of this market, if any, or the ultimate size of the biometric and smart card technology market. The expansion of the market for our products and services depends on a number of factors such as:

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Even if biometric and smart card solutions gain wide market acceptance, our products and services may not adequately address market requirements and may not gain wide market acceptance. If biometric or smart card solutions or our products and services do not gain wide market acceptance, our business and our financial results will suffer.

Our reported financial results will suffer as a result of purchase accounting treatment, the impact of amortization of certain intangibles relating to the merger with Litronic and the direct transaction costs of the merger, and may suffer further if goodwill is deemed in the future to have been impaired.

We have accounted for the merger as a purchase of Litronic by us under the purchase method of accounting. Under purchase accounting, we recorded the fair value of the consideration given for the Litronic common stock and for options and warrants to purchase Litronic common stock assumed by us, plus the amount of direct transaction costs, as the cost of acquiring Litronic. We allocated these costs to the individual assets acquired and liabilities assumed, including various identifiable intangible assets such as developed technology, acquired trade names, acquired patents, customer relationships, and non-competition agreements based on their respective fair values. Goodwill will be tested at least annually, and may be deemed in the future to have been impaired. As a result, the purchase accounting treatment for the merger will result in a reduction of earnings and earning per share for the foreseeable future. This change could cause the market price of our stock to decline.

Any acquisition we make in the future could disrupt our business and harm our financial condition.

To date, most of our revenue growth has been created by acquisition. In any future acquisitions or business combinations, we are subject to numerous risks and uncertainties, including:

We may not be able to successfully complete the integration of the businesses, products or technologies or personnel in the businesses or assets that we might acquire in the future, and any failure to do so could disrupt our business and seriously harm our financial condition.

We have depended on a limited number of customers for a substantial percentage of our revenue, and due to the non-recurring nature of these sales, our revenue in any quarter may not be indicative of future revenue.

One customer accounted for 15% (Bearing Point) of our revenue for the nine months ended September 30, 2004, while two customers accounted for 29% and 11% of our revenue for the nine months ended September 30, 2003. A substantial reduction in revenue from any of our significant customers would adversely affect our business unless we were able to replace the revenue received from those customers. As a result of this concentration of revenue from a limited number of customers, our revenue has experienced wide fluctuations, and we may continue to experience wide fluctuations in the future. Many of our sales are not recurring sales, and quarterly and annual sales levels could fluctuate and sales in any period may not be indicative of sales in future periods.

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Government sales accounted for 89% and 71% of our revenue for the three and nine months ended September 30, 2004, respectively. Government customers accounted for 90% and 8% of our ending accounts receivable for the periods ending September 30, 2004, and 2003, respectively.

Doing business with the United States government entails many risks that could adversely affect us by decreasing the profitability of government contracts we are able to obtain and interfering with our ability to obtain future government contracts.

Sales to United States government agencies accounted for 71% and 22% of Litronic’s consolidated net revenues for the nine months ended September 30th 2004, and 2003, respectively. Our sales to these agencies are subject to risks that include:

In addition, the government may be in a position to obtain greater rights with respect to our intellectual property than we would grant to other entities. Government agencies also have the power, based on financial difficulties or investigations of their contractors, to deem contractors unsuitable for new contract awards. Because we will engage in the government contracting business, we will be subject to audits and may be subject to investigation by governmental entities. Failure to comply with the terms of any government contracts could result in substantial civil and criminal fines and penalties, as well as suspension from future government contracts for a significant period of time, any of which could adversely affect our business by requiring us to spend money to pay the fines and penalties and prohibiting us from earning revenues from government contracts during the suspension period.

Furthermore, government programs can experience delays or cancellation of funding, which can be unpredictable. For example, the U.S. military’s involvement in Iraq has caused the diversion of some Department of Defense funding away from certain projects in which we participate, thereby delaying orders under certain of our government contracts. This makes it difficult to forecast our revenues on a quarter-by-quarter basis.

Our efforts to expand our international operations are subject to a number of risks, including our potential inability to obtain government authorization regarding exports of our products, any of which could adversely affect our future international sales.

We must comply with U.S. laws regulating the export of our products in order to ship internationally. In some cases, authorization from the U.S. government may be needed in order to export our products. The export regimes applicable to our business are subject to frequent changes, as are the governing policies. Although we have obtained approvals to export certain of our products, we cannot assure you that such authorizations to export will be available to us or for our products in the future. If we cannot obtain the required government approvals under these regulations, we may not be able to sell products abroad or make products available for sale internationally.

Additionally, our international operations could be subject to a number of risks, any of which could adversely affect our future international sales, including:

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If third parties, on whom we partly depend for our product distribution, do not promote our products, our ability to generate revenue may be limited and our business and financial condition could suffer.

We utilize third parties such as resellers, distributors and other technology manufacturers to augment our full-time sales staff in promoting sales of our products. If these third parties do not actively promote our products, our ability to generate revenue may be limited. We cannot control the amount and timing of resources that these third parties devote to marketing activities on our behalf. Some of these business relationships are formalized in agreements that can be terminated with little or no notice, which may further decrease the willingness of such third parties to act on our behalf. We also may not be able to negotiate acceptable distribution relationships in the future and cannot predict whether current or future distribution relationships will be successful.

The lengthy and variable sales cycle of some of our products makes it difficult to predict operating results.

Certain of our products have lengthy sales cycles while customers complete in-depth evaluations of the products and receive approvals for purchase. In addition, new product introduction often centers on key trade shows and failure to deliver a product prior to such an event can seriously delay introduction of a product. As a result of the lengthy sales cycles, we may incur substantial expenses before we earn associated revenues because a significant portion of our operating expenses is relatively fixed and based on expected revenues. The lengthy sales cycles make forecasting the volume and timing of orders difficult. In addition, the delays inherent in lengthy sales cycles raise additional risks that customers may cancel or change their minds. If customer cancellations or product delays occur, we could lose anticipated sales.

We may be unable to keep pace with rapid technological change in the information security industry, which could lead to an increase in our costs, a loss of customers or a delay in market acceptance of our products.

Software design and the biometric and smart card technology industry are characterized by rapid development and technological improvements. Because of these changes, our success will depend in part on our ability to keep pace with a changing marketplace, integrate new technology into our software and hardware and introduce new products and product enhancements to address the changing needs of the marketplace. Various technical problems and resource constraints may impede the development, production, distribution and marketing of our products and services. In addition, laws, rules, regulations or industry standards may be adopted in response to these technological changes, which in turn, could materially and adversely affect how we will do business.

Our future success will also depend upon our ability to develop and introduce a variety of new products and services, and enhancements to these new products and services, to address the changing and sophisticated needs of the marketplace. Frequently, technical development programs in the biometric and smart card industry require assessments to be made of the future directions of technology and technology markets generally, which are inherently risky and difficult to predict. Delays in introducing new products, services and enhancements, the failure to choose correctly among technical alternatives or the failure to offer innovative products and services at competitive prices may cause customers to forego purchases of our products and services and purchase those of our competitors.

Continued participation by us in the market for governmental agencies may require the investment of our resources in upgrading our products and technology for us to compete and to meet regulatory and statutory standards. We may not have adequate resources available to us or may not adequately keep pace with appropriate requirements to compete effectively in the marketplace.

Our financial and operating results often vary significantly from quarter to quarter and may be adversely affected by a number of factors.

Our financial and operating results have fluctuated in the past and our financial and operating results could fluctuate in the future from quarter to quarter for the following reasons:

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Particularly important is our need to invest in planned technical development programs to maintain and enhance our competitiveness, and to develop and launch new products and services. Improving the manageability and likelihood of success of such programs requires the development of budgets, plans and schedules for the execution of these programs and the adherence to such budgets, plans and schedules. The majority of such program costs are payroll and related staff expenses, and secondarily materials, subcontractors and promotional expenses. These costs will be very difficult to adjust in response to short-term fluctuations in our revenue, compounding the difficulty of achieving profitability.

Our failure to maintain the proprietary nature of our technology and intellectual property could adversely affect our business, operating results, financial condition and stock price and our ability to compete effectively.

We principally rely upon patent, trademark, copyright, trade secret and contract law to establish and protect our proprietary rights. There is a risk that claims allowed on any patents or trademarks we hold may not be broad enough to protect our technology. In addition, our patents or trademarks may be challenged, invalidated or circumvented, and we cannot be certain that the rights granted thereunder will provide competitive advantages to us. Further, because we do business with the government, we may already have granted, or we may in the future have to grant, greater rights with respect to our intellectual property than we would grant to other entities. Moreover, any current or future issued or licensed patents, or trademarks, or existing or future trade secrets or know-how, may not afford sufficient protection against competitors with similar technologies or processes, and the possibility exists that certain of our already issued patents or trademarks may infringe upon third party patents or trademarks or be designed around by others. In addition, there is a risk that others may independently develop proprietary technologies and processes that are the same as, or substantially equivalent or superior to ours, or become available in the market at a lower price. There is a risk that we have infringed or in the future will infringe patents or trademarks owned by others, that we will need to acquire licenses under patents or trademarks belonging to others for technology potentially useful or necessary to us, and that licenses will not be available to us on acceptable terms, if at all.

We may have to litigate to enforce our patents or trademarks or to determine the scope and validity of other parties’ proprietary rights. Litigation could be very costly and divert management’s attention. An adverse outcome in any litigation could adversely affect our financial results and stock price. We also rely on trade secrets and proprietary know-how, which we seek to protect by confidentiality agreements with our employees, consultants, service providers and third parties. There is a risk that these agreements may be breached, and that the remedies available to us may not be adequate. In addition, our trade secrets and proprietary know-how may otherwise become known to or be independently discovered by others.

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Our reliance on third party technologies for some specific technology elements of our products and our reliance on third parties for manufacturing may delay product launch, impair our ability to develop and deliver products or hurt our ability to compete in the market.

Our ability to license new technologies from third parties will be critical to our ability to offer a complete suite of products that meets customer needs and technological requirements. Some of our licenses do not run for the full duration of the third party’s patent for the licensed technology. We may not be able to renew our existing licenses on favorable terms, or at all. If we lose the rights to a patented technology, we may need to stop selling or may need to redesign our products that incorporate that technology, and we may lose a competitive advantage. In addition, competitors could obtain licenses for technologies for which we are unable to obtain licenses, and third parties may develop or enable others to develop a similar solution to digital communication security issues, either of which events could erode our market share. Also, dependence on the patent protection of third parties may not afford us any control over the protection of the technologies upon which we rely. If the patent protection of any of these third parties were compromised, our ability to compete in the market also would be impaired.

We face intense competition and pricing pressures from a number of sources, which may reduce our average selling prices and gross margins.

The markets for our products and services are intensely competitive. As a result, we face significant competition from a number of sources. We may be unable to compete successfully because many of our competitors are more established, benefit from greater name recognition and have substantially greater financial, technical and marketing resources than we have. In addition, there are several smaller and start-up companies with which we compete from time to time. We expect competition to increase as a result of consolidation in the information security technology industry.

The average selling prices for our products may decline as a result of competitive pricing pressures, promotional programs and customers who negotiate price reductions in exchange for longer-term purchase commitments. The pricing of products depends on the specific features and functions of the products, purchase volumes and the level of sales and service support required. As we experience pricing pressure, the average selling prices and gross margins for our products may decrease over product lifecycles. These same competitive pressures may require us to write down the carrying value of any inventory on hand, which would adversely affect our operating results and adversely affect our earnings per share.

Any compromise of public key infrastructure, or PKI, technology would adversely affect our business by reducing or eliminating demand for many of our information security products.

As a result of our merger with SSP-Litronic, many of our products are now based on PKI technology, which is the standard technology for securing Internet-based commerce and communications. The security afforded by this technology depends on the integrity of a user’s private key, which depends in part on the application of algorithms, or advanced mathematical factoring equations. The occurrence of any of the following could result in a decline in demand for our information security products:

A security breach of our internal systems or those of our customers due to computer hackers or cyber terrorists could harm our business by adversely affecting the market’s perception of our products and services.

Since we provide security for Internet and other digital communication networks, we may become a target for attacks by computer hackers. The ripple effects throughout the economy of terrorist threats and attacks and military

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activities may have a prolonged effect on our potential commercial customers, or on their ability to purchase our products and services. Additionally, because we provide security products to the United States government, we may be targeted by cyber terrorist groups for activities threatened against United States-based targets.

We will not succeed unless the marketplace is confident that we provide effective security protection for Internet and other digital communication networks. Networks protected by our products may be vulnerable to electronic break-ins. Because the techniques used by computer hackers to access or sabotage networks change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques. Although we have never experienced any act of sabotage or unauthorized access by a third party of our internal network to date, if an actual or perceived breach of security for Internet and other digital communication networks occurs in our internal systems or those of our end-user customers, it could adversely affect the market’s perception of our products and services. This could cause us to lose customers, resellers, alliance partners or other business partners.

We may be exposed to significant liability for actual or perceived failure to provide required products or services.

Products as complex as those we offer may contain undetected errors or may fail when first introduced or when new versions are released. Despite our product testing efforts and testing by current and potential customers, it is possible that errors will be found in new products or enhancements after commencement of commercial shipments. The occurrence of product defects or errors could result in adverse publicity, delay in product introduction, diversion of resources to remedy defects, loss of or a delay in market acceptance, or claims by customers against us, or could cause us to incur additional costs, any of which could adversely affect our business. Because our customers rely on our products for critical security applications, we may be exposed to claims for damages allegedly caused to an enterprise as a result of an actual or perceived failure of our products. An actual or perceived breach of enterprise network or information security systems of one of our customers, regardless of whether the breach is attributable to our products or solutions, could adversely affect our business reputation. Furthermore, our failure or inability to meet a customer’s expectations in the performance of our services, or to do so in the time frame required by the customer, regardless of our responsibility for the failure, could result in a claim for substantial damages against us by the customer, discourage customers from engaging us for these services, and damage our business reputation.

Delays in deliveries from suppliers or defects in goods or components supplied by vendors could cause our revenues and gross margins to decline.

Our Litronic business relies on a limited number of vendors for certain components for the products it is developing. Any undetected flaws in components supplied by its vendors could lead to unanticipated costs to repair or replace these parts. Litronic currently purchases some of its components from a single supplier, which presents a risk that the components may not be available in the future on commercially reasonable terms, or at all. For example, Atmel Corporation has completed the masks for production of a specially designed Forté microprocessor for which Litronic developed the Universal Secure Access Operating Security System^™. Commercial acceptance of the Forté microprocessor will depend on continued development of applications to service customer requirements. Any inability to receive or any delay in receiving adequate supplies of the Forté microprocessor, whether as a result of delays in development of applications or otherwise, would adversely affect our ability to sell the Forté PKI card.

We do not anticipate maintaining a supply agreement with Atmel Corporation for the Forté microprocessor. If Atmel Corporation were unable to deliver the Forté microprocessor for a lengthy period of time or were to terminate its relationship with us, we would be unable to produce the Forté PKI card until we could design a replacement computer chip for the Forté microprocessor. This could take substantial time and resources to complete, resulting in delays or reductions in product shipments that could adversely affect our business by requiring us to expend resources while preventing us from selling the Forté PKI card.

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Government regulations affecting security of Internet and other digital communication networks could limit the market for our products and services.

The United States government and foreign governments have imposed controls, export license requirements and restrictions on the import or export of some technologies, including encryption technology. Any additional governmental regulation of imports or exports or failure to obtain required export approval of encryption technologies could delay or prevent the acceptance and use of encryption products and public networks for secure communications and could limit the market for our products and services. In addition, some foreign competitors are subject to less rigorous controls on exporting their encryption technologies. As a result, they may be able to compete more effectively than us in the United States and in international security markets for Internet and other digital communication networks. In addition, governmental agencies such as the Federal Communications Commission periodically issue regulations governing the conduct of business in telecommunications markets that may adversely affect the telecommunications industry and us.

Litronic has outsourced a portion of our commercial software development to India, which could prove to be unprofitable due to risks inherent in international business activities.

Litronic has contracted portions of its commercial software development activities to India in an effort to reduce operating expenses. We are subject to a number of risks associated with international business activities that could adversely affect any operations we may develop in India and could slow our growth. These risks generally include, among others:

Any of these risks could adversely affect our business and results of operations.

Conflicts involving India could adversely affect any operations we may establish in India, which could interfere with our ability to conduct any or all of our other operations.

If we fail to attract and retain qualified senior executive and key technical personnel, our business will not be able to expand.

We will be dependent on the continued availability of the services of our employees, many of whom are individually keys to our future success, and the availability of new employees to implement our business plans. Although our compensation program is intended to attract and retain the employees required for us to be successful, there can be no assurance that we will be able to retain the services of all of our key employees or a sufficient number to execute our plans, nor can there be any assurance that we will be able to continue to attract new employees as required.

Our personnel may voluntarily terminate their relationship with us at any time, and competition for qualified personnel, especially engineers, is intense. The process of locating additional personnel with the combination of skills and attributes required to carry out our strategy could be lengthy, costly and disruptive.

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If we lose the services of key personnel, or fail to replace the services of key personnel who depart, we could experience a severe negative impact on our financial results and stock price. In addition, there is intense competition for highly qualified engineering and marketing personnel in the locations where we will principally operate. The loss of the services of any key engineering, marketing or other personnel or our failure to attract, integrate, motivate and retain additional key employees could adversely affect on our business and financial results and stock price.

Provisions in our certificate of incorporation may prevent or adversely affect the value of a takeover of our company even if a takeover would be beneficial to stockholders.

Our certificate of incorporation authorizes our board of directors to issue up to 1,000,000 shares of preferred stock, the issuance of which could adversely affect our common stockholders. We can issue shares of preferred stock without stockholder approval and upon terms and conditions, and having those types of rights, privileges and preferences, as our board of directors determines. Specifically, the potential issuance of preferred stock may make it more difficult for a third party to acquire, or may discourage a third party from acquiring, voting control of our company even if the acquisition would benefit stockholders.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market rate risk for changes in interest rates relates primarily to money market funds included in our investment portfolio. Investments in fixed rate earning instruments carry a degree of interest rate risk as their fair market value may be adversely impacted due to a rise in interest rates. As a result, our future investment income may fall short of expectations due to changes in interest rates. We do not use any hedging transactions or any financial instruments for trading purposes and we are not a party to any leveraged derivatives.

We have certain foreign operations for which expenses are incurred in local currency. As exchange rates vary, transaction gains or losses will be incurred and may vary from expectations and adversely impact overall profitability. If, in the remainder of 2004, the US dollar uniformly changes in strength by 10% relative to the currency of the foreign operations, our operating results would likely not be significantly affected.

We have a long-term liability related to warrants and the value is dependant upon the market price of our common stock. The value of these warrants is estimated using the Black-Scholes model, which incorporates the market price of our common stock as a significant variable. As long as the warrants are outstanding, this value will fluctuate each reporting period to reflect the change in fair value of these warrants from period to period. This fluctuation will be in the form of a gain or a loss, depending upon the estimated valuation, and will be reflected in the condensed consolidated statement of operations. If, as of September 30, 2004, the closing price of our common stock would have ended 10% higher or lower than the actual close price, our net loss would have been either increased or decreased by approximately $85,000, respectively.

ITEM 4. CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we evaluated the effectiveness of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based on that evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

On August 6, 2004, we completed our merger transaction following which Litronic became our wholly-owned subsidiary. In connection with the merger, we conducted an evaluation of Litronic’s internal controls over financial reporting and believe them to be adequate with respect to the financial information consolidated from Litronic in this quarterly report.

Other than changes resulting from the Litronic merger, there has been no significant change in our internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II—OTHER INFORMATION